Cato Online Forum

Structural Reforms to Reduce Debt and Restore Growth

By Douglas Holtz-Eakin
November 2014

America’s future is in jeopardy. Since World War II, the average rate of growth in real (inflation-adjusted) income (Gross Domestic Product, or GDP) per capita was 2.1 percent. At about that pace of growth, the average income would double in 35 years. Put differently, in the course of less than one person’s working life, the standard of living would double. One car could become two. One child’s chance to go to college could open up to the whole family. Two spouses at work could turn into only one, with more time with the family for the other. The opportunity is enormous.

Unfortunately, since 2007, the rate has slowed to a meager 0.7 percent. This is a recipe for diminished opportunity. At that pace, it takes 99 years for incomes to double. More than two working lives will be needed to achieve the same increase in the standard of living that once was experienced in a lifetime. Given the economic turbulence of the post-2007 era, one might expect the bad news to be transitory. So it is even more troubling that the non-partisan Congressional Budget Office (CBO) projects that long run growth per capita will recover to only 1.3 percent over the next 10 years. The poor growth outlook is a direct threat to Americans’ future.

The poor growth outlook is also a threat to the nation’s fiscal strength. The CBO forecasts that federal deficits will total another $7.6 trillion in the next decade and the federal debt will continue to climb from $13 trillion to $21 trillion.

Finally, because it exacerbates the debt problem, the poor economic growth outlook is a threat to our security. According to Admiral Mike Mullen, former chairman of the Joint Chiefs of Staff: “I’ve said many times that I believe the single, biggest threat to our national security is our debt, so I also believe we have every responsibility to help eliminate that threat.”

Fortunately, this is also an opportunity. Americans need not be condemned to this dismal economic outlook. To take advantage of this opportunity will require leadership, a new approach to policy, and better policies themselves.

Leadership is a key. At its core, long-run economic growth is driven by the willingness to sacrifice in the present — no Twizzlers, no Twinkies, no T-shirts, no tanks, no television — in order to devote those dollars to higher skills, bigger production facilities, development of new technologies, advanced machinery and other investments in the ability to produce more and better. Put simply, to sustain growth any nation has to make sacrifices in the present.

Most politicians recoil from this idea, with the result that much of federal policymaking is driven by the desire to act like the sugar plum fairy. It will require strong leadership to appeal to voters and other elected officials on behalf of the nation’s future.

A leadership of that vision and discipline will be necessary to change the style of policy to produce better growth. Facilitating economic growth is more a philosophy than a specific piece of legislation. It is a commitment at every juncture in the policy process to evaluate tradeoffs among social goals, environmental goals, political backers’ goals and economic growth — and err on the side of growth. The Obama administration championed a new health care law that raised $700 billion in new taxes and created two new entitlements at a time when the spending-swollen federal debt was already exploding. The White House also chose social objectives over growth. It unleashed the Environmental Protection Agency, choosing a green agenda over growth. It launched the National Labor Relations Board on a union agenda at odds with growth.

The second flaw in recent policy approaches has been its misguided reliance on temporary, targeted piecemeal policymaking. Even if one believed that countercyclical fiscal policy (“stimulus”) could be executed precisely and had multiplier effects, it is time to learn by experience that this strategy is not working. Checks to households (the Economic Stimulus Act of 2008), the gargantuan stimulus bill in 2009 (American Recovery and Reinvestment Act), “cash for clunkers” (the Car Allowance Rebate System), tax credits for homebuyers (the Federal Housing Tax Credit and the HIRE Act, consisting of a $13 billion payroll hiring credit, expensing of certain investments, and $4.6 billion for schools and energy), the Small Business Jobs Act of 2010, and the state-local bailout Public Law 111-226 ($10 billion for education, $16 billion for Medicaid) have all failed to generate growth.

The policy regime of macroeconomic fiscal (and monetary) fine-tuning backfired in the 1960s and 1970s, leaving behind high inflation and chronically elevated unemployment, and it is working no better in the 21st century. Instead, there should be a commitment to raising the long-term growth rate of the economy through permanent reforms.

What kinds of permanent, structural reforms are necessary? There are a lot of potential candidates but I think one handful will ensure that the 21st century is the second American century: (1) entitlement reforms to make the social safety net sustainable, pare down the federal debt, and reduce its economic drag; (2) modernize the tax code to eliminate distortions and raise international competitiveness; (3) bring a 21st century immigration system built on principles of economic policy; (4) transform the embarrassing and underperforming U.S. K-12 education system; and (5) clean out the regulatory overgrowth that limits U.S. economic flexibility and dynamism.

Begin with entitlement reform. The policy problem facing the United States is that spending exceeds any reasonable level of taxation for the indefinite future. There is a mini-industry devoted to producing alternative numerical estimates of this mismatch, but the diagnosis of the basic problem is not complicated and leaves bare the prescription for action. The budget problem is primarily a spending problem and correcting it requires reductions in the growth of large mandatory spending programs-Social Security and federal health programs.

