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When Unbearable Debt Meets Unsustainable Political Support
Many idealists think we can just inform the public enough to understand the best policies to govern ourselves. Unfortunately tilting at windmills seems more productive. Policies gain and maintain support not by voter knowledge but by voter experience. I don’t care how many TV specials or column inches get devoted to explaining that congestion pricing is better for drivers – it will only reach a critical mass of support when drivers experience the benefits outweighing its costs.
As a pure political argument, do you think hugely slashing defense spending is a winner? Maybe right now. What about the months after 9/11? Voters have no idea what the practical differences are of a few hundred billion more or a few hundred billion less in spending on the military. If the country feels safe they’ll support a low level of defense spending (assuming that the level is compatible with actual and perceived safety). Are high tax rates politically sustainable? If there is strong economic growth, yes. Of course if they’re too high and they weaken growth they’re not sustainable. Bill Clinton easily won reelection and somehow maintained higher tax rates that many currently think would be politically reckless to advocate. Those tax rates even gave us a surplus and would do a lot to balance our budget. What’s the difference? Clinton didn’t explain it better – he presided over a growing economy. Clinton even won large percentages of wealthy voters (not majorities though). Today, growth is anemic.
What does this tell us about any debt reduction plan? Since future congresses will have to keep any policies in place that balance the budget, the policies can’t be incompatible with voters’ improving experiences. Paul Ryan’s medicare “fix” isn’t bad because it is unfair or ideologically conservative – even if you forced everyone to read and love Atlas Shrugged it wouldn’t fix the deficit. When the elderly start getting vouchers that decrease in value (they grow at the rate of inflation but healthcare grows faster) they’ll see their situation as steadily deteriorate and vote to change the policy. That doesn’t mean that benefits need exponential growth to maintain support, but shifting the cost to consumers also doesn’t work. Public debt means higher taxes and less ability to spend elsewhere while private debt directly consumes personal wealth that reduces demand and economic growth. That’s why costs need to be contained not payments. Ezra points out that smaller versions of Ryan’s plan failed:
Various states have gotten waivers to radically remake their Medicaid program, and the consumer-driven model that Ryan is proposing for Medicare has been attempted in the Federal Employee Health Benefits Program and Medicare Advantage. None of these programs have worked, which is why we’re in our current predicament.
Voters need to feel that their overall well-being is improving which means holding down costs in a way that doesn’t prevent economic growth. A growing economy makes every policy sustainable; the trick is to pick solutions that don’t kill economic growth. Paul Ryan correctly realizes that medicare can’t be an open-ended commitment because doing so would eventually harm the economy. His numbers don’t add up, the distribution is unjust, and its prospects are inconceivable but we can debate the merits of it as policy. He should be commended for offering something tangible even as we reveal its flaws. Are there other solutions?
The Kaiser Family Foundation compares some proposals. Many Democrats think strengthening the Independent Payment Advisory Board holds promise. Introducing a dedicated VAT to government healthcare spending always made sense to me – that way it explicitly ties what we’re willing to spend to what is politically sustainable.
Politicians should remember that the single best thing they could do to reduce the deficit is choose policies that maximize economic growth (even if that means taking advantage of cheap borrowing now). Yet, our debt is so large more must be done. Since the major problem is too many retirees relative to able workers, we could change one policy that no one seems to notice would dramatically help. Increase the number of young workers… otherwise known as immigrants. Obviously immigrants age too so it’s not a magic bullet, but anything that keeps the dependency ratio at a reasonable level would be enormously helpful.
Another aspect of immigration policy that needs consideration (since we can’t feasibly let in enough migrants completely solve everything) are temporary workers. Temporary workers are great because they come at almost no cost to the taxpayer. We don’t have to educate them and we don’t have to pay for their retirement, but they grow the economy and pay taxes. As Matthew McConaughey might observe, high school girls and temporary immigrants have a lot in common: they “stay the same age.”
Much more needs to be done, but anything that passes must maintain support.
Taxplomacy
You’ve all heard the cliche enough times used in international diplomacy: “All options are on the table.” Of course, that’s code for the military option or even the nuclear option. Here, I want to use that metaphor to discuss our current debate about tax policy. Since the previous administration and legislature wrote into law that the “Bush tax cuts” must expire, we’re now faced with the predicament that lots of taxes will be raised amidst an anemic economy if something isn’t done, but if we extend them the deficit problem will be even worse. The locus of the debate or, if you will, the options on the table seem to be that we do nothing and let all the tax cuts expire, extend all the tax cuts, extend all but those for the wealthiest taxpayers, or compromise by extending the tax cuts for only 2 years.
