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October 3, 2011
Last Class Before the Deficit Exam

Full Text Published by Tax Analysts®

By Martin A. Sullivan --

OK, class, settle down. Judging from the less than stellar work you've handed in so far, it looks like most of you have been studying cable TV news instead of the assigned reading. I'm not optimistic about your chances on next week's exam. So I'll tell you what I will do. You will still have to struggle through the multiple-choice questions on your own, but for the short essay section I'll tell you in advance what the questions are going to be. And in an unprecedented display of academic largesse, I am actually going to give you the answers. So take careful notes. And nobody should have any excuses for getting these wrong and not knowing the most important lessons of Deficits 101.

Question #1. Right now, politicians of all stripes agree that reducing the federal deficit is a top priority. Similarly, President Hoover insisted in 1932 that deficit reduction had to be the top priority for Congress and his administration. Are there real economic arguments in favor of deficit reduction, or is all this concern about the deficit just irrational fear?

The Congressional Budget Office projects that the net federal debt held by the public will be equal to 67.3 percent of GDP at the end of fiscal 2011. That is more than double the figure of 30.6 percent in 2007. There are two main reasons why economists worry about high levels of federal debt.

First, they fear that public debt will crowd out private capital formation. When private saving is invested in public debt, there are fewer funds available for investment in plant, equipment, and research. The resulting slowdown in capital formation and technological progress reduces productivity, real wages, and competitiveness. The amount of crowding out is not dollar-for-dollar, however, because the supply of saving available for capital formation is not fixed. Domestic households may increase saving when the federal debt rises. And inflows of foreign capital will rise when the government increases its borrowing.

Second, economists fear that high public debt could result in financial instability. For example, any threat of default by the U.S. government could set in motion a series of bank failures and subsequently cause the collapse of lending to the nonfinancial sector.

For decades economists have studied crowding out, and although -- as with most aspects of empirical economics -- there is considerable uncertainty and controversy about the size of the crowding-out effect, it is a phenomenon that is well understood and widely accepted. In contrast, the concerns about financial instability effects of the debt only began to receive significant attention in the last few years, and they are not well understood in either theory or the real world.

Economists do know, as a matter of arithmetic, that if federal debt is on an unsustainable path -- that is, if as a share of GDP it is constantly rising (as is now currently projected) -- government finances and the entire economy will collapse. But what is highly uncertain is at what point financial markets start to fear the collapse. At that unpredictable tipping point, investors' expectations may become self-fulfilling, and it would be extremely difficult and maybe even impossible to prevent default on government debt. We are in uncharted territory. The outlook for U.S. government finances has never been so poor. The tipping point may be decades away, or it may be much closer.

Question #2. With the unemployment rate stubbornly remaining above 9 percent, all politicians are insisting that job creation is a high priority. How might high unemployment change government policy toward deficit reduction?

The standard Keynesian prescription for fighting unemployment in a recession is to stimulate aggregate demand through direct government spending or through tax cuts that should spur increased consumer spending by individuals and capital expenditure by businesses. If that is true, and assuming the level of federal debt is not immediately threatening financial stability, it would make sense for the federal government to postpone deficit reduction until after unemployment is reduced to acceptable levels. In short, the federal government should increase the deficit in the short term (to increase demand) and reduce it in the long term (to expand aggregate supply and promote financial stability).

One of the oldest debates in economics is whether Keynesian policy actually works. Conservative economists generally believe that the economy is rarely out of equilibrium and that even if there is nonstructural unemployment, there is little that government macroeconomic policies can do to correct it. (However, microeconomic policies that reduce government interference in the market -- like eliminating the minimum wage and reducing government regulations -- could help increase employment.) Conservative economists believe that any increase in aggregate demand stimulated by an increasing deficit will be completely offset by reductions in private spending -- that is, private spending is completely crowded out by government policies.

The long-standing debate on the effectiveness of Keynesian policy has entered a new phase, as it is widely believed that the various stimulus packages (small ones enacted under President George W. Bush and capped off with the large stimulus enacted at the beginning of the Obama administration) have not worked because unemployment remains so high. However, the persistence of high unemployment is not evidence of ineffectiveness, because we cannot observe what unemployment would have been in the absence of those measures. As a theoretical matter, that businesses are reluctant to make capital expenditures despite having large stores of cash would suggest that this is exactly the right time to engage in Keynesian policy. Crowding out will be minimal because the private sector is not spending. The government can and should try to stimulate spending, because the private sector is unwilling.

