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Chapter 18
Fiscal Policy and Its Impact on
Productivity Growth
• Economists disagree about the size of the
Federal government, the relative
proportions spent on national defense and
social welfare, and the amount of
progressivity in the tax code. We will not
solve these problems to everyone’s
satisfaction either. Nonetheless, there is
still a basic core of principles with which
almost all economists agree.
Core Rules of Fiscal Policy
• 1. The Federal budget should be
balanced over the cycle, running deficits in
recessions and surpluses during periods
of overfull employment.
• 2. If that rule is followed, the size of the
national debt is almost irrelevant.
• 3. Whatever taxes are collected, they
should be levied in such a way to minimize
economic distortion.
Core Rules, Slide 2
• 4. The private sector is inherently more
productive than the public sector. Some
fields, such as national defense or public
safety, will always be proper government
functions. Other fields, such as utilities,
transportation, and communications, are
proper private sector functions, although
regulatory oversight may be needed.
Core Rules, Slide 3
• The gray areas are found primarily in
education and health care. Keeping these
in the public sector creates inefficiencies,
boosts costs, and in many cases delivers
inferior services. Keeping them in the
private sector means that many lowincome people cannot receive the proper
amounts of these services, and the profit
motive may cause some to cut corners.
The Case for Vouchers
• One solution to these areas would appear to be
”vouchers”, in which everyone is given a certain amount
of money to spend on these services. Although most
economists favor vouchers, many politicians do not.
• Vouchers, in the form of food stamps, have generally
worked well. The concept could be expanded to
education and medical care; the size of the voucher
could be reduced as income increased. Part of the
medical care voucher could be used to buy insurance for
catastrophic medical care; routine costs would be paid
for directly by individuals, hence reducing the costs of
paperwork.
What Kind of Tax Structure?
• The other controversial item is the progressivity
of the tax structure. A flat tax is more efficient.
But many believe it is also unfair. Yet the fact of
the matter is that when social security taxes are
included at the low end of the income scale, and
exemptions and loopholes are included at the
high end, the current system is very close to a
flat tax. However, there are obviously too many
vested interests who favor keeping the current
structure.
Automatic and Discretionary
Stabilizers
• Throughout this book we have stressed
the importance of the fundamental identity
I = S, and shown that recessions start
when I falls below S on an ex ante basis.
• When that happens, much of the
adjustment occurs through a decline in
government saving. As a general rule,
every 1% decline in the growth rate boosts
the Federal deficit ratio by about ½%.
Automatic Stabilizers, Slide 2
• Thus, for example, a drop in real growth
from 4% to -2%, which is fairly typical for
an average recession, would transform a
balanced budget into a deficit equal to
about 3% of GDP.
• This is a very positive development. If it
did not occur, recessions would be much
longer and more severe.
Discretionary Stabilizers
• If automatic stabilizers are a good idea, then perhaps
discretionary stabilizers – temporary tax cuts or public
works programs – are an even better idea. Yet they
haven’t worked nearly as well.
• If tax cuts are temporary, they don’t change consumer or
business spending very much. Public works projects
have several drawbacks. First, they generally take a
long time to get started. Major public works projects
tend to stretch out into the boom. Also, they often turn
out to be pork-barrel projects.
• By comparison, automatic stabilizers have the great
advantage of disappearing as the economy picks up,
and returning the budget to balance as full employment
is approached again.
State and Local Budgets
• Unlike the Federal government, these must be balanced
every year. So when the economy slumps, either taxes
must be raised or expenditures must be cut. That is
counterproductive in terms of ending the recession.
• The change is not quite as severe; during a recession,
the total ex ante state and local government deficit ratio
rises about 1%, compared to 3% for the Federal
government. To balance the budget, taxes are raised,
and many needed public services are cut.
• So why doesn’t the Federal government extend the
concept of automatic stabilizers to the state and local
level?
State and Local Budgets, Slide 2
• The U.S. government tried Fiscal Federalism and
revenue sharing in the 1980s, but it didn’t work. Much of
the money went to wealthy suburbs who used it for
frivolous projects.
• How about giving it to those facing the biggest deficits?
That just encourages profligate spending.
• How about giving it to those most in need, defined as the
poverty level or something. That encourages them not
to tax themselves.
• How about only giving it to those who have made a valid
effort to tax themselves first? That encourages too big a
public sector.
• Apparently there are no easy answers, so nothing gets
done. If the politics could be worked out, though, it
would be a good idea from an economic viewpoint.
The Full-Employment Budget
• In 1961, the Council of Economic Advisors came
up with the idea of a “full employment balanced
budget” in order to emphasize that the budget
should be in deficit during recessions as long as
it “would have” been balanced at full
employment. The idea was distorted by Nixon to
create deficits at full employment, and since then
has fallen into disfavor.
• Empirically, it is difficult to measure.
Theoretically, though, the idea that the size of
the deficit should be related to the gap between
actual and full employment is still valid.
Who Will Pay for Social Security
and Medicare When We’re All Old?
• Demographic trends are inexorable; the ratio of
older to younger people will continue to rise.
People live longer and use more new “miracle”
drugs and life-extending procedures. Who pays
for all this?
