Designing federal budget policy to spur economic growth

Designing Federal Budget Policy to Spur Economic Growth
Luncheon Speech, Annual Meeting of the
National Association for Business Economics

Thank you. I am delighted to be back at NABE. My goal today is to make the case for a set of changes to federal budget policy that would spur economic growth. In contrast to my talks when I was director of the Congressional Budget Office (CBO), today I will be making policy recommendations. I will try to be explicit, though, about the ways in which the recommendations are based on the analysis done by CBO and others, and the ways in which the recommendations are based on my personal value judgments.

Before discussing specific policies to spur economic growth, we need to address a preliminary question: Economic growth for whom? The traditional answer is “economic growth for the country as a whole.” That answer stems from a view that growth in total output and income will generate growth in incomes for most people. But that view has been wrong in the past few decades: The rising tide has not lifted most people’s boats very much.

Between 1979 and 2011, real gross domestic product (GDP) per person increased 67 percent. CBO has published estimates of the growth in market incomes—that is, incomes before taking account of taxes and transfers—for different groups over that same period. CBO estimated that market incomes rose 16 percent in the bottom quintile of the distribution, 9 percent in the middle quintile, and 77 percent in the top quintile. Within that top quintile, market incomes grew about 60 percent for the people not in the top percentile and 174 percent in the top percentile. We should not put too much weight on those specific numbers because measuring income growth is difficult, and even though CBO’s methodology resolves some of the problems in other time series, measurement issues remain. Still, it is clear that the market incomes of people across most of the income distribution have benefited very little from the growth of total output and income in the past few decades. Given that pattern, my value judgment is that we should focus on designing fiscal policy to spur income growth for lower- and middle-income people. I want to be explicit about that judgment, because it matters for the policy recommendations that follow.

How could we accomplish that goal? Here is a five-part agenda for federal budget policy to spur income growth:

• One, maintain federal investment as a share of GDP;
• Two, reform the tax code to increase the efficiency of business investment;
• Three, encourage innovation;
• Four, reduce federal debt relative to GDP, but only slowly; and
• Five, reduce uncertainty about future budget policy.

Let me address each of those items in turn.

First, maintain federal investment as a share of GDP.

Most federal investment is funded through the discretionary appropriations that Congress approves each year. Not surprisingly, defense investments primarily enhance our ability to protect the country, although they sometimes have positive spillovers to economic growth. I will focus on nondefense investments, which CBO analyzed in a report two years ago. Under the current caps on discretionary spending, federal nondefense investment in infrastructure, education and training, and research and development soon will be smaller relative to GDP than at any time in at least 50 years. Specifically, the current caps imply that nondefense discretionary spending will be a smaller percentage of GDP each year after 2016 than at any time in at least 50 years, and those investments have represented about half of nondefense discretionary spending nearly every year in the past 50. Therefore, unless the composition of nondefense discretionary spending shifts toward investments and away from other items to an extraordinary degree, the decline in that spending relative to the size of the economy will mean a decline in key federal investments relative to the size of the economy.

That is not forward-looking, growth-oriented budget policy. Spending for infrastructure like roads and airports decreases the cost of moving people and delivering good and services; spending for education and training enhances the skills of our workforce; and spending for research and development promotes innovation. Cutting those federal investments will reduce total output and income relative to what they would otherwise be. In particular, cutting federal investment in education and training will reduce the incomes of lower- and middle-income people who are dependent on government help to have a real opportunity to advance.

To boost economic growth, we should raise the caps on nondefense discretionary spending substantially, in order to maintain federal investment as a share of GDP. That increase would also have the short-term benefit of providing a little more fiscal stimulus to an economy that needs it; I will come back to this issue later.

We should also work to increase the return on federal investments. Sometimes we build critical transportation links, and sometimes we build bridges to nowhere; sometimes education funding supports a breakthrough in a person’s life, and sometimes it is dissipated. CBO’s central estimate is that additional federal investment yields half of the typical return on private investment, in part because federal investment can crowd out investment by private entities or state and local governments, and in part because federal investments are not always chosen with an eye to maximizing their effect on future income. We can do better. For example, we should increase the role of careful cost-benefit analysis in deciding which specific investments to undertake.