The argument for extending all the tax cuts is pretty simple. Raising taxes now during a weak economy is going to make the economy worse, not better. Cato’s Jeff Miron wants to see them extended permanently.
Extending the Bush tax cuts — permanently — is a crucial step in restoring economic growth. The Bush cuts provided lower taxes on ordinary income, especially for taxpayers at the high end of the income distribution. These are some of the most energetic and productive people in society; raising tax rates would discourage their effort and entrepreneurship. High-income taxpayers also have multiple ways of avoiding high tax rates, so any revenue gain from raising rates would be modest.
Alan Viard of AEI likes them all too.
The figure shows the increases that will occur in marginal tax rates at the top income levels if the high-income rate reductions (including the dividend tax cut) expire. Beginning in 2011, the top income-tax bracket for wages and self-employment income, and for ordinary investment income, would revert from 35 to 39.6 percent; wages and self-employment income would continue to face an additional 2.9 percent Medicare tax. The top capital-gains tax rate would revert from 15 to 20 percent. Dividends would lose their current 15 percent tax rate and become taxable as ordinary income, subject to the new 39.6 percent rate. All four categories of income would also face a 1.2 percent stealth-tax-rate increase, from the restoration of a provision that phases out itemized deductions at high income levels.
Economists left of center like Paul Krugman think that extending the top-rate tax increases is not worth the $700 billion price tag (sounds hypocritical but it’s well reasoned).
Now, consider first what would happen if we extend the [high-end] tax cuts for the next 10 years. This would add $700 billion to the debt (pdf). If the rich spread their windfall evenly across the decade, that’s $70 billion a year in additional consumer spending — or $140 billion during the period when we need it. So, $700 billion in deficits for $140 billion in stimulus; not a good bargain!
Alternatively, suppose we extend the tax cuts for only 2 years. That’s only $140 billion on the deficit. But the rich, knowing that it’s temporary, won’t spend much of it — if they really operate on a 10-year horizon, they’ll spend only $14 billion a year more, so $28 billion of stimulus when we need it, in return for $140 billion of debt; still a lousy bargain!
Just for the record, it’s not like the rich wouldn’t get a tax cut under the Democrat’s proposal.
Most famously President Obama’s former OMB director, Peter Orszag wants to extend all the tax cuts for 2 years, then let them all expire.
In the face of the dueling deficits, the best approach is a compromise: extend the tax cuts for two years and then end them altogether. Ideally only the middle-class tax cuts would be continued for now. Getting a deal in Congress, though, may require keeping the high-income tax cuts, too. And that would still be worth it.
In a great piece, Bruce Bartlett explains why the Bush tax cuts were inefficient, of little benefit, and harmful to the debt, but acknowledges that during this recession recovery economy it’s probably best we just extend them.
Subsequent research by Federal Reserve economists has found little, if any, impact on growth from the 2003 tax cut. The main effect was to raise dividend payouts. But companies cut back on share repurchases by a similar amount, suggesting that only the form of payouts changed. (See here, here, and here.) Moreover, according to a study by Steven Bank of the UCLA law school, the fact that the dividend tax cut was temporary was a key motivation for higher dividend payouts; had the dividend tax cut been permanent, as the supply-siders favored, the impact probably would have been much less.
Maybe the answer is obvious (politics) but I’m not sure why these are the only options on the table. Can’t we extend the table? The nuclear option doesn’t even seem to be an option right now. But now may be the perfect time to blow up the tax code and put a new one in place. Here’s the diplomatic stick for the Administration to use: “Let’s put in a simpler, better tax code or all the tax cuts are going to expire and opponents will be responsible for raising taxes on Americans at the worst possible time.” There’s a carrot too: “You get to support a simple efficient tax code that everyone has long claimed they support.”
