In Response to Alan Blinder
In yesterday’s Wall Street Journal, Professor Alan Blinder argued that “a serious debate over fiscal policy is now raging.” It sure is. Unfortunately, this is the only part of his stalwart defense of the Administration’s fiscal folly with which I can agree. Let’s get this debate grounded in reality.
Professor Blinder makes a series of related claims:
- The stimulus bill worked,
- That it is a good idea to raise taxes – specifically the top two marginal tax rates, dividend taxes, and associated elements of the 2001 and 2003 tax bills,
- That it makes sense to not pay for additional spending on unemployment insurance, and
- The net effect will be to improve economic performance.
With all due respect: Nope.
The fiscal stimulus did not “work.” Recall that the underlying rationale for Keynesian fiscal fine-tuning is the notion that if the government cuts taxes by $1 (any taxes, regardless of incentive effects) or spends $1 (any spending regardless of incentive effects) the economy will expand by some multiple of that dollar.
What is the historical record? The Administration’s claim has been that the economy was “falling off a cliff”; indeed GDP declined at a 6.4 percent annual rate in the fourth quarter of 2008. Thus, the implicit assumption is that it would have continued falling at that rate. This path is labeled “Continued Decline” in the chart (below). In contrast, the economy stopped falling in 2009 and began to grow in the third quarter (the path labeled “Actual”). The shaded area is the difference – the additional GDP from not continuing to decline – and totals $268 billion.
Stimulus (outlays and reductions in receipts) in 2009 was roughly $260 billion. Thus, if one attributes all improvement in GDP to the stimulus – that is, no role for the Federal Reserve’s policy efforts, no role for mortgage relief programs, no role for worldwide economic improvements, and so forth – then the stimulus bill essentially broke even. Every $1 dollar the federal government spent resulted in $1 of spending. No multiplier effects. No Keynesian magic. It did not “work.”
The next mistake is conceptual. Even if one believed that countercyclical fiscal policy (“stimulus”) could be executed precisely and had multiplier effects, now is not the time for more. That playbook has been run to no good effect: 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), and tax credits for homebuyers (the Federal Housing Tax Credit).
Instead, it is time to recognize that the U.S. has a growth problem. The U.S. economy is growing, albeit slowly, not declining. GDP has been rising since the third quarter of 2009, and employment is up from its trough in December 2009. NFIB’s small business confidence index was 92.2 in May 2010, up from 81.0 in March 2009. Consumer confidence is up from 26 in March 2009 to 63.3 in May. The ISM manufacturing and non-manufacturing indices are above 50, signaling growth. There is substantial and widespread evidence of an ongoing economic expansion. This is not the time for counter-cyclical fiscal fine-tuning.
The elements of a pro-growth strategy are not complicated: low, efficient regulation; adherence to opening markets to competition at home and abroad; protection of the rewards to innovation and risk-taking and a streamlined, competitive tax code. In choosing pieces of the agenda, it is especially important to recognize that at this juncture the balance sheets of both households and governments are severely impaired. Instead, the real payoff to growth strategies will be supporting the ability of the business community to spend in the U.S. and sell abroad.
Professor Blinder’s comments on the sunset of the 2001 and 2003 tax laws are especially perplexing in this light. It is now widely recognized they are an important aspect of business taxation. The Joint Committee on Taxation projects that $1 trillion in business income will be reported on individual income tax returns in 2011. Notably, of that $1 trillion, nearly one-half, $470 billion, will be reported on returns that will be subject to the top two rates of 36 percent and 39.6 percent if EGTRRA and JGTRRA are allowed to sunset.
According to Gallup survey data conducted for the National Federation of Independent Business (NFIB), half of the small business owners in this group fall into the potential 36 percent and 39.6 percent tax brackets. This means there is a pool of more than 20 million workers in those firms directly targeted by the higher marginal tax rates. This is likely a conservative estimate as it ignores flow-through entities with one to 19 workers
Eliminating the tax uncertainty regarding their future would be an important step in the right direction. It has been widely noted that uncertainty over the policy environment itself may contribute to a desire by businesses to hoard cash instead of spending. A temporary extension of the tax laws will merely defer resolving the uncertainty over the tax policy outlook. In the other direction, a permanent extension would set expectations, permit long-range business planning, and support long-term economic growth. Notice that at the same time, there would be immediate economic benefits as businesses step up their spending to match the improved long-run outlook.
In thinking about permanent extensions it is useful to recognize that not all the components are equal from a growth perspective. Innovation, investment, and saving decisions are directly affected by structure of marginal tax rates, the taxation of returns to equity investment in the form of dividends and capital gains, and provisions for capital cost recovery (e.g., Section 179 expensing). In contrast, provisions for refundable tax credits, marriage penalty relief, and other targeted incentives make no contribution to growth incentives.
Lastly, many believe that a deep structural reform of the tax code is essential to generate maximum feasible growth. Any such reform would be built on low marginal rates, investment and innovation incentives, and a broad base. A temporary extension that simultaneously raises marginal rates, diminishes investment incentives, preserves a narrow base, and perpetuates uncertainty is a step in the wrong direction from every perspective.
Which brings us to the most important point: raising taxes is not about real deficit reduction. Remember, the Obama budget includes these higher taxes. Despite that, over the next ten years the deficit will never fall below $700 billion. Ten years from now, in 2020, the deficit will be 5.6 percent of GDP, roughly $1.3 trillion. Why? Because federal outlays in 2020 are expected to be 25.2 percent of GDP – about $1.2 trillion higher than the 20 percent that has been business as usual in the postwar era. The deficit is a spending problem.
Professor Blinder’s admonition is exactly backwards: raise taxes and don’t offset unemployment insurance extensions. He makes this argument on humanitarian and technical grounds.
Regarding the former, conservatives understand that unemployment insurance has mixed incentives. The good news is that it permits individuals to search longer and make better labor market matches. The bad news is that it diminishes search intensity, raises unemployment durations, allows skills to deteriorate, and ultimately lowers earning potential. At some point, the damage to a worker’s prospects outweighs the benefit of extended earnings.
For this reason, there is no reason to always and automatically extend benefits. Professor Blinder argues that in these circumstances it is “humanitarian” to extend them, even if the worker does not benefit on balance. Fine. Why is it humanitarian to leave the bill to our children? Even humanitarian extensions of unemployment insurance have a cost that should be acknowledged via deficit-neutral reductions in other spending.
The second part of the argument is to argue that this humanitarian transfer is really “stimulus” that is so potent it will outweigh the negative impact of tax increase. The first thing to note is that this is “paying for” the extension, something Democrats have steadfastly opposed. Second, Professor Blinder points toward Mark Zandi’s assertion that unemployment insurance has more bang for the buck. Unfortunately, this is neither a fact nor a research finding. In basic Keynesian models, spending multipliers are assumed to be larger than tax multipliers. As a result, adopting these models presumes this result. In contrast, recent empirical work on both sides of the budget suggest that tax impacts are larger – perhaps much larger – than spending impacts.
Here is the reality. The U.S. economy is growing, but too slowly for meet the needs of the unemployed, build the capacity to shoulder the burdens the debt explosion places on it, and meet our obligations to the next generation. Every policy should be focused on growth, not sugar-high “stimulus” fixes. For tax policy, this is simple. Near-term tax policy should be relentlessly pro-growth, enhancing the strength of the business community, assisting households repair damaged balance sheets, and consistent with a path to tax reform. Deficit reduction should be focused on getting federal spending under control.
This article is in response to Professor Alan Blinder's article which appeared yesterday July 19, in the Wall Street Journal.