In addition, it is important to understand that some federal spending outside nondefense discretionary spending also represents an investment in future income, especially for lower-income people. There is a growing body of evidence that certain health-care benefits, housing subsidies, education subsidies, and other means-tested benefits raise future incomes of some young people. We should protect those investments as well.

You will note that I have made the case merely for preserving the current amount of federal investment relative to the size of the economy. One can make a case for increasing federal investment as well. But even preserving federal investment would require a significant increase relative to what will happen under current law.

The second element of my agenda to spur income growth is to reform the tax code to increase the efficiency of business investment.

I considered urging tax reform to increase the amount of business investment. However, increasing the amount of business investment through tax reform would be difficult to achieve while still collecting sufficient tax revenue and not increasing the tax burden on people of modest means. Consider the comprehensive reform proposal put forward by Congressman Dave Camp when he was Chairman of the Ways and Means Committee. According to the staff of the Joint Committee on Taxation, his proposal was roughly revenue-neutral (excluding the budgetary feedback from the proposal’s macroeconomic impact) and roughly distribution-neutral. But to achieve those goals along with others that Chairman Camp had identified, the proposal would have raised the marginal tax rate on capital and thereby reduced business investment.

If one relaxed the condition of revenue neutrality, than naturally it would be easier to reduce the marginal tax rate on capital. However, the increase in federal borrowing would diminish economic growth. Instead, if one shifted the tax burden toward people of modest means, then again it would be easier to reduce the marginal tax rate on capital. However, people of modest means might well be worse off, even after accounting for the effects of additional capital, and I stated at the outset that I would focus on fiscal policy to spur income growth for people of modest means.

Still, tax reform could increase economic growth by increasing the efficiency of business investment. The current tax code distorts businesses’ decisions regarding asset types, industries, organizational forms, and geographic locations. Reducing those distortions would boost future incomes. Therefore, we should enact revenue-neutral and distribution-neutral tax reform that increases the efficiency of business investment.

The third item on my agenda is to encourage innovation.

The development and diffusion of new products and new processes for making products are key determinants of economic growth in the long run. That does not mean that innovation and growth track each other precisely. Indeed, an important puzzle regarding recent years is that innovation seems strong in some visible ways, but growth in total factor productivity has been quite weak. Nonetheless, over the long run, a faster pace of innovation should lead to faster productivity growth and thereby faster growth in incomes.

CBO published a report last fall that examined a range of policies to encourage innovation. Some of the key policies are not primarily budget policies. Among those, I would highlight policies to increase immigration of high-skilled people and to improve the patent system. Other important policies are budget policies. Those policies could be viewed as part of my earlier recommendation to maintain federal investment, but I want to highlight them separately. One important policy is to provide robust funding for research. Another is to provide strong support for education in science, technology, engineering, and mathematics—or STEM. Both of those policies would be facilitated by raising the caps on nondefense discretionary spending.

The fourth element on my agenda to spur economic growth is to reduce federal debt relative to GDP, but to do so only slowly.

Federal debt as a percentage of GDP is currently very high by historical standards, and it probably will be much higher in a few decades without significant policy changes. Specifically, federal debt held by the public is now 74 percent of GDP, compared with an average of 38 percent during the past 50 years, and CBO’s long-term baseline shows debt exceeding 100 percent of GDP in 25 years and on an upward path.

That long-term baseline is unsustainable, because federal debt cannot increase indefinitely relative to the size of the economy. Unless we are remarkably lucky regarding the key demographic and economic variables that affect the budget, we will need to make significant policy changes. However, it is not clear what level of federal debt we should aim for. Economics does not offer a straightforward guide to the optimal amount of federal debt. In my assessment, based on what economists know now, the prudent approach is to reduce the debt-to-GDP ratio gradually over the next few decades rather than letting it increase. That approach would, in the long run, allow for additional investment in private capital, which would raise future incomes, and give policymakers flexibility to respond to unexpected events, such as financial crises, recessions, and international threats.

