The United States faces two economic challenges: slow growth and an ever-increasing ratio of debt to GDP. Many policymakers believe they face a dilemma because the policy solutions to the two problems are opposite. To address the slow recovery, standard—Keynesian—economics suggests further fiscal stimulus in the form of lower taxes or higher spending. But that recommendation runs head-first into the economy’s second crucial challenge, the long-run fiscal imbalance.
Yet policymakers are wrong to see this as a dilemma. The Keynesian model does not evaluate government expenditure using the standard microeconomic concepts of economic efficiency (cost-benefit analysis); rather, it assumes that all expenditure is beneficial. Some government purchases, however, are not a productive use of resources, and transfer payments distort economic incentives and thus can reduce economic output. In contrast, broad-based tax cuts, especially those that lower marginal tax rates, enhance economic growth.
The implication is that tax cuts are the most appealing kind of fiscal stimulus because they are beneficial on both Keynesian and efficiency grounds. Higher transfers and government purchases—increased expenditures—are questionable because any Keynesian benefits must be balanced against potentially large efficiency costs.
Thus the United States should cut unproductive expenditures while keeping tax rates low. A high deductible for Medicare would save money and improve the efficiency of the health care market. With rising life expectancies, Social Security is more generous than necessary to accomplish any reasonable goal of the program. Much military spending goes to programs not related to the defense of the United States. Business subsidies, drug prohibition, and pork-barrel spending should be cut.
The United States therefore has a simple path to a brighter economic future: slash expenditures and keep tax rates low. Reducing expenditures will improve the debt outlook and make the economy more productive, implying higher levels of output and further debt reductions for any given tax rates. Keeping tax rates low will improve the incentives for labor effort, savings, and entrepreneurship, which promotes a more productive economy.