Transcript 2011 - Harvard Kennedy School

Back to School on the Budget:
History & Arithmetic
Jeffrey Frankel
Harpel Professor of Capital Formation & Growth
Senior Executive Fellows
March 14, 2011
In September 2010, the NBER Business
Cycle Committee announced that the
trough of the recession came in June 2009

which marked the end of the longest
& most severe recession since the 1930s.

As usual, we were attacked

both for not having declared the obvious trough earlier,
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
based on the rule of 2 consecutive quarters of positive growth,
and also for not waiting until the economy was better

which showed we were “out of touch with reality.”
BUSINESS CYCLE REFERENCE DATES
Peak
Trough
Quarterly dates are in parentheses
August 1929 (III)
May 1937 (II)
February 1945 (I)
November 1948 (IV)
July 1953 (II)
August 1957 (III)
April 1960 (II)
December 1969 (IV)
November 1973 (IV)
January 1980 (I)
July 1981 (III)
July 1990 (III)
March 2001 (I)
December 2007 (IV)
Average, all cycles:
1854-2001
March 1933 (I)
June 1938 (II)
October 1945 (IV)
October 1949 (IV)
May 1954 (II)
April 1958 (II)
February 1961 (I)
November 1970 (IV)
March 1975 (I)
July 1980 (III)
November 1982 (IV)
March 1991 (I)
November 2001 (IV)
June 2009 (II)
(32 cycles)
1945-2001 (10 cycles)
Source: NBER
Contraction
Peak to Trough
43 months
13
8
11
10
8
10
11
16
6
16
8
8
18
17
10
3
National output shows the trough
Figure 1. Monthly Output, Jan. 2006 - June 2010,
Indexed to Dec. 2007 = 100
S-W GDI
Peak
102
Average S-W
GDP&GDI
101
Index Value
S-W GDP
100
Trough
99
98
97
96
95
94
Jan-06
Jul-06
Jan-07
Jul-07
Jan-08 Jul-08
Year
Jan-09
Jul-09
Jan-10
Danger of a double-dip?

There could always be new shocks:
 Sovereign
debt contagion,
 spreading from Greece, Ireland…
 Hard landing for the $
 Geopolitical/oil shock…

I put the odds of a double dip recession as small.
5
Time to enact return toward fiscal discipline

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The only way to do this is both reduce spending
& raise tax revenue, as we did in the 1990s.
Tax revenue
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Let President Bush’s tax cuts expire for the rich in 2013
Introduce a VAT or phase in auctioning of tradable emission permits
Curtail expensive and distorting tax expenditures

E.g., Tax-deductibility of mortgage interest

All politically very difficult, needless to say.

Any solution requires:
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Honest budgeting (e.g., Iraq war on-budget, etc…)
Regime of Shared Sacrifice
Wise up to politicians who insist on doing it entirely on the spending
side & but who raise overall spending when they get the chance.
6
Short fiscal history: The 1980s

In 1981, the newly elected Ronald Reagan complained
he had inherited (almost) $1 trillion of national debt,
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as $1,000 bills stacked up, the debt would reach 67 miles high.
Reagan’s policy: sharp tax cuts (& rise in defense spending)
The claim: budget surpluses would result.
The reality: record deficits that added to the national debt

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a 2nd trillion in his 1st term
a 3rd trillion in his 2nd term
a 4th trillion when G.H.W. Bush initially continued the policies
(“Read my lips, no new taxes.”)
Fiscal history, continued: The 1990s

The deficits were gradually cut, and then
converted to surpluses by the end of the 1990s.

How was this accomplished?
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Regime of “Shared Sacrifice” --3 key policy steps.
1990: GHW Bush agreed spending caps, taxes, & PAYGO
 1993: Clinton extended the policy.
 1998: As surpluses emerged, “Save Social Security first.”

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Strong growth in late 1990s.
Fiscal history, continued: The 2000s

The Shared Sacrifice regime ended
the day G. W. Bush took office in 2001.

He returned to the Reagan policies:
Large tax cuts
 together with rapid increase in spending (triple Clinton’s)
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Not just in military spending (e.g., Iraq & Afghanistan),
but also domestic spending: discretionary + Medicare drugs benefit.
Just like Reagan, he claimed budget surpluses would result.
Just like Reagan, the result was record deficits:

The national debt doubled.

I.e., GWB left more debt than his father + Reagan + 39 predecessors
On what basis do “fiscal conservatives”
claim that tax cuts lead to budget surpluses?

(1) Tea Party logic:

Claim: We can do it by cutting HeadStart & foreignaid.
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(2) The Laffer Hypothesis:
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I.e., repeal the Laws of Arithmetic.
Claim: Tax rate cuts raise income
so much that tax revenue goes up.
(3) “Starve the Beast”

Claim: Tax revenue decline will force spending cuts.