However, we should reduce debt only slowly. A further decline in the deficit in the next few years would hurt the economic expansion—just as the rapid drop in the deficit in the past few years slowed the recovery by lowering output, investment, employment, and wages relative to what they would have been otherwise. Therefore, we should not reduce federal debt quickly. And certainly we should not try to balance the budget, because that would definitely harm the expansion and not needed to reduce the debt-to-GDP ratio slowly.

Indeed, in my view, a rush to “normalize” fiscal policy has been the biggest policy error during the economic recovery. When the economy is suffering from a shortfall in demand, and the federal funds rate is close to its lower bound, the tax increases or spending cuts that reduce budget deficits lower output, investment, employment, and wages. Similarly, tax cuts or spending increases improve economic conditions. CBO made this point repeatedly, and it has been confirmed by many analyses and by experience around the world since the financial crisis. The legitimate concern about federal debt has been its long-term path, not its short-term spike, so reducing the deficit as quickly as we did was a significant mistake. Similarly, although this is beyond the scope of my talk, a rapid normalization of monetary policy would have been a significant mistake, and the Federal Reserve has wisely resisted pressure to do that.

To reduce the debt-to-GDP ratio over time, what changes in spending and taxes should we make? The answer matters for the size of the overall economic pie and for the size of different people’s slices. My own answer comes primarily from two sources.

One is the evolution of the federal budget in CBO’s baseline. If we look ahead 25 years, and express budget components as percentages of GDP, we can see that revenue will rise above its historical norm, but spending will outpace it. The future rise in spending is driven by both growing interest payments and growing noninterest spending. When we divide noninterest spending into three components, we can see that spending for Social Security and Medicare will continue to increase. Defense spending is declining. All other noninterest spending taken together is roughly the same share of GDP now that it was 25 years ago, and in CBO’s baseline it is roughly the same share 25 years from now. Of course, there have been important shifts within this very broad category. But the key point is that the rise in federal noninterest spending does not stem from general growth in the federal government relative to the size of the economy but instead from a dramatic increase in spending for Social Security and Medicare. The principal factor underlying the increase during the next 25 years is the rapidly growing share of the population over age 65.

The second source of my answer to the question of how to adjust spending and taxes is a value judgment. I argued at the beginning of the talk that we should try to spur income growth especially for lower- and middle-income people, who have been experiencing the slowest growth in incomes.

If that is our goal, then restraining federal debt by cutting their benefits or raising their taxes would be counterproductive. Specifically, based on those budget data and that value judgment, I think we should avoid significant cuts in benefits targeted at lower- or middle-income people—as well as significant across-the-board cuts in benefits, such as increasing the eligibility age for full Social Security benefits. Such cuts would significantly reduce income for people of modest means. Instead, we should impose most of the burden of debt reduction on higher-income people: We should increase means-testing of Social Security and Medicare benefits, and we should raise taxes on the affluent. I discussed this point at greater length in a talk a few weeks ago, and you can find that talk on the Brookings web site.

I want to emphasize that this approach does not offer a free lunch. Making Social Security and Medicare more progressive would weaken the connection between an individual’s taxes and benefits, which could undermine the earned-benefit character of the programs if taken too far. Also, people with higher incomes would face both higher taxes and lower benefits, which would reduce their incentives to work and save. But I think this is the best of the available alternatives for restraining federal debt without unduly burdening those Americans who have fared the worst in economic terms in recent years.

The fifth item on my agenda for boosting economic growth is to reduce uncertainty about future budget policy.

Consider corporate taxes. We have been discussing tax reform for a number of years, but no Congressional committees have voted on a reform proposal, so businesses have no clear basis for predicting future tax rates on different activities. Indeed, given our delayed approach each year to addressing the so-called tax extenders, businesses do not even know all of the past tax rates on certain activities. That uncertainty makes it more difficult for businesses to have the confidence to undertake investment and more difficult for them to know what they should invest in.

Admittedly, the quantitative significance of this problem generally is not clear. Uncertainty about federal taxes is only one of many sources of uncertainty faced by businesses, and even the most forward-looking policymaking would leave some uncertainty. But if we are serious about encouraging economic growth, unnecessary policy uncertainty is a self-inflicted wound.

