Thursday, November 27, 2014

Lessons from the Fiscal Cliff

CAMBRIDGE – One of the many things I learned from Milton Friedman is that the true cost of government is its spending, not its taxes. To put it another way, spending is financed either by current taxes or through borrowing, and borrowing amounts to future taxes, which have almost the same impact on economic performance as current taxes.

We can apply this reasoning to the United States’ unsustainable fiscal deficit. As is well known, closing this deficit requires less spending or more taxes.

The conventional view is that a reasonable, balanced approach entails some of each. But, as Friedman would have argued, the two methods should be considered polar opposites. Less spending means that the government will be smaller. More taxes mean that the government will be larger. Hence, people who favor smaller government (for example, some Republicans) will want the deficit closed entirely by cutting spending, whereas those who favor larger government (for example, President Barack Obama and most Democrats) will want the deficit closed entirely by raising taxes.

As the economist Alberto Alesina has found from studies of fiscal stabilization in OECD countries, eliminating fiscal deficits through spending cuts tends to be much better for the economy than eliminating them through tax increases. A natural interpretation is that spending adjustments work better because they promise smaller government, thereby favoring economic growth.

For a given size of government, the method of raising tax revenue matters. For example, we can choose how much to collect via a general income tax, a payroll tax, a consumption tax (such as a sales or value-added tax), and so on. We can also choose how much revenue to raise today, rather than in the future (by varying the fiscal deficit).

A general principle for an efficient tax system is to collect a given amount of revenue (corresponding in the long run to the government’s spending) in a way that causes as little distortion as possible to the overall economy. Usually, this principle means that marginal tax rates should be similar at different levels of labor income, for various types of consumption, for outlays today versus tomorrow, and so on.

From this perspective, a shortcoming of the US individual income-tax system is that marginal tax rates are high at the bottom (because of means testing of welfare programs) and the top (because of the graduated-rate structure). Thus, the government has moved in the wrong direction since 2009, sharply raising marginal tax rates at the bottom (by dramatically increasing transfer programs) and, more recently, at the top (by raising tax rates on the rich).

One of the most efficient tax-raising methods is the US payroll tax, for which the marginal tax rate is close to the average rate (because deductions are absent and there is little graduation in the rate structure). Therefore, cutting the payroll tax rate in 2011-2012 and making the rate schedule more graduated (on the Medicare side) were mistakes from the standpoint of efficient taxation.

Republicans should consider these ideas when evaluating tax and spending changes in 2013. Going over the “fiscal cliff” would have had the attraction of seriously cutting government spending, although the composition of the cuts – nothing from entitlements and too much from defense – was unattractive. The associated revenue increase was, at least, across the board, rather than the unbalanced hike in marginal tax rates at the top that was enacted.

But the most important part of the deal to avert the fiscal cliff was the restoration of the efficient payroll tax. I estimate that the rise by two percentage points in the amount collected from employees corresponds to about $1.4 trillion in revenue over ten years. This serious revenue boost was not counted in standard reports, because the payroll-tax “holiday” for 2011-2012 had always been treated legally as temporary.

It is true that some macroeconomic modelers, including the Congressional Budget Office, forecasted that going over the cliff would have caused a recession. But those results come from Keynesian models that always predict that GDP expands when the government gets larger. Entirely absent from these models are the negative effects of more government and uncertainty about how fiscal problems will be resolved.

Another recession in the US would not be a great surprise, but it can be attributed to an array of bad government policies and other forces, not to cutting the size of government. Indeed, it is nonsense to think that cuts in government spending should be avoided in the “short run” in order to lower the chance of a recession. If a smaller government is a good idea in the long run (as I believe it is), it is also a good idea in the short run.

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    1. CommentedStefan S

      The answer is quite simple. We need to raise our tax revenues to cover our spending. Those revenues can be found "where the money is": from the wealthy, who have hardly been taxed less while enjoying such wealth, and from the corporations, who have hardly been taxed less while enjoying such profits. A good society--one affording decent wages, fairness, and social justice-- may never be "better for the economy" according to Prof. Barro's lights. Barro fails to account for the ways that effective government promotes the growth of a good life.

