Issues 2008: Fiscal Policy

‘My other piece of advice, Copperfield,’ said Mr. Micawber, ‘you know. Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery. The blossom is blighted, the leaf is withered, the god of day goes down upon the dreary scene, and – and in short you are for ever floored. As I am!’

Charles Dickens, David Copperfield, Chapter 12

Simply stated, our fiscal house is a mess. In Mr. Micawber’s words, we are floored.

Before beginning a discussion of fiscal policy it might be helpful if I defined my terms. When I say “fiscal policy”, I don’t just mean tax policy. I mean it in a Micawber sense: the relationship between income and expense. To understand our real fiscal situation you’ve got to consider both sides of the ledger: the revenue side

and the expense side

These figures are from the budget for 2008. The total net deficit in 2007 was roughly $161 billion. Bleak as these numbers they don’t include the supplementals for funding the conflicts in Iraq and Afghanistan nor the cost of the whopping rescue plan for the financial system that was enacted into law last week. We don’t really know how high those will hike the deficit. I think we can expect a total deficit of something between $500 billion dollars and $1 trillion.

Defenders of the status quo point to the relationship between the deficit and GDP:

I think we can agree that between the likelihood of a higher deficit and lower GDP that will be a somewhat rosy projection. It doesn’t even add our unfunded liabilities which according to the CBO look something like this:

Opponents of the war in Iraq point to the cost of the war as a prospective source of funds with which to fix the budget. I have yet to see any advocate for immediate withdrawal from Iraq who supports increasing our forces in Afghanistan who’s disaggregated the two (they’re funded in the same supplemental) or accounted for the real, likely scenario in which we reduce our forces without completely removing them from Iraq and increase our forces in Afghanistan (which is likely to result in nearly a wash from a budgetary standpoint). We shouldn’t count our peace dividends before they’re realized.

If you’d like a handy measure of our irresponsibility over time look at the figure for debt service on the expenditures chart above. That $227 billion would fund a lot of education, health care, and infrastructure improvement if those expenditures float your boat. Or a lot of tax cuts if that’s your preference. It would go a long way to balancing the budget.

But reducing debt service requires not only a long-term commitment to making your revenues equal your expenses, it requires paying down the debt for which there is absolutely no political will.

We’re not going to grow our way out of the total budgetary problem. There is no reasonably foreseeable level of economic growth that will result in our being able to pay all of the commitments in that projection above without sacrificing other priorities or increasing taxes.

We’re not going to tax our way out of the total budgetary problem. There are many reasons for this but one of them is deadweight loss. IIRC the deadweight loss due to taxation increases proportionally to the square of the tax rate. That’s a lot of economic activity (and prospective future income and tax revenues) that won’t happen when we increase taxes. If there were a bright future in nationalizing the economy the Soviet Union would still be around.

We can’t get out of our current budgetary problem by eliminating earmarks AKA pork-barrel spending or eliminating waste, fraud, and abuse. Pork-barrel spending accounts for a very small proportion of the budget—something like $18 billion. That’s a tiny fraction of what needs to done. Sure, it needs to be controlled but I think that a certain portion of that should be chalked up to an operating expense, part of the administratiive cost of representative government.

We need to suit our wants to our means. For me this means we’re going to need to increase taxes a little, recognizing that will result in less economic growth than we otherwise might have, reduce our military expenditures, recognizing that we should reduce our military commitments right along with our military expenditures, bring Social Security into balance, and curb the growth of Medicare and Medicaid, the most troubling future liability as the projection chart above clearly shows.

John McCain was right in what he said last night in the second presidential debate on a couple of things. During a recession is a lousy time to raise taxes and we can correct the problems with Social Security using some combination of the measures we’ve used in the past. But Barack Obama was right, too: FICA is unfair. Fairness and, more importantly, the perception of fairness are very important in representative government and our current system is rather obviously perceived as unfair.

Medicare and Medicaid are really the elephants in the room and I’ll talk more about them in the installment in my issues series on health care.