And in some specific cases, this is a serious problem. One clear example is climate policy. Given the views of experts about climate change, we will almost certainly need to legislate policy changes that reduce carbon emissions substantially. But because we have not legislated such changes yet, utilities and energy-intensive businesses that are making long-lasting investments in plant and equipment face more uncertainty than they should. And the regulations being developed do not solve this problem because they can be changed more easily by a future Administration than legislation could be—in addition to being less efficient than a carbon tax or cap-and-trade system would be.

Uncertainty is also created by the constant brinkmanship over critical policy actions. Businesses trying to sell products to the federal government do not know whether the government will be open on December 12th, and they do not know what agencies’ budgets will be if the government is open. Participants in financial markets want to be sure that federal interest payments and payments for other obligations will occur on time, and not doing so would be terribly dangerous for the country. Yet, the so-called extraordinary measures for managing our debt when an increase in the debt ceiling is overdue have now become entirely standard in a recurring game of chicken.

I should also mention that policy uncertainty hampers effective decision-making far beyond the business community. We want households to plan ahead for their retirements, but that is much more difficult when future Social Security and Medicare benefits and future taxes are up in the air. State and local governments want to plan ahead, but that is much harder when the federal highway bill experiences its 35^th short-term extension in seven years. Federal officials who are managing programs would like to know their budgets and legislated priorities for the fiscal year already underway, but they do not. As with businesses, those organizations face many sources of uncertainty beyond federal budget policy, but uncertainty about budget policy makes their decisions much harder.

Indeed, decision-making by the Congress is hampered by the constant brinkmanship. The time spent on repeated short-term extensions of expiring policies and appropriations is time not spent on more significant policy issues. For example, the elimination of the SGR mechanism for Medicare’s payments to physicians not only reduced the uncertainty faced by the health care sector, it also allows health care experts on Capitol Hill to devote their time to other issues.

Therefore, we should reduce uncertainty about future budget policy by: avoiding shutdowns and debt-ceiling threats; avoiding short-term extensions of expiring policies and continuing resolutions for appropriations; and addressing, rather than deferring, long-term issues, such as entitlement policies, tax policies, and policies to address climate change.

That concludes my five-part agenda for federal budget policy to spur income growth. For the reasons I have offered, I think we should maintain federal investment as a share of GDP; reform the tax code to increase the efficiency of business investment; encourage innovation; reduce federal debt relative to GDP, but only slowly; and reduce uncertainty about future budget policy.

Let me end with one final recommendation: Analysts and policymakers should not over-promise about the effects of federal budget policy on economic growth.

Demographic changes have greatly slowed the feasible pace of labor force growth and therefore the feasible pace of GDP growth. Baby boomers are retiring in large numbers, and the labor force participation rate among working-age women has roughly stabilized after increasing sharply for a few decades. As a result, the labor force will undoubtedly grow more slowly in the next few decades than it did in the 1970s, 1980s, and 1990s. In those earlier decades, potential GDP grew about 3¼ percent per year, on average, according to CBO’s estimates; designing budget policy that would achieve that pace in the coming decade would be very difficult.

I realize that exaggerating what better budget policy could accomplish may seem like a harmless way to encourage action by our inertial political system. But I think there is harm to over-promising, because it increases distrust between people and their government. When people are told that our economic problems can be solved with simple policy changes that have no apparent downside, they will inevitably be disappointed. Some people will conclude that the failure to solve problems easily stems from bad will or lack of will by their leaders, rather than from the inherent complexity of the problems and the technical understanding and difficult tradeoffs that are required. Such an increase in distrust between people and the government would be very unhealthy.

Still, despite the limitations of federal budget policy, it can make a significant difference to the growth of people’s incomes over time. Federal policy matters for labor force participation, even if it cannot counteract all of the demographic changes. Federal policy matters for how much research and development we do, how well educated and well trained we are, how much public infrastructure we have, how much private capital there is and how efficiently it is allocated, and more. To make a brighter future, I hope we will make policy changes along the lines I have suggested today. Thank you.