Cut Federal Spending, Don’t Raise Taxes

Creative Commons License photo credit: SOGKnives

In my previous blog blasting Nouriel Roubini for suggesting that Uncle Sam should raise taxes to close the budget deficit, I made this statement: “Tax increases will only hamper the ability of the economy to recover and worsen our fiscal condition in the long-run.”  Of course, you don’t have to take my word for it . . . so I thought I would review some pieces in the academic literature (at the international, national and state-level) that make the same arguments.

First, Harvard economists Alberto Alesina and Silvia Ardagna examine the economic effects of fiscal policy (pdf) in countries the constitute the Organization for Economic Cooperation and Development (OECD) from 1970 to 2007.  They find that:

“As for fiscal adjustments those based on spending cuts and no tax increases are more likely to reduce deficits and debt over GDP ratios than those based on tax increases.  In addition, adjustments on the spending side rather than on the tax side are less likely to create recessions.”

Second, UC Berkely economists David Romer and Christina Romer (former Chair of the Council of Economic Advisors to President Obama), examine the economic effects of U.S. fiscal policy (pdf) since 1947.  The find that:

“The resulting estimates indicate that tax increases are highly contractionary.  The effects are strongly significant, highly robust, and much larger than those obtained using broader measures of tax changes.  The large effect stems in considerable part from a powerful negative effect of tax increases on investment.”

Finally, economists Stephen Brown, Kathy Hayes and Lori Taylor examine the economic effects of fiscal policy of the U.S. states (pdf).  They find that:

“If anything, most public services do not appear to justify the taxes needed to finance them . . . this finding would seem to imply that other state and local public capital has been increased to the point of negative returns, perhaps because a growing stock of other public capital is indicative of an increasingly intrusive government.”

You decide . . .

Nouriel Roubini Says Raise Taxes to Fix Federal Deficit?!

I have long been a fan of Nouriel Roubini, but some recent comments of his made from Leen’s Lodge in Grand Lake Stream, Maine has me reconsidering my fan-hood. (Note: Due to conflicts, I was unable to attend this year’s event where, one year ago, the idea for this blog blossomed).

In this interview with Bloomberg, Roubini states that taxes should have been raised in order to tackle the deficit problem and avoid the recent S&P credit downgrade (clip around the 13 minute mark). He went on to say that the deficit can not be reduced “only on the spending side.”  Really?!

Of course, that is an empirical question, so let’s now turn to the data to see where the source of the deficit is coming from–lack of revenue or run-away spending. The charts below are all created from the data from the Congressional Budget Office.

Chart 1 shows federal outlays and revenue from Fiscal Year (FY) 2007 to 2021.  The chart basically shows that we are being lied to in the sense that the so-called stimulus package, which by definition are supposed to be temporary, is in fact a permanent increase in federal spending (red line). Between FY 2008 and 2009, federal spending jumped by $535 billion, but never does it decline by the same amount.

To look at it another way, in FY 2007 federal spending represented 19.6 percent of Gross Domestic Product (GDP). In FY 2009, federal spending jumped to 25 percent of GDP.  One would expect that over the next 10+ years that the share of federal spending would fall by back to around 20 percent. You’d be wrong.  Federal spending will hit a low of 23 percent of GDP in 2014 and then CLIMB up to 24 percent by 2021.

In contrast, the green line shows federal spending if spending were fixed at pre-recession, FY 2007 levels (19.6 percent of GDP). The gap between the green and red lines represents the permanent increase in spending–some from the stimulus, some from Obamacare some from who-knows-where. The blue shows federal revenue in which I assume that Bush tax cuts will be made permanent (this is to better show that the deficit is due to spending and is not attributable to the Bush tax cuts).

Chart Showing Federal Revenues and Outlays Between FY 2007 and FY 2021

Chart 2 zooms in on just the difference between federal revenue and federal outlays, i.e., the budget deficit. There are a couple of interesting things that pop-out of this chart.

First, even with federal spending held at 19.6 percent of GDP (green line), there still would have been a strong stimulative environment from the federal government due to the revenue drop-off due from the recession and, to a lesser extent, the Bush Tax Cut extension. The spending stimulus package was an add-on (red line) to the natural stimulus that automatically occurs when revenue drops but spending stays the same. So the real question was not whether or not we needed a spending stimulus (we get one anyways), but whether or not we needed additional spending stimulus.

