Tag: fiscal policy

With Tax Increases Looming, CBO Does About-Face and Frets about Deficits and Debt

Like the swallows returning to Capistrano, the Congressional Budget Office follows a predictable pattern of endorsing policies that result in bigger government. During the debate about the so-called stimulus, for instance, CBO said more spending and higher deficits would be good for the economy. It then followed up that analysis by claiming that the faux stimulus worked even though millions of jobs were lost. Then, during the Obamacare debate, CBO actually claimed that a giant new entitlement program would reduce deficits.

Now that tax increases are the main topic (because of the looming expiration of the 2001 and 2003 tax bills), CBO has done a 180-degree turn and has published a document discussing the negative consequences of too much deficits and debt. A snippet:

[P]ersistent deficits and continually mounting debt would have several negative economic consequences for the United States. Some of those consequences would arise gradually: A growing portion of people’s savings would go to purchase government debt rather than toward investments in productive capital goods such as factories and computers; that “crowding out” of investment would lead to lower output and incomes than would otherwise occur.

…[A] growing level of federal debt would also increase the probability of a sudden fiscal crisis, during which investors would lose confidence in the government’s ability to manage its budget, and the government would thereby lose its ability to borrow at affordable rates. …If the United States encountered a fiscal crisis, the abrupt rise in interest rates would reflect investors’ fears that the government would renege on the terms of its existing debt or that it would increase the supply of money to finance its activities or pay creditors and thereby boost inflation.

At some point, even Republicans should be smart enough to figure out that this game is rigged. Then again, the GOP controlled Congress for a dozen years and failed to reform either CBO or its counterpart on the revenue side, the Joint Committee on Taxation (which is infamous for its assumption that tax policy has no impact on overall economic performance).

“Rahn Curve” Video Shows Government Is Far Too Big

There is considerable academic research on the growth-maximizing level of government spending. Based on a good bit of research, I’m fairly confident that Cato’s Richard Rahn was the first to popularize this concept, so we are going to make him famous (sort of like Art Laffer) in this new video explaining that there is a spending version of the Laffer Curve and that it shows how government is far too large and that this means less prosperity.

Prof. Krugman Is Wrong, Again

Prof. Paul Krugman asserts in his New York Times column of May 31st that “Both textbook economics and experience say that slashing spending when you’re still suffering from high unemployment is a really bad idea – not only does it deepen the slump, but it does little to improve the budget outlook, because much of what governments save by spending less they lose as a weaker economy depresses tax receipts.”

While Prof. Krugman and most other fiscalists believe this to be self-evident, it is not.  Indeed, this fiscalist dogma fails to withstand the indignity of empirical verification.  Prof. Paul Krugman’s formulation fails to mention the state of confidence.  This is an important oversight.  As Keynes himself put it: “The state of confidence, as they term it, is a matter to which practical men pay the closest and most anxious attention.”

By ignoring the confidence factor, economic theory can lead to wildly incorrect conclusions and misguided policies.  Just consider naive Keynesian fiscal theory – the type presented (as Prof. Krugman notes) in textbooks and embraced by most policymakers and the general public.  According to Keynesian theory, an expansionary fiscal policy (an increase in government spending and/or a decrease in taxes) stimulates the economy, at least for a year or two after the fiscal stimulus.  To put the brakes on the economy, Keynesians counsel a fiscal contraction.

A positive fiscal multiplier is the keystone for Keynesian fiscal theory because it is through the multiplier that changes in the budget balance are transmitted to the economy.  With a positive multiplier, there is a positive relationship between changes in the fiscal deficit and economic growth: larger deficits stimulate growth and smaller ones slow things down.

So much for theory.  What about the real world?  Suppose a country has a very large budget deficit.  As a result, market participants might be worried that a further loosening of fiscal conditions would result in more inflation, higher risk premiums and much higher interest rates.  In such a situation, the fiscal multipliers may be negative.  Fiscal expansion would then dampen economic activity and a fiscal contraction would increase economic activity.  These results would be just the opposite of those predicted by naive Keynesian fiscal theory.

The possibility of a negative fiscal multiplier rests on the central role played by confidence and expectations about the course of future policy.  If, for example, a country with a very large budget deficit and high level of debt (estimated U.S. deficit and debt levels as a percentage of GDP for 2010 are 10.3% and 63.2%, respectively) makes a credible commitment to significantly reduce the deficit, a confidence shock will ensue and the economy will boom, as inflation expectations, risk premiums and long-term interest rates decline.

