Impact of Taxes and Spending on the Economy

The fiscal policy of the US federal government is unsustainable – something will, eventually, break under the load of debt and long-term obligations that we are piling up, and the economy will suffer extremely for it.  However, that is a long-term threat, something that can be prevented before it happens.  The real problem in this part of the Interlock is how to prevent that calamity from happening, without wrecking the economy.

As pretty much anybody could figure out by watching the news these days, politicians (and, to be fair, most Americans) are of wildly differing opinions on how to solve the issue of the national debt.  Experts have crunched the numbers and presented their findings (repeatedly).  Unfortunately, to the discomfort of most politicians, the numbers consistently add up to one choice – pain now, or pain later.

The only way that we can balance the federal budget in the short run is to do two things which are, in and of themselves, harmful to the economy and the American people: cut entitlement spending and raise taxes.  However, this would balance the budget only briefly.  The shock of abruptly cutting spending, sharply raising taxes, or any combination of the two, would very likely trigger a recession, reducing government revenue and increasing government spending for welfare and jobless benefits.  This would require a new round of cuts & tax increases to keep the budget balanced, and so on.

This is the “solution” that was forced on the Greeks when they let their debts get out of hand, and the effect has been to drive the Greek economy into a deep depression, with GDP down for 20 consecutive quarters and the unemployment rate over 25% as of the fall of 2013, in spite of partially defaulting on Greek government debt and receiving well over $300 billion in aid.  This isn’t really a solution – it’s a self-destructive vicious circle, inflicted on a nation that ran itself out of options.

The two extreme solutions in this problem set – doing nothing to prevent a fiscal meltdown, or implementing draconian austerity measures – aren’t useful solutions.  While neither of the parties in Washington favor these extremes, their own views on what should be done to solve the problem aren’t much more useful:  the Republicans favor a version of austerity which forgoes tax increases in favor of deeper cuts in spending, while the Democrats favor raising taxes on the rich while forgoing cuts in spending.  Neither approach works – you can’t cut spending enough to make up for the lack of taxes without completely gutting Social Security and Medicare, and you can’t squeeze enough taxes from the upper fifth of the population to make up for the sheer scale of entitlement spending without destroying the little economic growth we still have.

This leads me to point out something that seems to be completely missed in the political debate about the debt: what you do with borrowed money is absolutely critical.  If you borrow to finance consumption and waste, it’s ruinous, especially if your lenders demand appropriate interest rates.  If you borrow to finance investments with a high rate of return, your debt goes up in the short term but down in the long term, and everybody wins.

The deficit debate goes off the rails because no one in Washington is willing to subject government taxing and spending to anything approaching a rational analysis of what is necessary, what is wasteful, and what is productive investment.  There is, in fact, no category in the budget for investments and no way to distinguish between true investments in America’s future and other government expenses.

Both of the approaches that we see in Washington are fundamentally wrong, because both refuse to recognize the vital role that is played by government investment.  Borrowing lots of money and investing it wisely makes us all richer.  Borrowing lots of money and spending it only on consumption is stupid and leads to disaster.  This is one of the few lessons of economics that is as true for nations as it is for individuals.

Right now, the US is facing a crisis not because we have been borrowing and spending too much, but because we have been spending too much on the wrong things and far too little on the right things, the things that will truly pay back that investment at rates of 10%, 20%, or more per year.

There are three keys to fixing our long-term budget and deficit problem without completely destroying what economic growth we have left, or cutting many Americans off from the government’s safety net:

•  Radically reform the tax system to:  lower the tax rate; slightly increase the effective tax rate; eliminate most or all of the $1.1 trillion dollars in tax deductions for special interest groups and rich political donors; improve clarity, simplicity, and compliance; and reduce the damage that our current unplanned, inconsistent, and irrational tax system does to our economic productivity.

•  Fix Social Security and Medicare.  Redesign the rules and revise the funding sources as needed to put them both on a sound, sustainable financial path.  This will be politically painful, but it has to be done.

•  Fix the rest of the Interlock, which will increase our labor force, raise productivity, and add greatly to our long-term capacity for economic growth.  This will require substantial investment, which will mean a higher deficit in the short run, but a lower deficit in the long run.  (Creativity can help here.  For example, the much-discussed infrastructure bank would let states and local governments borrow at the federal government’s low rates to finance solid infrastructure projects with a high return on investment, a good business decision in any world.)

If we are going to stop this drift toward economic disaster, without blowing up our economy like Greece and much of Europe are in the process of doing, we need to stop debating magical painless fairy-tale solutions and get serious about restoring the fundamentals of our economy.  Getting it back on a sturdy growth path – and soon – is the only way out of this mess.

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