Second, holding federal spending at 19.6 percent would also create an automatic path toward reducing the federal deficit. As shown in Chart 2, by FY 2021, the federal deficit is not only nearly back to zero, but would already be at a sustainable rate (relative to GDP growth) by FY 2014-ish. In contrast, the current projection of federal spending shows that the federal deficit will actually be growing in FY 2021! Overall, between FY 2011 and FY 2021, the current path will create another $11.8 trillion in debt (nearly doubling our current debt load) whereas spending at 19.6 percent of GDP would create only 1/3 of that debt ($3.5 trillion)–again, assuming Bush Tax Cuts are extended.

Chart Showing Federal Budget Deficit Between FY 2007 and FY 2010

So, Nouriel Roubini is flat wrong . . . federal spending is THE problem and only CUTS to federal spending will solve this deficit/debt crisis. Tax increases will only hamper the ability of the economy to recover and worsen our fiscal condition in the long-run. But, wait a minute, this is similar to what was proposed by the Cut, Cap and Balance folks. Although even that plan wasn’t enough since they only cut federal spending down to 19.9 percent of GDP and take until FY 2018 to phase-in to that level. What a bunch of big-spending liberals . . .

The State of America’s Private Sector XV

Today the U.S. Department of Commerce’s Bureau of Economic Analysis released their monthly personal income data for November 2010 (pdf).

The chart below shows the private sector share of personal income from January 1959 to November 2010. The private sector grew again by another 0.1 percentage points and has now grown for 3 consecutive months adding a total of 0.5 percentage points.  Interestingly, while the public sector grew in November, the private sector grew even faster allowing the private sector to gain share.

Now that the Bush tax cuts extensions are now law, will the private sector be able to continue its growth against another round of government spending?  All of the new spending contained in the bill will show up in personal current transfer receipts, thus accelerating the growth in government spending.  As long as the private continues to grow as it has, I think the new spending will cause the private sector to plateau for awhile but not retreat.  Of course, in the long-run, I think the opposite is true with the downward trend in the private sector continuing.

Note: “Supplements to Wages and Salaries” (benefits) in the BEA data are not broken down into “private” sector” versus “government” components. I used the ratio of private wages and salaries to total wages and salaries in order to disaggregate supplements.

Private Sector Share of Personal Income for November 2010

Taxes Matter III – Especially Capital Taxes

Following my previous Taxes Matter blog making the case for lower capital taxes, what should I find in my inbox today from the National Bureau of Economic Research (NBER) but a new study showing how capital taxes worsened the Great Depression.

The study is by Ellen R. McGrattan and is titled “Capital Taxation During the U.S. Great Depression” (pdf).  McGrattan works as a Monetary Advisor for the Minneapolis Federal Reserve Bank.  For those of you not familiar with the ideological leanings of the various Federal Reserve Banks, let me assure you that the Minneapolis Fed is not a hot-bed of free-market, anti-tax, tea-party thinking.  So, let’s read McGrattan’s finding in her own words (citations removed):

Although there is no general agreement on the primary causes of the U.S. Great Depression—the sharp economic contraction in the early 1930s and the subsequent slow recovery—many do agree that fiscal policy played only a minor role. This conventional view is based on both empirical and theoretical analyses of the period. Although federal government spending notably increased during the 1930s, the data show that as a share of gross domestic product (GDP), it did not increase enough to have had a large impact. At the same time, income tax rates increased sharply, but taxes were filed by few households and paid by even fewer. Feeding estimates of spending and tax rates into a standard neoclassical growth model, Cole and Ohanian confirm that the impact of fiscal policy during the 1930s was too small to matter.

Here, I challenge that conventional view. My challenge is based on an examination of all types of taxation during the 1930s. As is standard, Cole and Ohanian and others limit their attention to taxes on wages and business profits. I look as well at taxes on capital stock, property, sales, excess profits, undistributed profits, and dividends. When these overlooked taxes are incorporated into the neoclassical framework, the model predicts patterns in aggregate data that are much closer to those in U.S. data than previous studies have found. A crucial factor for the model predictions is the tax treatment of capital income. If tax rates on undistributed and distributed profits (i.e., dividends) are equated, then the impact of taxation is found to be small. If they are not assumed to be equal and are set at levels observed in the 1930s, then the impact of taxation is found to be large.

