November 7, 2010
The New Congress and Economic Growth—Posner's Comment
An Economic Growth and Deficit Reduction Agenda for Congress and the President- Becker
In a wide-ranging interview in the Wall Street Journal published on March 27, 2010 I indicated that the American people were unhappy with the state of the economy, wanted greater economic growth and more limited government, and that they would vote that way in November. Indeed, voters did give President Obama a real "shellacking" (to use his words), as Republicans gained control of the House of Representatives and the governorships of most states, and made large gains in the Senate. The common expectation is that this division will produce a political stalemate, as both parties position themselves for the presidential election in 2012. Yet, the American people need an agenda to raise the growth rate of the American economy, and cut sharply actual and future fiscal deficits. If these happen, not only would unemployment and other short-term problems would be taken care of, but also optimism would return about the longer-term prospects of the United States.
What follows is a partial agenda to raise economic growth and reduce the long run fiscal deficit. The most important step in raising the growth rate is not to increase but rather to lower taxes on capital and entrepreneurship. This implies maintaining essentially all the Bush tax cuts, including those on capital gains and dividends, and those on incomes at all levels, including quite high incomes. The estate tax on very high levels of wealth could be reinstated if politically necessary, but it will only bring in a very small amount of tax revenue, and will be more costly than it is worth. Tax reform also implies a reduction in the corporate income tax, and especially reductions in taxes on incomes of small businesses. Successful small businesses that grow to become large companies, such as Wal-Mart, Starbucks, Microsoft, and Apple, form the foundation of the American economy. They should be strongly encouraged.
One goal of such tax reform is to eliminate as much as possible taxes on capital since economic theory basically implies that economic efficiency requires that capital not be taxed in the long run. For the supply of capital in the long run is highly responsive to after-tax rates of return on capital.
Modern economies are based on the command of knowledge and information. Since knowledge is created by basic and applied research, the United States should increase the share of its GDP that is spent on R&D, a share that has been stable at a little more than 2.5%. The patent system encourages applied research, but basic research, in medicine and other fields, is not patentable, so it needs, and has received, an extra push through subsidies. While most basic research projects fail, the successes often bring enormous benefits to society. Neither bureaucrats nor scientists can predict in advance which projects will succeed and which will fail, so it is important to encourage a broad peer-reviewed approach to basic research topics and investigators.
I do not have space in this brief comment to discuss many other policies beyond taxation that are needed to speed up significantly the growth rate of an advanced country like the United States. These include a quite free approach to international trade, encouragement of immigration, especially skilled and ambitious immigrants, flexible labor and product markets, and limited regulation of most economic activities.
Since the tax cuts and subsidies I advocate will tend to reduce tax revenue, it is especially important to control government spending and the fiscal deficit. I will concentrate on the two main entitlement programs, old age retirement support and medical spending. Together they take about 45% of the total federal budget, and unless reformed, will be even more important in the future.
The drain of social security benefits on the federal budget can be reduced relatively easily. The best approach is to change from a pay as you go system to a defined contribution system. Barring such a drastic change, it would help a lot to continue to extend the retirement age for healthy men and women until it reaches age 70. Older persons live longer and in better health than their predecessors, yet social security systems have been slow in all countries in adapting retirement ages to these health improvements of the elderly.
Controlling spending on medical care is much more challenging, and requires radical changes in the present health care delivery system. The health care law passed this spring (so-called Obama Care) made matters worse rather than better, for reasons partly discussed in my post "The Health Care Bill: Progress or Retrogression?" (3/28/10). I will not repeat all the arguments in that post, and concentrate on only two major defects of both the old and new laws. Out of pocket expenses by individuals receiving care should be much higher in the United States than its average level of about 12% of medical spending. If the American system can move even half way towards the Swiss level of an out of pocket share of over 30%, substantial savings in medical spending would occur in ways that would reflect patients' evaluations of how much the care is worth to them. In addition, the American system should be weaned from being mainly tax-deductible employer based health insurance to a more desirable system, where individuals and families can buy insurance in other ways on the same after tax terms as from employers.