Before I leave this subject I’d like to toss out a few more-or-less random ideas. First, no discussion of fiscal policy in the U. S. is complete without including a consideration of state and local taxes and expenditures. Under our system most of the things that really touch peoples’ lives, e.g. education, roads, sewers, and so on are primarily the province of state and local government. Considering relative government expenditures without considering state and local governments’ expenditures is distorting. Unfortunately, with few exceptions state and local governments’ fiscal situation is lousy, too, and likely to get worse.

Second, a lot of the smaller budget items in the federal budget, e.g. things like food inspections, border control, or the SEC actually need more funding to do their jobs properly. That’s what makes an across the board cut a bad idea. It substitutes method for judgment.

Third, I opposed the Bush tax cuts in 2001 and 2003, however, I think that the vitriol they’ve drawn is misplaced. Some kind of tax cut was a political necessity for any number of reasons. I just think that they were the wrong tax cuts. We didn’t have any lack of consumer spending; the problem was in businesss investment. We really needed to cut the corporate tax rate in such a way that it encouraged more domestic business investment and so it’s more in line with those of other OECD countries and that that subject can’t even be broached without partisan rancor is a mark of how dysfunctional both of our political parties have become.

Finally, although ideas like balanced budget amendments are tempting I think they’re mistaken. Once again, they substitute method for judgment. Self-government is supposed to be hard, our legislators are supposed to make difficult decisions, and we should be holding them to a much higher standard than we are.

Other contributions

Eric Rall at Dean’s World has posted an excellent review of both candidates’ tax proposals.

John Stonger at Heretical Ideas has posted a fine contribution to the discussion.

9 comments… add one
  • If a government opperating a fiat currency system were to consistantly ‘save’ more money then it spent (have tax reciepts in excess of spending) it would be disasterous. Such a situation would mean a decline in the money supply, rampant inflation and an economic contraction.

    Even balancing the budget would cause an artificial restraint on growth.

    Thats why debt to GDP is a good metric for if we are spending too much or not.

    As for the expense of our military efforts, a lot of that is hard to judge from an economic sense. The cold war was hugely expensive, but the Soviet Union is no more and Europe is still free. I don’t think that a ‘cheaper solution’ would have cost us less, even on purely economic terms.

  • I’m aware of that, Dave. Note that I didn’t advocate compelling a balanced budget or always having surpluses to balance deficits.

    However, one point that I didn’t make but perhaps should have is that perennially running deficits means that in order for Keynesian stimuli to work you’ve occasionally got to run big deficits. To make that practical you’ll need to balance the budget sometimes and even run a surplus occasionally or the interest payments will eat you alive.

    The key problem is future commitments. Our future commitments are so large that in order to pay for them we’re either going to need to completely reorganize our society around them. That will result in a slowing of growth that will dwarf what we might see from minor deficits.

  • Well, another way to measure if we have too much debt or not is interest as a percentage of tax receipts. By this measure, our debt load has generally declined during the Bush years.

    I think that the way to pay our future commitments is to grow our economy, not to try and save up for a rainy day. Part of this is simply the fact that while we could theoretically save money (although government ‘saving money’ in a fiat system is fairly paradoxical) at the end of the day, we have to provide real stuff produced in the current time frame to satisfy those entitlement needs. We can’t ‘save’ medical care for 2023 to take care of more elderly people, we have to produce that care in 2023. If too large a percentage of our production is going to this sort of need, we won’t be able to provide it no matter how much money is in some government bank account. Growing our economy (producing more) is the only answer to keeping that balance in the feasible terrirtory.

    As such, we should be looking for the best ways to encourage economic growth, in particular productivity growth, and financing that growth through a balanced ratio of taxes and increased debt is the sensible way to do that.

  • Brett Link

    What’s burning through all the money in Medicare? Is it that accursed Plan D drug hand-out that Bush gave to seniors?

  • Dave,

    An excellent series, and I’m a little late to the party, but I’ve added some common sense steps that should be paired with any discussion of economic or fiscal policy.

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