“Congress can’t spend money that it doesn’t have.”
Goal of eliminating budget deficits

Threats of a government shut-down,

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either when a continuing resolution is needed to keep the
government operating,
or when an increase in the national debt ceiling is required.

Description of showdown as a high-stakes game of chicken
is right.

But at least some of the Tea Partiers say that their goal
is literally to avoid an increase in the debt ceiling –

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not just as a bargaining ploy or abstract goal,
but they want to cut spending so sharply that there is no more need
to borrow.
Similarly, Senators Mike Lee (Utah) & John Kyl (Ariz.)
How far can we get by cutting spending?

Total federal spending = $3 ½ trillion in round numbers.

That spending minus tax revenue left
a budget deficit of $1.3 trillion in FY 2010.

Most Republican congressmen want to exempt
defense & senior-related spending (Soc.Security & Medicare),
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to make all the cuts in non-defense discretionary spending.
That was their official platform in November’s election.

Aside from Ron Paul, a genuinely sincere libertarian.
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How much would we have to trim non-defense
discretionary spending to balance the budget?
How far can we get by cutting spending? continued
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Start by eliminating all foreign aid.
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Next imagine zeroing out all of veterans’ benefits and
all federal spending on education & transportation.
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That includes programs so popular
that the congressmen voting for them would lose re-election.
But some of the freshmen say they are willing to pay that price.
We are only up to 6% of total outlays.
Now eliminate all non-defense discretionary spending:
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Foreign aid is only about 1% of total outlays, not 25% as people think.
parks, weather service, food safety, SEC, FBI, border patrol,
politicians’ salaries… everything !
Does that close the gap? It only gets you half way there!
Conclusion: Domestic discretionary spending
is not where the big bucks are.
These 4 categories = 6% of outlays
The arithmetic works out quite simply.

Of the $3 ½ trillion in federal outlays,
1/5 is non-defense discretionary spending.
 Another 1/5th is defense.
 Social security is the third 1/5th.
 Medicare is the fourth 1/5th
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slightly less now, but far far more in the future.
The last 1/5th is interest on the debt
(which will also grow enormously in the future)
plus other entitlements.
1/5 + 1/5 + 1/5 + 1/5 + 1/5
The arithmetic works out quite simply, continued.

Numerically speaking, we would have to eliminate
not just all non-defense discretionary spending,
but also all defense.

Or else all social security spending
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but still collect the payroll taxes that are supposed to fund it!
Or else all Medicare spending.
The unmistakable implication: a solution to our
long-term fiscal problems must involve some
sharing of sacrifice among each of these 5
categories, and increased tax revenue as well.

Admittedly, the Republican leadership’s goal for
the current fiscal year was to reduce domestic
spending by “only” $100 billion.
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But the freshmen’s position: this goal is not enough.
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At the same time, they can’t come up with that
much in specific cuts that they are willing to put
their names to,
let alone enough to offset the Dec. extension of Bush tax cuts,
 let alone anything like budget balance.
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Why? The familiar reasons:

domestic discretionary spending is not where the money is.
Reasonable medium term goals:
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raise taxes as a share of GDP at least to 18%,
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& lower spending to 23%
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= what it was during the Reagan administration,
= what it was then as well.
Of course these two numbers still leave us with
a deficit of 5% of GDP, = Reagan’s record.
It will take us much longer to get back to the
fiscal rectitude of Clinton. It is not possible to
eliminate the need to borrow, in the short run.