Significantly reforming entitlements would greatly slow down the rate of growth in federal government spending. Despite what some elected Republican officials are saying, politically it will be impossible to actually cut government spending. However, overall cuts in federal spending are not necessary to get the main fiscal problems under control, and to reduce the effective relative size of government, as long as the economy grows significantly faster than government spending does. Speeding up the growth rate of the economy, and slowing down significantly the growth rate of federal spending, would accomplish these goals.
Are these changes likely during the next few years? I am optimistic about the tax cuts, and about extending the age of eligibility on access to social security benefits. Medical care will continue to be a tough nut to crack, but the recently expressed opposition by American voters to the new health care law might help push health reforms in the right direction.
The New Congress and Economic Growth—Posner's Comment
Becker makes the important point that growth in the deficit, because of an increased gap between government spending and tax revenues, is tolerable if GDP grows faster; for it is not the absolute size of the deficit, but its relation to the size of the economy, that is important. And there are, as he says, a number of reforms that would result in faster economic growth, including tax reforms and a rational immigration policy. And spending could be cut—just placing social security and Medicare on a means-tested basis would do wonders.
But there are two questions to ponder. One is whether reforms aimed at increasing economic growth (rather than reducing spending) would be likely to increase that growth by a large enough margin to make a growing deficit shrink as a percentage of GDP. I am skeptical. Americans are lightly taxed by international standards and the rate of formation of new businesses normally is very high. Small businesses are currently having trouble borrowing but that is a consequence of the continuing weakness of the banking system rather than of anything to do with the tax system, and the financial system is likely to revive before tax reform could be implemented. The higher tax rates of the Clinton years seem not to have inhibited economic growth. It would be great if the immigration laws were changed to encourage more immigration by high-IQ foreigners and also by wealthy ones, but, again because of the continuing weakness of the U.S. economy, the demand for skilled immigrants is at present weak.
There may also be a practical ceiling on the rate of economic growth of a mature, highly complex economy. Maybe at a growth rate above 3 percent, labor and materials shortages create bottlenecks and inflation that make it prudent for the Federal Reserve to push up interest rates in order to slow down growth. If this is right and if taxes are cut and spending rises, it is hard to see how the annual deficit can be kept from rising by more than 3 percent. It is illuminating to compare the increase in the national debt during the Presidency of George W. Bush—a period in which Congress (until 2007) and the Presidency were highly pro-business—with the increase in GDP during that period. In 2002, the debt increased by 5.5 percent and GDP by 1.3 percent. The corresponding figures for 2003 were 6.2 percent and 1.4 percent; for 2004, 5.7 percent and 3.4 percent; for 2005, 3.7 percent and 2.6 percent; for 2006, 3.4 percent and 2.9 percent; for 2007, 3.6 percent and 2.8 percent; for 2008, 5.0 percent and 2.0 percent; and for 2009, 5.5 percent and 2.6 percent. Since then of course the gap has widened, but that is because of the economic crisis. We would feel great if we were back in the Bush economy! Yet in every year of Bush's Presidency, the deficit grew faster than GDP. That may be the "new normal."
The second question (which relates to the hypothesis of a new normal) is the political realism of economic reforms that would increase the growth rate or reduce the deficit. As I have argued previously, both political parties seem to have converged on a policy of high spending and low taxes. The Democrats want even higher spending than the Republicans do, and the Republicans want even lower taxes than the Democrats do, but these differences should not blind us to the realization that neither party has serious plans for reducing the annual increases in the deficit. I do not see this changing in the new Congress. If the Republicans had won control of the Senate, they would be under pressure to produce legislation that the President would sign, lest the new Congress be accused of being a "do-nothing" Congress—the accusation that won Truman the Presidency in 1948. But since the Republicans do not control Congress, an oppositional stance is attractive. And it is more difficult for Obama to compromise with Republicans than it was for Clinton, because Obama is more liberal than Clinton was and the Republicans are more conservative today than in the 1990s.
The status of the dollar as the international reserve currency, and the mercantilist policies of countries like China and Germany, will enable us to finance our growing deficit, and thus postpone the day of reckoning, for some time. But at some point the wheels may start coming off the chassis.
Still, life is full of surprises. The prospects for the United States looked grim in the 1970s and bright for Japan. Then Reagan was elected and the sky cleared here, and then the Japanese housing and banking bubbles burst and Japan entered the long period of economic stagnation in which it still finds itself. Maybe we'll get lucky again.