The CBO has estimated that the 2009 stimulus increased employment between 1 million and 2.9 million jobs ("Estimated Impact of the American Recovery and Reinvestment Act on Employment and Economic Output From April 2011 through June 2011," August 2011, Doc 2011-18147 , 2011 TNT 165-19 ). Given all this, if Congress is concerned about job creation, it should not immediately reduce the federal budget deficit. On the contrary, it should increase it.

Question #3. President Kennedy famously said that a rising tide lifts all boats -- meaning that economic growth will help all citizens, rich and poor. Over the last three decades, has the rising tide lifted all boats? What role might income distribution play in efforts to reduce the deficit?

A variety of economic statistics indicate that the gap between rich and poor is growing. For example, according to data from the Census Bureau, median family income (adjusted for inflation) was lower in 2010 than it has been in every year since 1996. (See the adjacent figure.) And according to the CBO, the top 1 percent of households in 1979 accounted for 7.5 percent of all after-tax income, while that share had more than doubled to 17.1 percent by 2007. These data are telling us that economic growth over the last few decades has favored the rich much more than the poor. This long-term trend suggests that there may be significant political pressure for the wealthy to bear a proportionately larger share of the burden of deficit reduction.

However, there is little in economics to recommend the redistribution of taxes from poor to rich or government benefits from rich to poor. On the contrary, the most fundamental tenets of economics recommend against these types of changes if the goal of policy is to promote long-term economic growth.

Question #4. The Tax Reform Act of 1986 was the last major tax reform effort in the United States. To many it seems like another major tax reform is imminent. Both conservative and liberal politicians are clamoring for tax reform to be part of a deficit reduction package. What is tax reform? What role would it have in deficit reduction?

There is no official definition of tax reform, but it is usually characterized as a reduction in rates that is funded by a reduction in tax expenditures. By design, the Tax Reform Act of 1986 was deficit neutral. Because it had no estimated impact on the budget deficit, it played no direct role in budget policy.

In contrast, much of the newfound interest in tax reform is closely associated with major deficit reduction. When deficit hawks and Democrats use the term "tax reform," they are talking about a tax reform plan that would increase taxes. But deficit reduction could be achieved just as well by a simple increase in taxes without all the rigmarole of major tax reform -- as President Clinton did in 1993. Most Republicans are in favor of tax reform, but they have publicly stated that they oppose any tax increases. If tax reform is not going to increase revenues, it is hard to understand what it has to do with deficit reduction.

It is true, as many conservatives argue, that fundamental tax reform -- that is, reform that significantly lowers tax rates and/or significantly reduces taxes on savings and investment -- could increase economic growth and revenue in the long run. But politically realistic tax reform will have many compromises and transition rules that diminish the economic benefits -- particularly in the short run. The magnitude of economic benefits from tax reform is highly uncertain and controversial. And as a practical matter, it would be extremely difficult, if not impossible, to implement a procedure for scoring macroeconomic benefits of tax and spending legislation that would not be susceptible to gaming by Congress.

Bonus question: Many leading politicians are arguing that U.S. policy should promote U.S. manufacturing. Many also argue that the United States should reform its corporate tax system and lower corporate tax rates. Why might reconciling those two goals be difficult?

Median Family Income in the United States, 1978-2010

Source: Census Bureau, Table 1E-1, "Selected Measures of Household Income Dispersion," available at All income converted to 2010 dollars.

If Congress weren't so overwhelmed with concerns about the federal debt -- as in 2003, when it expanded Medicare to include a prescription drug benefit, estimated to cost about $70 billion per year -- these two goals would be easy to reconcile. For example, Congress could reduce the top corporate tax rate from 35 percent to 25 percent at a cost of about $100 billion per year in lost revenue -- that is, it would be a debt-financed corporate tax cut. This rate cut would provide a major benefit to America's major manufacturers as well as other large American businesses.

But now the U.S. government is under severe budget pressures. It would be extremely difficult for the corporate community to obtain an overall reduction in corporate tax receipts. Democrats are clamoring for the opposite -- the closing of corporate loopholes to pay for deficit reduction. Probably the best that corporate America can hope for in this environment is deficit-neutral corporate reform.

Therefore, corporate rate reduction will require cutting corporate tax expenditures. Rate reduction to the oft-stated goal of 25 percent will require cutting almost all tax expenditures. The largest corporate tax expenditures are accelerated depreciation, the research credit, the deduction for domestic production, and the deferral of U.S. tax on foreign profits. The vast bulk of these tax expenditures disproportionately benefit U.S. manufacturing. Therefore, it is hard to conceive of a revenue-neutral corporate tax reform in which American manufacturing could gain more from rate reduction than it would lose from cutting back tax expenditures.

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OK, class, that's all we have time for now. Stay healthy, study hard, don't watch cable news, and I'll see you on exam day.

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