    2. CommentedAyse Tezcan

      I believe the Miltonians live in a deeper dreamland than the Keynesians... since we can never show the counterfactual data, each side will keep arguing the causal pathways to demise resulted from activities of the opposing economic viewpoint. And please don't give examples of short-term policy applications; most are laden with uncontrolled confounding. At the end, everyone will subscribe to the economic view that fits one's own perceptions of the world.

    3. CommentedBen Leet

      Federal debt reached a peak in 1946 exceeding 120% of GDP after extensive borrowing. Did this negatively impact economic performance? Between 1949 - 1979 family income grew averaging 2.2% to 2.5% per year among all income groups, all five income quintiles. Between 1979 - 2007 it averaged, per lower to upper quintiles, 0.0%, 0.4%, 0.6%, 0.9%, and 1.5%. The debt/GDP level decreased to around during the 1949-1979 period while marginal tax levels at the top exceeded 70%. This essay begins with an error. I found it unconvincing.

        Commentedjack lasersohn

        Those who make this point always fail to mention that household and business debt was extremely low in 1946, so that the total debt to gdp ratio was only about 140%. Since households must ultimately service all debt, not just fed debt, total debt is what matters. Over the next 60 years total debt went to nearly 250% of GDP as households and businesses leveraged up like crazy(as the new generation forgot the lessons of the Great Depression). There is no question that at least some of the growth during that period was due to this excess leveraging and that is gone forever. For example, the trend of ever increasing house size was almost certainly a case of debt driven excess demand. So the fact that high federal debt was manageable in 1946 is largely irrelevant given the much higher level of overall leverage in the economy today. We are in for a long period of deleveraging and will probably lose at least 1% per year of GDP growth as a result. More federal debt will increase the tendency for households to deleverage and cut back, only making the problem worse, in the long run.

    4. CommentedJose araujo

      Professor, you enter this discussion with a clear dogma smaller government is a good idea, large government is a bad idea, and under this dogma your argument is reasonable.

      The question is why the dogma, why the prejudice against government, you are a scientist, a scholar so you must have learned that you have to reject this kind of thinking.

      One thing we know, and its not a dogma, its empirically verified, is that government is more efficient producing some goods then private initiative. We also know why government is more efficient and we know what kinds of goods they are.

      If with the development of countries the demand of this goods increase (we also know that) then for sake of efficiency government should increase, not decrease.

      You see, if you eliminate your dogma and realize governments not only have to govern (on the strict sense) but also to produce public/social goods you come to the conclusion that government going bigger isn't necessarily a problem , the problem is government producing goods we don't want.

      So since our demand for some social goods increase (things like security, health, education) has we have more money, government should grow this areas since its the more efficient way produce this goods.

    5. CommentedSiddhartha Gadgil

      By calling "to collect a given amount of revenue (corresponding in the long run to the government’s spending) in a way that causes as little distortion as possible to the overall economy" a "general principle" the author has tried to hide the fact that he has not even slightly justified it. And half the article builds on this.

    6. CommentedKen Presting

      "Smaller government" and "spending cuts" are only the latest euphemisms for privatization - converting non-profit public services (often administered with the utmost efficiency) into for-profit enterprises with a captive market. Medicare pays out a higher percentage of what it collects as benefits to clients than any other insurance operation in the country. As consumers, there is no way our competitive position could improve over the monopsony power of a single-payer plan. Any competent economist sees through Mr. Barro's argument without a second thought.

      For those of us who cherish public discussion, the true crisis in American political life is the incursion of paid propagandists into academic life and public debate. The Hoover Institution is emblematic of this. An unbiased department can support itself with grants and students, and will typically have a variety of views among the faculty (um, like Harvard). But when corporate donations dominate the endowment or the budget, corporate interests alone will be advanced.