• That’s obvious. Our tax dollars. And yet it’s not
quite that simple.
• Suppose the government ran ever-increasing
deficits forever to meet these rising costs. By
now everyone knows there is “no free lunch”.
So what’s the catch?
Who Pays the Bills?
• First, let’s forget about the silly argument that the
government will “run out of money”. The government
never runs out of money.
• Second, higher deficits need not lead to higher inflation.
We saw that in the 1980s in the U.S., and we see the
same thing now in Europe and Japan, both of which
have large budget deficit ratios but virtually no inflation.
• Actually the answer is simple. If the U.S., or any other
country, spends more on consumption – including public
sector consumption – it spends less on investment.
• That means capital stock does not grow as fast, and
hence productivity growth is retarded. The standard of
living does not rise as fast, or in an extreme case it
actually declines.
Who Pays The Bills, Slide 2
• The argument that “some day” we must pay
back the national debt is also unsupportable.
Every nation in the world has a sizable national
debt; some are very healthy and some are very
weak, but they all have national debts.
• The economic impact of the national debt is
found elsewhere: the larger the deficit relative
to GDP, the slower the productivity growth rate.
It is the deficit that has this negative impact, not
the debt per se.
Maximizing Productivity Growth
• From an economic viewpoint – as opposed to a political
or social welfare viewpoint – the government sector
should be structured to maximize productivity growth. In
particular that means:
• Balanced budget over the cycle
• Smallest size consistent with political requirements
• Tax code should stimulate saving and investment rather
than consumption
• Tax code and regulations should generate minimal
distortion of economic incentives
• Enforce the rule of law, financial transparency, and
economically sound antitrust laws.
Tax Code Incentives for Saving and
Investment
• These would seem to be a good idea, but they
should work in the sense that they really do
increase saving and investment. They should
not just be a series of tax shelter gimmicks that
reduce taxes and leave saving and investment
at the same amount that would have occurred.
• There is generally a tradeoff in the sense that
(say) a targeted investment tax credit would
boost the deficit and raise interest rates, hence
partially offsetting the beneficial impact on
investment. The two sides must be balanced.
The Economic Impact of LongTerm Capital Gains Tax Reduction
• Accounts for only a very small proportion of total
Federal revenue. The main question is the
degree to which capital gains tax reduction
boosts the stock market, capital formation,
productivity, real GDP – and hence government
revenues; the so-called feedback effect.
• In the past, capital gains tax reduction has paid
for itself by increasing the growth rate – one of
the very few tax cuts for which that is true.
• The main opposition to this tax cut appears to be
centered on the grounds that it will serve as just
another tax break to the rich, who don’t need it.
Radical Tax Reform
• Flat Income Tax. All personal and corporate
income, including forms of income that are now
exempt, gets taxed once. No more deductions
for health care, mortgages, charitable
contributions, or anything else, except for a lowend income deduction.
• Value added, or national sales tax. Only
consumption get taxed, saving does not. Some
necessities, such as medical care, some food,
rent, and mortgage payments, are exempt.
How a Flat Tax Works
• In 2003, before the Bush tax cuts, Federal
personal and corporate income taxes would
have been about $1 trillion.
• Total personal and corporate income would be
about $10 trillion. Assume a low-end income
deduction of $9,000 per person, which is about
$2.5 trillion. That means $7.5 trillion is taxed.
To raise the same amount of revenue, the tax
rate on all income would be 13.3%. Assuming
all states followed the same scheme, the flat
state tax rate would be 4%.
Pros and Cons of a Flat Tax
• Admittedly, whether this sounds appealing or not
depends on your income bracket.
• However, it is not true that the very rich would pay more;
most of them receive most of their income from capital,
which is already sheltered.
• The major beneficiaries would be those who earn
relatively large salaries.
• Of course, accountants, lawyers, and mortgage brokers
are dead set against it. That is to be expected. It is
more puzzling why so few economists have endorsed
the concept, since it would appear to end economically
useless tax shelters, sharply reduce cheating, and end
the current burden of paperwork.
The Value Added or National Sales
Tax
• Total consumption is currently about $8 trillion (capital
goods would remain exempt). However, almost half of
that would probably be exempt, leaving a taxable base of
$4 trillion. Hence the national sales tax rate would be
about 25%. That is in addition to state and local sales
taxes, so the total sales tax burden would be about 30%.
• On items such as cars, the tax would probably be paid.
But there would probably be widespread cheating on
personal services, and barter would increase sharply.
Also, such a tax would be much more regressive than a
flat income tax.
“Saving” Social Security
• The best way to pay for social security is
by boosting the growth rate. At 4%
growth, the system remains solvent; at 2
½%, it runs out of money by mid-century.
These facts are not in dispute; the
argument is about how fast one can
reasonably expect the economy to grow,
and what role fiscal policy has in
determining that growth rate.
Using Fiscal Policy to Boost Real
Growth
• Rationalizing the tax structure to
encourage saving and investment and
reduce tax avoidance
• Modernizing the infrastructure
• A more economically defensible energy
policy
• Rationalizing regulations on pollution
abatement and control and occupational
health and safety