I honestly have trouble understanding why we have to extend poorly designed, little bang-for-the-buck tax cuts rather than doing something that could really be a huge boon for the economy. Talk about a game-changer from the Obama Administration! A Democratic administration gets to be the one supporting fundamental and economically productive tax reform while forcing the Republicans (or Democrats), if they vote against it, to be essentially responsible for raising taxes and blocking what a lot of their supporters favor. If Republicans are really worried, rest assured that the tax reform wouldn’t be able to save the economy soon enough to have a dramatic positive effect by the election so the GOP candidates will still have a great chance to pick up a ton of seats – and most likely take the House. Will businesses, conservative intellectuals, and angry tea-partiers (so-called small government types) really be able to support the Republicans ever again if they don’t jump on an opportunity like this?
I’ve long touted a VAT as a potential replacement for our absurd tax code. Many mainstream conservatives have even had good things to say about it assuming it was replacing the tax code, not being added on top of it. Here’s a favorite option of progressive policy wonks – something that might appeal to Obama, that I’d be excited to support: the progressive consumption tax. Maybe the Democrats could even slip in some decent energy policy (that they’ve given up on) by raising energy taxes as part of tax reform. Even a flat tax that conservatives have often pushed for would be better than the status quo. Lots of different and better options have to exist rather than being stuck with tinkering with the Bush tax cuts.
If the problem is just lack of time, I’m not sympathetic – everyone has known since the Bush tax cuts passed that they were going to expire. It seems difficult to imagine a potentially better time to force lawmakers’ hands to simplify the tax code than now. We’re in desperate need of new revenue, the weak economy could strongly benefit from a more efficient tax code, taxes will automatically rise if nothing is done, and sometimes it takes the people you’d least expect to be able to dramatically shift course. Think of Nixon going to China or Clinton with welfare reform. What Republican wants to be outflanked by a “socialist president” on tax reform? President Obama might be able to drag along enough in his own party to support a tax reform that the business community surely must favor.
It seems perverse that such extreme options can be on the table for international relations but are so limited for domestic issues. When it comes to tax policy, I welcome the mushroom cloud.
Nietzsche and The Will To Inquire
Over at the Hannibal Blog an interesting discussion is going on over Nietzsche’s message on the nature of truth. Andreas Kluth sets the stage with a letter from 19 year old Fritz to his sister.
On the other hand, is it really so difficult simply to accept as true everything we have been taught, and which has gradually taken firm root in us, and is thought true by the circle of our relatives and many good people, and which, moreover, really does comfort and elevate men? Is that more difficult than to venture on new paths, at odds with custom, in the insecurity that attends independence, experiencing many mood-swings and even troubles of conscience, often disconsolate, but always with the true, the beautiful and the good as our goal?
[…]
Here the ways of men divide: if you wish to strive for peace of soul and happiness, then believe; if you wish to be a disciple of truth, then inquire.
In others words, it is easy to take for granted accepted wisdom and propositions that don’t challenge one’s own opinions and bias. Nietzsche understands that it is not comfortable to have to follow truth wherever it leads, so to speak. I think Sam Harris explains this idea well in his debate with Nature writer Philip Ball.
A person cannot (or least should not be able to) believe something because it “makes him feel better.” The fact that people occasionally do manage such contortions is what renders phrases like “self-deception,” “wishful thinking,” “experimenter bias,” etc., so important to keep on hand. Please notice that these phrases describe how it looks from the outside when people believe a proposition because “it makes them feel better.” Please also notice that this frame of mind represents a failure of cognition and reasoning that all sane people decry in every area of serious discourse but one.
A world in which people believe propositions merely because these propositions “make them feel better” is a world gone utterly mad. It is a world of private and irreconcilable epistemologies. It is a world where communication, even on the most important issues—perhaps especially on the most important issues—is guaranteed to fail. Of course, you have tried to arrest your slide into the abyss in your parenthetical remark about evolution and blood transfusions—but one can draw no such boundary unless one draws it based on some deeper principle. You cannot say that a person’s reason for believing in the virgin birth is “good” just so long as this belief has no negative consequences on his behavior. Whether a belief is well founded or not has nothing to do with its consequences.
The Real Reason American Education Has Slipped – David Barton – The funniest movie is here. Find it
In the EU the VAT was designed as a replacement for other transaction-based consumption taxes like the sales tax, whereas if one were to be introduced into the US it would be added to the existing sales taxes collected by states.