Ten years ago, if the country thought it was important
enough to protect any single category against belttightening in the long run - say social security or
taxes - it would have been arithmetically possible, by
making the cuts elsewhere.
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But we no longer have the luxury of such choices
after the legacy of the last decade —
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after the effects of mammoth tax cuts (2001 & 2003),
two wars (2001, 2003),
the Medicare prescription drug benefit (2003),
and the severe financial crisis & recession (2008).
Starting from our current position, each of the 5
components must play a role, along with taxes.
The US public discussion is framed as a battle between
conservatives who philosophically believe in strong
budgets & small government, and liberals who do not.
“Conservatives,” “liberals,” & the media all use this language.
Not the right way to characterize the debate. [1]
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(1) The right goal should be budgets that allow
surpluses in booms and deficits in recession.
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(2) The correlation between how loudly an American
politician proclaims a belief in fiscal conservatism
and how likely he is to take genuine policy steps < 0.
[1] Never mind that small government is classically supposed to be
the aim of “liberals,” in the 19th century definition, not “conservatives.”
My point is different: those who call themselves conservatives in practice tend to adopt
policies that are the opposite of fiscal conservatism. I call them “illiberal.”
“Republican & Democratic Presidents Have Switched Economic Policies” Milken Inst.Rev. 2003.
Three pieces of evidence to support the claim
that “fiscal conservatives” are not:
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(i) The voting pattern among the 258 Congressmen
who signed an unconditional pledge not to raise taxes:
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As of 2004, they had voted for more spending
than those who did not sign the pledge. [2]
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(ii) The pattern of spending
under different presidents.[3]
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(iii) The pattern of states whose Senators win pork
& other federal spending. [4]
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[2] William Gale & Brennan Kelly, 2004, “The ‘No New Taxes’ Pledge,” Tax Notes, July.
[3] JF “Snake-Oil Tax Cuts,” EPI, Briefing Paper 221. 2008.
[4] JF Red States, Blue States and the Distribution of Federal Spending, 3/31/2010.
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(ii) Spending & deficts both rose sharply when
Presidents Reagan, Bush I, & Bush II took office.
Vs. the 1990s: The Shared Sacrifice approach succeeded in
eliminating budget deficits, importantly by slowing spending.
Spending and Budget Balance(inverse) as % of GDP (Current US$)
15
24
13
22
11
20
9
18
7
ρ = 0.86
5
16
G.W. Bush
R. Reagan
G.H.W. Bush
10
1
-1
-3
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008 Est
2009 Est
2010 Est
12
J. Carter
14
W.J. Clinton
3
Spending/GDP
Budget Balance/GDP
Source:
OMB
(iii) States ranked by federal spending received
per tax dollar paid in 2005
versus party vote ratio in preceding election
“red”
states
“blue”
states
big inflow of US $
Republican states take home
significantly more federal $
(relative to taxes paid)
than Democratic states
low inflow of US $
U.S. fiscal policy in 2010-2011, continued

How does one take steps today
to lock in future fiscal consolidation?
Not by raising taxes or cutting spending today (see above);
 nor by promising to do so in a year or two (not credible).
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There are lots of economically sensible proposals
for spending to eliminate,
 more efficient taxes to switch to,
 and “tax expenditures” to cut.

U.S. fiscal policy in 2010-2011, continued

One big reform might work best:
pass legislation today to put Social Security
on a sound financial footing in the long term.
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It would consist of a combination

of raising the retirement age

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and slowing the growth of benefits for future retirees

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just a little (in proportion to lengthening life spans)
just a little (perhaps by “progressive indexation).
If Washington could fix Social Security,

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it would address the long-term fiscal outlook,
yet would create no drag for the current fragile recovery.
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Spending
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Social security
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Cuts in farm subsidies for agribusiness & farmers, incl. ethanol
Cut unwanted weapons systems (a rare success: the F22 fighter)
Cut manned space program…
Raise retirement age – just a little
Progressively index future benefit growth to inflation
Raise the cap on social security taxes.
Health care

Encourage hospitals to standardize around best-practice medicine
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to pursue the checklist that minimizes patient infections,
avoid unnecessary medical tests & procedures,
& standardize around best-practice treatment.
Lever: making Medicare payments conditional on these best practices .
Curtail corporate tax-deductibility of health insurance,
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especially gold-plated.
29
When will US adopt the tough measures
to get back to fiscal sustainability?

Ideally, we would begin soon adopt measures that
would begin to go into effect in 2012 and over the
coming decades – repeating the 1990s success.

Otherwise, in response to future crises,
when it will be much more painful !
Appendix: More on the budget
The two-part strategy that would have made sense at the end of 2010

What changes in American fiscal policy
would be desirable if politics were not an obstacle?
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On the one hand, the economy is still weak.
On the other hand, the U.S. can’t wait until the recovery
is complete to tackle the long run fiscal problem.
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A two-part strategy:
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Steps to extend the fiscal stimulus,
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designed to maximize bang for the buck.
Simultaneous steps to lock in future progress
back toward fiscal discipline in the long run.
U.S. fiscal policy in 2010-2011, continued

Maximizing bang for the buck ≡ fiscal stimulus that
gives the most demand per $ added to long-term debt.
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Example that would minimize bang for the buck:
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proposal to make permanent the 2010 estate tax abolition .
Almost as poorly targeted: proposal to prevent the Bush tax
cuts from expiring in 2011 for those households > $250,000.
If the stimulus has to take the form of tax cuts,
then the best options are:
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extending President Obama’s “Make Work Pay” tax cuts,
fixing the Alternative Minimum Tax, and
extending the Bush tax cuts for those households < $250,000.
Some business tax cuts could also give high bang for the buck.

such as temporary credits for investment or hiring.
U.S. fiscal policy in 2010-2011, continued

But spending boosts demand more than tax cuts do,

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because the latter are partly saved.
Extend elements of the Obama stimulus
such as infrastructure investment and
 giving money to the states

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so that they don’t have to lay off teachers, policemen,
firemen, subway drivers & construction workers.
The national debt as a share of GDP
Source: CBO, March 2011
Projected shares of budget in 2021
Source: CBO, March 2011