It is hard to fix a problem without a correct diagnosis. Unfortunately, the dominant economic theories in today’s budget debates fail at this essential task. They therefore prescribe the wrong solutions.
Protracted budget deficits are not the only thing inhibiting America’s economic growth. A long history of over-consumption and low savings has produced an investment deficit that has depleted the nation’s capital stock and left it ill-prepared for the future. The American Society of Civil Engineers estimates for example, that the U.S. needs to invest $3.6 trillion in public infrastructure alone by 2020. Government spending needs to be carefully supervised, but it should be obvious that investment produces a positive return whereas consumption does not. For example, a 1 percent increase in the stock of scientific research increases productivity by 0.23 percent.
The country also suffers from a competitiveness deficit as it becomes increasingly attractive for investors and companies to send their money and production activities overseas. During the last decade, the annual trade deficit has averaged almost $600 billion.
A sensible approach to fiscal policy must therefore address all three of the major deficits. The best way to do this is to focus on long-term economic growth and on the debt-to-GDP ratio rather than the aggregate debt as the key measure guiding budget policy. Doing so has two implications. The first is that policies that promote economic growth are necessary even if they increase the deficit in the short term. All spending or taxes are not the same. Spending on research and development or necessary infrastructure plays an important role in boosting future incomes, while most subsidies merely shift money around. Similarly, corporate taxes clearly influence where and how much companies invest and hire. Individual tax rates, including the capital gains rate, have little effect on decisions to work and save.
Unfortunately, the key conceptual approaches to budgeting ignore the three deficits and underestimate the importance of growth-inducing policies, reducing the economic impact of budget policy and actually hampering growth. Keynesians emphasize the need to boost consumption in the near-term even if we have to borrow the money to do so and even if this deters investment by the private sector. They seem to think that higher tax rates never affect productive behavior and that people will always lend the United States whatever it needs at a low interest rate.
Conservatives have a difficult time admitting that any government programs can be effective. They oppose all taxes even though it is clear that fixing the debt problem requires additional revenue from individuals. And they have too much faith that private markets alone will develop the solutions to our investment and competitiveness deficits.
Finally, while moderate neoclassical economists correctly see the economic threat that future deficits pose, they tend to focus on debt levels rather than the debt-to-GDP ratio. As a consequence, they believe “everything should be on the table” and are all too willing to cut all spending, even investments in infrastructure and research. They adopt the same approach to tax expenditures, giving equal treatment to the R&D tax credit and the mortgage interest rate deduction. Yet the former clearly increases private investment, while the latter merely subsidizes bigger houses for the middle- and upper-classes.
The current debt-to-GDP ratio is 72 percent and would be much worse if the cost of unfunded entitlements such as Social Security and Medicare or the significant debt problems of some states and cities were factored in. Current policy will make it much worse over the next few decades. To promote the health of the economy experts argue that we must reduce the debt-to-GDP ratio below 60 percent.
To accomplish this we need to restructure federal policy around the following principles. First, all federal programs should be rigorously monitored to ensure they produce results. Second, spending on policies that promote economic growth should be increased even if it worsens the deficit in the short term. Areas that deserve more resources include research and development, education, and infrastructure. Third, Americans need to work longer. The Social Security and Medicare retirement ages should be increased and the disability insurance program should be reformed to keep more people in the workforce. Fourth, taxes should be shifted from corporations, who can easily move activity across national borders, to individuals, who are less mobile and less likely to change behaviors based on rates. Finally, government programs that mainly transfer money from one group of people to another should be ended unless they effectively address poverty.
In short, new fiscal approaches are required which address our 21st century economic reality of intense global economic competition. If we continue using the same failed theoretical frameworks America risks further erosion of our international competitiveness and economic health.