      No concept is more fundamental to American politics than that our government is us. Those who advocate "smaller government" are forgetting both their Hobbes and their Jefferson. Unless the sovereign has a monopoly on the means of coercion, petty domestic princes who are "too big to fail" will privatize their profits while socializing their risk.

      Government spending is not some external authority making our purchasing decisions for us. It is we ourselves, setting a purchasing strategy together and combining our purchasing power.

      Now, it may be argued that Congress is not truly representative and that their decision are corrupt. I'd agree, but we should discuss that on the other side of this blog.

    7. CommentedProcyon Mukherjee

      Spending cuts versus taxation and the reference to OECD countries is fine, but the question is if we take health care for example, which is a sector that contributes to 17% of U.S. GDP, every % cut would take hundreds of thousands of jobs away. This can be counter-balanced by a far-reaching social program that reduces wastes from the system on one hand and increases optimization of resources on the other with the overall focus on increasing the awareness on health, not on wasteful consumption that leads to an almost deep rooted dependence on 'advertized' medicine that does precious little to health. But do we have patience for such a program to take root that would take decades of restructuring and could actually impact those who benefit from wastes that the current system generates?

      Outside of health care, we have education and infrastructure, where we get into different problems of allocation and mismatch and quality of spending rather than the quantum which takes the shine off the intended and unintended consequences.

    8. Portrait of Pingfan Hong

      CommentedPingfan Hong

      The size of the government in an economy is more a political issue than a economic one, a result of vote in a democratic society, where the objective function of the voters is not to maximize the economic efficiency of the country. The debate on smaller government versus bigger government will never reach a conclusion. What the economists should do is to take the given size of the government determined by politics as the condition for optimization of resources.

    9. CommentedAndrew N Mason

      Smaller government is better on the long run, but the rate at which you make it smaller matters

    10. CommentedFrancisco Estudillo

      "...Keynesian models that always predict that GDP expands when the government gets larger..."

      It must be considered when there is a recession.

    11. CommentedCarol Maczinsky

      The US could sent a Nimitz class air carrier to Europe and turn it into a war keynesianism museum. The operating costs of these navy vessels are insane.

      Or leave some bombs and helicopters and so forth in the Mali desert. US military capabilities are overblown. It's too expensive and inefficient.

    12. CommentedAndres Castillo

      And what about the lessons from Europe. Are those not valid?

        CommentedJose araujo

        Europe's problem is the Euro not the government sizes.

        If you take closer look at Europe they both validate and deny Barro's points of view, but looking closer...

        Scandinavia clearly tells us that a bigger government with high taxes and a strong production of social goods (like education, security, health and social security) is the way to go.

        Southern Europe on the opposite tells us that bigger governments are bad, but governments here act in favor of corporations, they are big because they have to buy goods that are produced by the ones that support. Big government with high inequality.

        In the end its not the size that matters its what government does.

        CommentedMatthew Cowan

        I believe the lessons from Euorpe tend to vindicate Mr. Barro's article, not discredit it. Several economies, including Greece and Italy, were able to structure financial products that added more debt and spending than was officially shown in reports to the EU. These debts were the equivalent of 'off-balance sheet' borrowing for these nations.

        This enabled Greece and others to add debt while still meeting their EU targets for budget deficits. This, in turn, increased the size of government and its ability to spend during the boom years with the unfortunate consequence of leaving these countries heavily indebted when the crisis of 2008 hit in full force.

        Greece also had a higher tax on labor than many other European countries. Greeks tended to retire earlier than their European counterparts and pension expense was forecast to increase much faster than other nations.

        Liberals tend to look at the significant drop in government spending and the simultaneous drop in GDP and blame the latter on the former, but the situation in Greece is more complicated than that. Cuts in government spending are part of the decrease in GDP, but the fall is much more complicated. The social fabric of Greece is being tested by its unsustainable debt boom and entitlement commitments.