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See Inside July 2010

Get Serious about Budget Deficits

Nations need to curb their public debt to avoid stifling future growth

The continuing economic crisis in the U.S. and Europe is quickly sharpening the debate over public finances. Several countries have budget deficits around 10 percent of national income or larger, and their governments must show their publics and the financial markets that they have a plan for dealing with these unprecedented peacetime imbalances.

In the wake of the financial panic in late 2008, most economies adopted fiscal stimulus packages of spending increases and tax cuts in keeping with Keynesian ideas (which I cautioned about in my March 2009 column). Because consumer spending was falling, offsetting the decline through higher government spending or by stimulating private spending by tax cuts was considered necessary. Keynesian thinking presumes that the financial markets will readily buy government bonds to finance the stimulus.

It proved overoptimistic for many smaller European countries, most recently Greece. Potential investors looked ahead skeptically to governments’ ability to service those debts through some combination of higher taxes and lower spending in the future. Consequently, the bond markets slammed the door on new financing by Greece early in 2010 and threatened to do the same for various other European countries, including the U.K.

So far the U.S. has not been similarly touched. Unlike Greece, the U.S. borrows in its own national currency: whereas the Greek government can run out of euros, the U.S. government cannot really run out of dollars as long as the Federal Reserve provides them. Of course, the fear in that case is not bankruptcy but that central bank financing of future deficits will stoke inflation.

Yet even if the markets agree to finance deficit spending, large-scale borrowing might not be wise. Large deficits today mean that the public debt will rise sharply as a percent of national income. The ratio of U.S. debt to GDP will roughly double between 2007 and 2011, from around 37 percent to 70 percent. Even if the budget deficit is then reduced through spending cuts and tax increases, the costs of servicing the extra debt will remain and will distort the economy. Furthermore, awareness that today’s budget deficits will eventually require spending cuts and tax increases at least blunts the short-term stimulus effects of the deficits. Households may save rather than spend any tax cuts on the grounds that future taxes are rising. And higher interest rates caused by budget deficits may dampen any boost in private investment spending.

America’s budget deficit challenge is worsened by the country’s deep political division over the role of government. Tax increases are anathema, but contrary to common belief, there are few easy cuts in the budget for removing simple waste.

The biggest waste, I would suggest, lies in the Pentagon budget, which now stands at around 5 percent of GDP and finances two expensive wars, hundreds of overseas military bases, and overpriced service contracts and weapons systems. Yet no public consensus on a sharp reduction of military outlays exists.

Still less will there be an agreement on cutting civilian spending, the bulk of which is on Social Security, Medicare, Med­i­caid, food stamps and other mandated programs. Many categories of discretionary civilian spending—sustainable energy, R&D, infrastructure, higher education, global development and more—are chronically underfunded rather than laden with waste. The much disparaged earmarks, which do distort the budget, constitute only perhaps 1 percent of total budget spending or even less.

We need to look again at higher taxation of the superrich. The wealthiest 1 percent of U.S. households now take home more than 20 percent of all household income, more than double their roughly 10 percent share around 1980. The richest 0.01 percent of households brings home around 5 percent of total household income.

The superrich households have also enjoyed repeated tax cuts during the past 30 years. Their increased tax contribution will not be sufficient to balance the books. We will also need to look at higher gasoline taxes, carbon-emissions levies and perhaps even a national value-added tax. Yet the superrich households are the right place to begin to get our public finances back in order.

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