There have been many cases in which negative fiscal multipliers have been observed.  The Danish fiscal squeeze of 1983-86 and the Irish stabilization of 1987-89 are notable.  The fiscal deficits that preceded the Danish and Irish fiscal squeezes were clearly unsustainable, and risk premiums and interest rates were extremely high.  Confidence shocks accompanied the fiscal squeezes, and with negative multipliers in play, the Danish and Irish economies took off.  (Evidence from the U.S. is presented in an article by Professors Jason E. Taylor and Richard K. Vedder which appears in the current May/June 2010 issue of the Cato Policy Report.)

Margaret Thatcher also made a dash for confidence and growth via a fiscal squeeze.  To restart the economy in 1981, Thatcher instituted a fierce attack on the British deficit, coupled with an expansionary monetary policy.  Her moves were immediately condemned by 364 distinguished economists.  In a letter to the Times of London, they wrote a knee-jerk Keynesian (Prof. Krugman-type) response: “Present policies will deepen the depression, erode the industrial base of our economy and threaten its social and political stability.”  Thatcher was quickly vindicated.  No sooner had the 364 affixed their signatures than the economy boomed.  People had confidence in Britain again, and Thatcher was able to introduce a long series of deep free-market reforms.

While Prof. Krugman’s authority is weighty, his arguments and evidence are slender.

The National Debt Is Huge, but Unfunded Liabilities Are America’s Real Red-Ink Challenge

I frequently argue that government spending is the problem, not budget deficits. Regardless of whether it is financed by taxing or borrowing, every penny of spending diverts resources from the productive sector of the economy. I narrated a video explaining why excessive spending is bad from a theoretical perspective. I did another looking at the empirical evidence for smaller government. And I had another video discussing why deficits are a symptom and the real problem is bloated budgets.

Nonetheless, some people seem convinced that deficits and debt are the real problem. While I think that focus is a bit misguided, I certainly agree that there is something utterly immoral about spending today and imposing a fiscal burden on future taxpayers (especially since so much government spending is for current consumption and transfers).

But here’s some really depressing news for the anti-debt crowd. Today’s deficits and debt actually are just the tip of the iceberg. Here’s a new video exposing the enormous unfunded liabilities resulting from entitlement programs. As the video explains, unfunded liabilities are promises by politicians that impose enormous long-term obligations for more spending and debt.

The narrator of the video is Kelly McDonough, a student at American University and a former Cato Institute intern. If this video is anywhere near as successful as the other video narrated by a former Cato intern, perhaps this will become a new tradition. That won’t be good for my video career, but it shows that the Cato Institute is doing a good job cultivating a new generation of freedom fighters.

The Greek Model

It was a good idea to get science and democracy from the ancient Greeks. It’s not such a good idea to get fiscal policy from the modern Greeks.

But that’s the way we’re headed.

Greece has a budget deficit of 13.6 percent. We’re not in that league – ours is only 10.6 percent, the highest level since 1945.

Greece has a public debt of 113 percent of GDP. We’re not there yet. But the 2009 Social Security and Medicare Trustees Reports show the combined unfunded liability of these two programs has reached nearly $107 trillion.

Under President Obama’s budget, debt held by the public would grow from $7.5 trillion (53 percent of GDP) at the end of 2009 to $20.3 trillion (90 percent of GDP) at the end of 2020. It could rise to 215 percent of GDP in 30 years. Welcome to Greece.

Here’s a graphic presentation of the official debt and real net liabilities of various countries, including the United States and Greece at the right. (From the Telegraph, apparently based on Jagadeesh Gokhale’s report.)


And here’s a Heritage Foundation chart on where the national debt is headed in the coming decade:

Paul Krugman wrote, “My prediction is that politicians will eventually be tempted to resolve the [fiscal] crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt. And as that temptation becomes obvious, interest rates will soar.” Now he was writing in 2003, when a different president was in office, but he was also warning about the possibility of a ten-year deficit of $3 trillion. Presumably the same warnings apply to today’s much larger deficit projections. And he was absolutely right to fear that government would turn to inflation as a supposed solution.

CBO, the Wizard of Oz, and the Keynesian Fairy Tale

The Obama Administration said that the so-called stimulus was necessary so that the unemployment rate would not rise above 8 percent. Indeed, the White House warned that the joblessness rate would climb to 9 percent if lawmakers did not approve the $787 billion package. Critics responded by explaining that making government bigger would divert resources from the productive sector of the economy and hurt growth. These skeptics also noted that nations using “Keynesian” policy, such as the United States in the 1930s and Japan in the 1990s, did not generate good results. And since the unemployment rate is now above 10 percent, it certainly seems like opponents were correct.

