August 20th, 2015
Have A Question?
Polls indicate that many voters are struggling to understand the nature of our deficits.
“There are widespread misperceptions about the state of the federal budget. A majority of voters incorrectly believe the federal government spends more on defense/foreign aid, than it does on Medicare and Social Security (63%). Also, a similar majority (60%) incorrectly believes problems with the federal budget can be fixed by just eliminating waste, fraud and abuse. Voters do not casually agree with these untruths—at least 40% strongly agree. Furthermore, fewer than half (44%) believe Medicare and Social-Security costs are a major source of problems for the federal budget (49% disagree). 60% believe fixing the waste will solve the nation’s budget problems and voters say that a mean of 42% of each federal dollar is wasted.”
According to the Congressional Budget Office[i], the gap between spending and revenues is likely to remain very large, even after we return to normal economic conditions. In addition, fiscal policy cannot be put on a sustainable path, just by eliminating waste and inefficiency. The policy changes that are needed, will significantly affect popular programs or people’s tax payments—or both. As you can see from the following charts, mandatory spending accounts for 61% of the 2010 budget, while three programs (Medicare, Medicaid and Social Security) account for a majority of this mandatory spending.
Moreover, these three programs are projected to grow significantly going forward.
At the same time, there is pressure to maintain (or even increase) federal spending, to help sustain economic growth and offset weakness in other areas of the economy. Yet it is clear, we cannot do it all. We will have to make some choices, none of which feel good. Namely, our choices are:
1. Raise Taxes
2. Cut Spending
3. Borrow More Money
Choice #3 is problematic, as we know there are limits to this (think Greece, Portugal, Ireland, etc.). By borrowing more, we will simply accelerate toward these limits.
Therefore, we ultimately are left with choices #1 and #2: Raising taxes or cutting spending. This will create a near-term drag on the economy (by lowering GDP from what it would be otherwise). So, if neither choice is good, then which one is the best “bad choice?”
This has actually been studied for years[ii]. The results of the data indicate that government spending has an impact of less than 1 (a multiplier of only .32-.40 times in many cases[iii]) and taxes have an impact of greater than 1 (a multiplier as high as 3.0 times has been estimated[iv]). In other words, a dollar of additional government spending, increases the GDP by less than one dollar. Conversely, a dollar decrease in taxes, increases GDP by more than a dollar. Intuitively, this makes some sense. A dollar of tax is fully removed from the economy, but not completely redeployed into the economy when it becomes government spending (since much of the spending is consumed by the administrative function of the government itself and does not show up in the production of goods and services). However, a dollar left untaxed, is spent in the real economy (direct consumption), saved in the bank (providing capital to be lent back into the real economy), or directly invested in a business or other productive project.
Each of these economic activities lead to others and the effects of that dollar are multiplied. If the opposite were true (i.e. if government spending did have a higher multiplier than taxes), then it would make sense to tax everyone and everything at 100%, and replace it with government spending. I think everyone would agree that in reality, such a policy would not grow the economy, but likely snuff out all economic activity.
From the data above, we should then expect that the larger the proportion of GDP (the economy) that is comprised of government spending, the slower the economy will grow. That is exactly what was observed by Treasury Secretary Henry Morgenthau, in 1939 (after years of the New Deal). He concluded, when whatever short-term benefits from increased government spending had evaporated, “We are spending more money than we have ever spent before, and it does not work… After eight years of this administration, we have just as much unemployment as when we started… and an enormous debt, to boot.'”
Indeed, hard choices are hard choices; but some are less painful than others.
[ii] Most Notably: Perotti, Roberto, “Estimating the effects of fiscal policy
in OECD countries”. mimeo (BocconiUniversity, 2004). Blanchard, Olivier and Roberto Perotti, “An empirical characterization of the dynamic effects of changes in government spending”,. Quarterly Journal of Economics (2002).
[iii] Centre for Economic Policy Research – Policy Insight #39, October 2009