An appendix to this study illustrates, using a supply and demand framework that will be familiar to students of economics, that the welfare loss of a VAT placed on top of state sales taxes would result in a substantially higher excess burden of taxation than a VAT of the same rate in a tax system without state sales taxes. The analysis in the appendix arrives at two conclusions important when considering levying a VAT in the US, where states already use a sales tax to tax the same tax base. First, even if the initial VAT rate is modest, once imposed, both state governments, with their sales tax rates, and the federal government, with its VAT, will have the tendency to raise rates so that the combined sales tax plus VAT rate will be larger than would be optimal.
The second important conclusion is that a federal VAT would lower state sales tax collections in any event, so state revenues would suffer if a federal VAT were imposed. The reason for this is that all taxes reduce the economic activities they tax. Adding a VAT on top of state sales taxes would reduce the sales tax base states now rely on for a substantial amount of their revenues.
The important lesson I want to stress is that all systems have flaws and recognizing so isn’t a sign of a weak argument but of acknowledging reality. It won’t necessarily make my advocacy of a VAT easier or more comfortable but the will to inquire will ensure I’m a disciple of truth not dogma.
(photo: Nietzsche 1864)
"Walking And Chewing Gum"
Martin Wolf explains to deficit hawks that tightening fiscal policy too early could cause more problems in global markets.
Despite the most aggressive monetary policy ever, private sectors moved into huge surpluses. Monetary policy was “pushing on a string”. The fiscal offsets – overwhelmingly due to built-in fiscal stabilisers, not the discretionary stimulus – helped sustain demand in the crisis. But they were insufficient, even with monetary support, to prevent deep recessions. The argument that stimulus was unnecessary is hard to accept. It is easier to believe it was too small, albeit also ill-targeted.
So how quickly should deficits be eliminated? We must recognise the danger here: cutting public spending will not automatically raise private spending. The attempted reduction in the structural deficit might lead, instead, to a rise in cyclical fiscal deficits, which would be running to stand still, or to a reduction in the private surpluses only because income fell even faster than spending. Either outcome would be grim. Yet neither can be ruled out.
As long as output remains depressed, the fiscal support is most unlikely to be inflationary. Nor will it crowd out the private sector: it is more likely to crowd it in. The big question, then, is whether deficits can be financed. My answer is: yes. Remember that so long as the private sector runs financial surpluses it must buy claims on the public sector, unless the developed world as a whole is about to move into huge external surpluses.
Deficits are a real problem, just not now. It’s clear that we should reassure private investors and financial markets by setting up long-term policies for controlling the deficit that don’t depress demand in the short-term. A VAT would be one obvious revenue side solution. Controlling health care costs is the biggest on the spending side. The good news is that the best way to curb the deficit is to enact policies that promote economic growth now. Fiscal restraint now isn’t one of those policies.
VAT Watch, ctd: Bill Clinton’s Endorsement
I’m happy to see President Clinton endorse a VAT. However, he need not make spurious arguments when plenty of sound ones exist. Greg Mankiw quotes Alan Viard on why a VAT wouldn’t “improve our trade balance.”
A common fallacy holds that border tax adjustments—imposing taxes on imports and rebating taxes on exports—would enhance American exports and reduce imports. The reasoning behind this mistake is simple enough. A border adjustment seems to provide a subsidy to exporters and to levy a tariff on importers. Border adjustment proponents, noting that international trade rules allow nations to border adjust consumption taxes such as European-style value added taxes, urge the adoption of a consumption tax in the United States so that we can border adjust and enhance our trade competitiveness.
Yet, such an argument ignores an essential truth about imports and exports: over the long term, exports and imports must be equal. We can think of a country like a household. Purchases are paid for from the proceeds of sales, and sales are made for the purpose of additional purchases. In the long run, purchases and sales must be equal. A nation’s trade policy works the same way. Over a nation’s history, the value of exports in current dollars must equal the value of imports in present value. Any attempt to permanently increase exports and decrease imports is futile.
Oh Ya, Just Cut Spending…
Anytime a discussion comes up about fixing the budget deficit and someone suggests that we should just cut spending recognize immediately that they probably don’t know what they’re talking about. If they do know what they’re talking about (doubtful), chances are they are being deliberately naive. David Leonhardt in The New York Times shows us why. My stomach sank a little when I read these numbers.
As a rough estimate, the government will need to find spending cuts and tax increases equal to 7 to 10 percent of G.D.P. The longer we wait, the bigger the cuts will need to be (because of the accumulating interest costs).