Since 2010, Social Security has been in cash-flow deficit. There are even larger deficits and future growth in outlays associated with Medicare, Medicaid, and the Patient Protection and Affordable Care Act (ACA). These share the demographic pressures that drive Social Security, but include the persistent increase in health care spending per person in the United States.

Any informed observer, especially credit market participants, can recognize these trends. Improving the outlook for entitlement spending would send a valuable signal to these observers and improve the economic outlook. The spending future outlined above represents a direct impediment to job creation and growth. The United States is courting further downgrades as a sovereign borrower and a commensurate increase in borrowing costs. Any sharp rise in interest rates would have dramatically negative economic impacts, equaling or exceeding the experience of late-2008.

Businesses, entrepreneurs and investors must also consider the future deficits as an implicit promise of higher taxes, higher interest rates, or both. For any employer contemplating locating in the United States or expanding existing facilities and payrolls, rudimentary business planning reveals this to be an extremely unpalatable environment.

In short, entitlement reform is a pro-growth policy move at this juncture. Our research at the American Action Forum indicates that the best strategy to both grow the economy and eliminate deficits is to keep taxes low and reduce public employee costs and transfer payments.1

With the size of the government contained by entitlement reform, the next step is to overhaul and modernize the U.S. tax code. Essential elements of that overhaul are lower rates on business income — both corporate and non-corporate, a competitive system of taxing overseas income, and broad elimination of distortionary tax preferences.

The types of reforms that generate beneficial economic effects extend past reducing the corporate tax rate to include repealing the corporate AMT, making the R&D tax credit permanent, and exempting 95 percent of foreign source dividends. At the same time, one could improve work incentives by simplifying individual income tax rate brackets (recent proposals have suggested two brackets of 10 and 25 percent) and excluding a substantial portion of dividends and capital gains from taxation.

Step three is to recognize that immigration reform can raise population growth, labor force growth, and thus growth in GDP. In addition, immigrants inject entrepreneurialism into the U.S. economy.2 New entrepreneurial vigor embodied in new capital and consumer goods promises a higher standard of living. A better and more open immigration system could thus raise the pace of economic growth substantially and reduce the cumulative federal deficit.

The next step is to acknowledge that education in America is a disgrace. Tests scores in primary and secondary school remain flat, high school dropout rates are still distressingly high, and growth in college graduation rates has bogged down.

Furthermore, our nation shows regular gaps in achievement between wealthy and low wealth students. Regardless of often having better than average funding, poor neighborhoods usually lack great teachers. There is as well a shamefully predictable gap in achievement based on race and ethnicity that persists. On average, students of color have a much lower, 50 percent likelihood of graduating. Of those students of color who do graduate, they typically exit high school with the functional equivalent of an 8th or 9th grade education. This feeds an embarrassingly persistent and worsening gap between our students’ performance and that of students in the rest of the industrialized world. The Organisation for Economic Co-operation and Development (OECD) found that in 2006, America ranked 25th out of 30 industrialized countries in math and 24th in science.

In the past, only parents with enough money could choose a school outside their government assignment — and money can still buy escape. However, around the “assigned sector” of public education, there is a whole other world slowly emerging. Increasingly, there are more choices in the public sector that families can access, among them public charter schools and access to private schools with scholarship or tax credit support.

The tragedy is that the government near-monopoly has prevented these new choices from being fully implemented and throwing open doors to the students that need them most. While thousand of parents have accessed choice programs immediately as they become available, thousands more sit on waiting lists while their children and their hopes languish. Better options driven by parental choice can expand as quickly as we can provide them the students and the resources to do so.

The final step is a new approach to regulation. The recent rapid increase in burdensome regulations comes at a considerable cost to American businesses, consumers, workers, and the economy in general. In 2013 the federal government imposed over $113 billion in compliance costs and an estimated 67 million net paperwork burden hours on American individuals and businesses.3 These costs take a real toll on employment: just $1 billion in additional regulatory compliance costs are associated with a 3.6 percent decline in industry employment. The cumulative effect of regulation is significant, and therefore policymakers should take existing regulatory burdens into account when writing new rules. A comprehensive re-evaluation of existing regulations, starting with the most burdensome, duplicative, and costly, should be undertaken to limit the negative impact on employment and prosperity.

Poor growth is the great threat at this moment. But a new strategy for better growth is the great opportunity for the future.

Notes:
1 See “Repairing a Fiscal Hole: How and Why Spending Cuts Trump Tax Increases,” American Action Forum, February 18, 2011.
2 See Douglas Holtz-Eakin, “Immigration Reform, Economic Growth, and the Fiscal Challenge,” American Action Forum, April 9, 2013.
32013 Regulation Rodeo Database, American Action Forum.
4 See Sam Batkins and Ben Gitis,“The Cumulative Impact of Regulatory Cost Burdens on Employment,” American Action Forum, May 8, 2014.


The opinions expressed here are solely those of the author and do not necessarily reflect the views of the Cato Institute. This essay was prepared as part of a special Cato online forum on reviving economic growth.

Douglas Holtz-Eakin is president of American Action Forum. He is a former director of the Congressional Budget Office.