But now the supposedly non-partisan Congressional Budget Office has jumped to the defense of the White House, estimating that the spending bill actually generated beween 600,000 and 1.6 million jobs. How can that be, you may ask, when the number of jobs has fallen by more than 3 million? The CBO neatly sidesteps that real-world concern by moving the goalposts, using a slightly more sophisticated version of Obama’s “jobs created or saved” alchemy. Their jobs-created estimate is compared to a make-believe baseline of how many jobs there would be “without the law.”

CBO estimates that in the third quarter of calendar year 2009, an additional 600,000 to 1.6 million people were employed in the United States, and real (inflation-adjusted) gross domestic product (GDP) was 1.2 percent to 3.2 percent higher, than would have been the case in the absence of ARRA. …CBO’s current estimates differ only slightly from those CBO prepared in March 2009. At that time, CBO projected that in the third quarter of 2009, U.S. employment would be higher by 600,000 to 1.5 million people with ARRA than it would be without the law, and real GDP would be 1.1 percent to 3.0 percent higher. CBO’s new estimates reflect small revisions to earlier projections of the timing and magnitude of changes to spending and revenues under ARRA. …Economic output and employment in the spring and summer of 2009 were lower than CBO had projected at the beginning of the year. But in CBO’s judgment, that outcome reflects greater-than-projected weakness in the underlying economy rather than lower-than-expected effects of ARRA.

Needless to say, this means there is no objective benchmark. The unemployment rate could jump to 15 percent and total job losses could reach 10 million, but CBO would continue to say, for all intents and purposes, that the results from their Keynesian model are more important than any real-world numbers. This is the fiscal policy version of the Wizard of Oz, and we’re supposed to ignore reality just as Dorothy and friends were supposed to ignore the man behind the curtain.

To be fair, there is nothing inherently wrong with CBO’s methodology. Economic analysis frequently requires people to make assumptions about how the world would behave with or without a certain policy. So the real question is whether Keynesian economics makes sense from a theoretical perspective, whether there is any supporting evidence, and whether there are more compelling alternatives. Click the links and decide for yourself.

Greedy Local Politicians Attempt to Grab Revenue Far Outside Their Borders

Regular readers of this blog are familiar with the tax competition battle, which largely revolves around high-tax governments attempting to track – and tax – economic activity that migrates to lower-tax jurisdictions. But this is not just a global fight between decrepit welfare states such as France and fiscal havens such as the Cayman Islands. American states also compete with each other, and there are numerous examples of high-tax states such as California and New York trying to grab money from people who escape to zero-income tax states such as Nevada and Florida. The fight even exists at the local level, and a good example is the attempt by politicians to tax faraway online travel agencies. The Orange County Register opines about these extraterritorial tax grabs:

A recent legal victory for some Texas cities against online travel companies over hotel taxes may have given Anaheim officials hope for their own case, but they shouldn’t start celebrating just yet. Other cities have not fared as well in similar lawsuits. …Here’s what Fairview Heights, Anaheim and other cities wanted to change: In a typical transaction, a traveler picks a hotel and books a room, stays there, and pays the hotel a room charge plus a local occupancy tax based on the room charge. The hotel keeps the room charge and forwards the tax money to the government. Enter online travel companies like Expedia, Hotels.com, Orbitz, Priceline and Travelocity, which allow travelers to sort through hotels and book a room on a central Web site. These companies do not reserve or resell hotel rooms, but act as intermediaries to facilitate the transaction between hotel and traveler. The hotel receives an amount for the room, on which the city’s hotel tax is based. Let’s say I search a Web site and book a $100 hotel room. The online company charges me $10 for their service. Anaheim argues that hotel occupancy tax should be paid not only on the $100 room charge, but also on the $10 service fee. …A federal bill is pending to limit hotel taxes to amounts collected by a hotel for occupancy purposes, excluding service fees and markups by intermediaries. The Constitution permits Congress to pass such laws if there is a danger that state and city laws are interfering with interstate commerce. Hotel taxes are attractive to local politicians because they are a way to shift the tax burden to “outsiders.” But because every U.S. city has a hotel tax, we’re all somebody else’s “outsider.” The net result is that everyone is taxing everyone else in an unaccountable way, and unless the cities and their lawyers are stopped, in an unpredictable way, too.