Seven percent of G.D.P. is about $1 trillion today. In concrete terms, Medicare’s entire budget is about $450 billion. The combined budgets of the Education, Energy, Homeland Security, Justice, Labor, State, Transportation and Veterans Affairs Departments are less than $600 billion.
This is why fixing the budget through spending cuts alone, as Congressional Republicans say they favor, would be so hard.
This is why I continue to favor cutting spending along with phasing in a VAT (while dialing down other less efficient taxes).
(via Marginal Revolution)
Who Needs An Economist When You Have A Lawyer?
On the Becker-Posner blog, the two offer their opinions on whether the US should institute a VAT. Here’s Posner:
Our public debt is soaring at a rate of more than $1 trillion a year, and for political reasons it is extremely unlikely that the debt will be brought under control by higher tax rates, spending cuts (or forbearance to adopt new spending programs), or a rate of economic growth faster than the rate of growth of the public debt. The fact that the dollar remains the strongest major currency, which is why it remains the dominant international reserve currency, is enabling the Treasury to borrow at low rates. But this will not last if we continue on the road of fiscal imprudence; and as interest rates on the public debt rise, compounding the deficit, we could find ourselves in the position that Greece is in.
[…]
Most important, by discouraging consumption in favor of savings, a VAT would reduce the interest rate on our public debt and the Treasury’s dependence on foreign lenders.
Becker, the Nobel Prize winning economist, explains why most economists support a VAT, but once he wades into political economy his reasoning is less sound. He also repeats the familiar trope that because a VAT is so good it’s actually bad.
The downside of a value added tax to anyone concerned about growing government spending and taxing is very much related to its upside; namely, that a VAT is a more efficient and relatively painless tax. As with all taxes, proposals to increase the rate of taxation on value added runs into opposition from individuals and companies hurt by a higher VAT. However, since a VAT is easy to collect and causes fewer distortions in behavior than income and most other taxes, governments have an incentive to raise the VAT over time. In fact, value added tax rates do usually start low, but tend to grow rapidly over time. For example, the VAT rate in Europe started low but now ranges from 15 to 25%, and averages about 20%. In Denmark, for example, the VAT rate was 9% in 1962, but quickly rose to 25% by 1992, and has remained at that level.
(my emphasis)
Aside from the fact that he tells us that Denmark’s VAT has remained at 25% for almost 2 decades (do they grow rapidly over time or not?) he doesn’t explain how that is a terrible thing in itself. First of the all, the US and Denmark have very different political cultures and it wouldn’t be as easy for the US to raise the tax that much or to increase the size of the US’s welfare state to Danish levels. He also thinks that we couldn’t lower other less efficient taxes when passing a VAT (I think it’d be impossible to pass a VAT without lowering other taxes). The biggest flaw in Becker’s (and most other VAT opponents’) argument is the latent assumption that it’s more politically possible to decrease spending enough to restore fiscal balance than it is to lower other taxes while passing a VAT. Becker is a lot more knowledgeable on economic issues than I am, but that is crazy. I suspect his visceral fear of higher taxes has more to do with his opposition.
Of course, Becker’s main worry is the growth of government. This is where I part company with a lot of libertarians. Although I have a generally libertarian temperament, I can’t get behind a movement that is devoted to small government for its own sake. I tend to favor smaller government because it often is the best system for individual citizens and society as a whole. But if a particular situation is improved by bigger government or higher taxes then one shouldn’t balk simply out of ideology. Becker exhibits this libertarian tendency well in this case. Even when the cost of bigger government would go down, the economic distortions on savings and business would go down, he doesn’t favor a VAT because government spending would increase.
In another good overview of the issue, the New York Times recently had Greg Mankiw’s column on a VAT. He lays out what it is and why some love it and some hate it. He’s pretty “ambivalent” about it (his word) but has normal conservative worries that it will lead to European levels of government intrusiveness. His final point is his best though.
The bottom line, from both political perspectives, is that a VAT is neither blessed nor evil. It is a tool. We can use it to advance a larger government, a more efficient tax system or some combination of the two.
He’s right, it’s a tool. That you can fix things with a hammer or break things isn’t a good reason to oppose hammers. Conservatives should demand that if a VAT is put in place then many of the more distortionary taxes should be removed or greatly reduced (they can pick their most hated ones) and real cuts in government spending should pass along with it. Seems like a reasonable compromise to me. Seems like a reasonable compromise President Obama’s bipartisan commission could recommend.
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