Perhaps surprisingly, given that capital taxation plays a central role in my analysis, a key policy change in the decade is the increase in tax rates on individual incomes. But individual incomes include corporate dividends. Although few households paid income taxes in the 1930s, those who did earned almost all of the income distributed by corporations and unincorporated businesses. Thus, increasing the tax rate on dividends would naturally have had a significant effect on economic activity.

Besides including overlooked taxes, I extend the neoclassical growth model to allow for both tangible and intangible business investment. I do this because the U.S. tax code allows businesses to reduce taxable income by expensing intangible investments like advertising expenditures, research and development (R&D), and labor devoted to building up businesses. I assume that part of intangible investment is financed by owners of capital and is expensed from corporate profits rather than capitalized. The remainder is financed by unincorporated business owners who are paid less than their marginal value product with the expectation of realizing future profits or capital gains. Making the distinction between tangible and intangible capital explicit in the model allows it to better capture the actual effect of taxes.

And it does. My model predicts that higher taxes during the 1930s led to a dramatic decline in tangible investment, similar to that observed in the United States, with the primary cause being the rise of the effective tax rate on dividends. The pattern of investment is a steep decline in the early part of the decade, followed by some recovery and another steep decline in 1937. The primary cause of the second decline is the introduction of the undistributed profits tax. Overall, the model predicts 1929–1933 declines in GDP and hours worked that account, respectively, for 41 and 48 percent of the actual declines. These are improvements over the Cole and Ohanian model predictions—four times larger for GDP and three times larger for hours. The model also predicts correctly that equity values should have fallen by about 30 percent over the decade.

My model’s quantitative results, especially for the early 1930s, do depend somewhat on how household expectations about future income tax rates are modeled, but sensitivity analysis shows that the main results are not overturned as I vary assumptions about expectations. The period was rife with institutional uncertainty. Major changes in the U.S. tax code were not enacted until the Revenue Act of 1932. However, as early as February 1930, President Herbert Hoover warned that large tax increases would follow if Congress enacted its proposed spending projects. Theoretically, anticipated tax increases on future distributions lead to immediate increases in current distributions and immediate declines in business investments and equity values. Regardless of the uncertainty, since tax rate increases are large, the effects on economic activity are too.

Note the importance of taxes on dividends in her analysis. Had the Bush tax cuts expired, taxation of dividends in the individual income tax would have reverted back to ordinary income tax rates up to 39.6 percent. This study is intriguing . . . I wonder if years from now economic researcher will find that extending the Bush tax cuts (thus keeping taxes on dividends and other capital lower) helped to prevent the Great Depression II?

Is the Bush Tax Cut Extension Stimulus in Disguise?

Mark Zandi, Chief Economist at Moody’s, thinks that the Bush tax cut extension is stimulus in disguise:

“It’s stimulus in the sense we’re providing some additional temporary tax cuts and some additional temporary spending increases, so I’m not sure what the difference is between what we’re talking about here and what we did back in early ’09,” Zandi said on America’s Election Headquarters Sunday.

I’ve been asking myself the same question the last few days.  The problem I have is that the plan only calls for a two-year extension of the Bush tax cuts.  Yet, one of the major headwinds on the recovery has been the pending expiration of the Bush tax cuts.  Moving the deadline out by 2 years doesn’t remove the uncertainty.  Individuals and businesses still have to wonder if they tax cuts will be extended, yet again, or allowed to expire.  Temporary tax relief is short-term stimulus . . . the economy needed them to be made permanent.

However, another way to look at the extension is that it is really a deferral of a planned tax increase.  The expiration of the Bush tax cuts  was, on the flip side, a trigger for higher taxes.  It still doesn’t help the uncertainty problem, but the absence of a negative is a positive.

So I think Zandi is right and wrong.  He’s right in that not making the Bush tax cuts permanent (along with all the new provisions) in effect reduces the economic impact of the  extension into Obama Stimulus Part Deux–with the same lackluster results.  However, he’s wrong in that no action would have triggered one of the largest tax increases in U.S. history–thus avoiding a certain policy-induced double-dip recession.

In the end, thanks to muddled U.S. policy, the economy will also continue to muddle its way forward.  While we lost an opportunity to reduce the odds of a double-dip recession (by permanently extending the Bush tax cuts); looking on the bright side, we’ve at least removed this option as the cause for a possible double-dip recession.