The economic debate in the U.S. regarding the fiscal stimulus package has revealed, once again, the soft underbelly of modern economics. It’s perhaps inevitable that a public debate over the allocation of trillions of dollars of taxes and spending should be cacophonous and confused, but the poor quality of the scientific discussion about the fiscal stimulus plan is unjustified. Economists have not helped the public to sort out crucial issues in the debate, leaving public policy to a hurried mish-mash of conflicting interests.
The stimulus debate has centered heavily around the question of “bang for the buck,” that is, whether tax cuts or spending increases would produce more jobs. This perspective is very limited and misleading, however: the implications of tax cuts, for example, depend importantly on whether they are perceived to be temporary or permanent. A temporary tax cut is more likely to be saved, or used to pay down credit-card debt, than consumed, a lesson demonstrated by the failed $100 billion tax-rebate stimulus last spring.
There is a far more important point, however. The choice of spending versus taxes should turn first and foremost on the purposes of government, or on what economists quaintly call “the allocation of resources.” It’s silly to debate whether investing in a $100 million bridge creates more jobs than a $100 million tax cut if we really need the bridge! The American Society of Civil Engineers has credibly documented for years the crumbling state of U.S. infrastructure—roads, bridges, water supply, waste treatment, mass transit, toxic waste cleanup, dams and levees—and the urgent need for more than $2.2 trillion of investments for our wellbeing and competitiveness.
A second crucial point is that government spending and taxation affect the distribution of income, both demographically and temporally, across different income classes at a point of time, and across generations. America ranks 22nd out of 23 high-income countries in public social outlays as a percent of national income (ahead only of Ireland), for health, pensions, income support, and other social services. Indeed, our political discourse tends to focus on the middle class and neglect the poor, while our actual tax and spending policies are often directed to the benefit of the wealthy. As a result, the U.S. has the highest poverty rates, greatest income inequality, highest per capita prison population and worst health conditions of all high-income countries.
The timing of tax cuts and spending increases also affects the wellbeing of today’s generation versus future generations. The U.S. has a chronic fiscal deficit because federal taxation, at around 18 percent of gross national product (GNP), is enough to cover only five types of federal programs: retirement and disability, medical care, veterans’ programs, defense and homeland security, and interest on the public debt. All the rest of federal outlays—for education, diplomacy and international assistance, public administration, science and technology, sustainable energy, water and sanitation, roads, broadband, help for the poor—are in effect funded by borrowing. The chronic deficit problem, now at least 5 percent of GNP, will tend to get much worse with the aging of the population and the rising costs of health care, until we finally choose to tax ourselves sufficiently to pay for the government we need and want (and have committed to by law in many entitlements programs).
Temporary deficits can boost the economy at a time of recession, though temporary income tax cuts or rebates tend to be saved rather than spent. Prolonged deficit spending, however, would impose future burdens on the economy, some obvious and others less so. The most obvious will be the need to service the accumulated public debts, which will be owed to China and other holders of treasury bills: the U.S. is already a massive international debtor and is on a path to multiply its international debts. Less obviously, the huge budget deficits will crowd out some private investment spending, not this year in the midst of a deep recession but as the economy recovers. Moreover, the higher taxes needed to cover the servicing of the accumulated debt will not only squeeze consumption but may also cause distortions in the economy through adverse tax incentives on saving, work or other activities.
There is a sound method to combine the analytical perspectives of macroeconomic stimulus, resource allocation, income distribution and generational equity and efficiency. It’s called a medium-term fiscal framework, which systematically presents the various tradeoffs of taxation and spending backed up by formal budget projections for at least five to 10 years, and in some budgetary processes up to 50 years or more. Norway, for example, takes such a long view in the management of its hydrocarbon wealth on behalf of current and especially future generations.
Higher deficits to increase spending on urgently needed public goods—such as infrastructure—and on transfers to states and cities to help them address the pressing needs of the poor and the unemployed (especially regarding health care, nutrition, education, and housing), can combine desirable macroeconomic stimulus, efficient resource allocation and urgently needed redistribution. Over time, however, we will almost surely have to raise taxes to close the deficits and to cover the long-term costs of government. Most important, however, it’s time to start thinking systematically about the long-term role of government in the U.S. economy today and how to pay for it in the future.