Fiscal responsibility: should we care?

Matt's take on fiscal responsibility is largely accurate, politically: it's a very good stick with which to beat back either spending or tax cuts that you don't like, but once you're in power, well, too hell with it.

But do modest budget deficits matter? Of the size we have now, probably not. Indeed, I've been meaning to blog for a while about my greatest frustration with Jonathan Chait's the Big Con, which is not that it's a mean-spirited polemic that presents a highly skewed selection of facts and half truths in order to make out that everyone who disagrees with one Jonathan Chait is either a liar, a charlatan, or a fool. Rather, it's that Chait's own political beliefs keep him from writing about the big story. The most interesting thing about the supply side movement is not that political movements occasionally spawn nutty theories that allow politicians to claim their policies involve no tradeoffs. (If you think the Republicans are the only ones hostage to this sort of thing, I suggest you go ask Democratic some politicians or policy activists whether legalizing abortions results in more women having abortions.)

To me the nuttiness, while amusing and definitely worth including, is a sideshow. The really interesting thing about the supply-side movement is that it is part of a larger, more important story: the discovery, over the last few decades, that how you finance government policy just doesn't matter very much.

The history of the various attempts to financially engineer our way to above-trend growth over the last fifty years--supply-side economics being only the most theatrical of these--seems to indicate that it doesn't matter how you finance government spending. All that matters is how much you spend, and that doesn't even matter all that much.

If you spend money and finance it by tax increases, this lowers the return to work and effort, which somewhat lowers economic activity. If you spend money and finance it by borrowing money, this soaks up excess capital, which lowers investment and hence the rate of economic growth. There's no decisive evidence that one effect is larger than the other. Neither effect seems to be particularly big. There are other sorts of government policy that can have large effects on the economy: regulation (particularly in labor markets), trade policy, monetary policy. But in America, where the major fiscal drivers--tax rates, government spending, and deficits--fluctuate within pretty narrow limits, trying to manage economic growth through fiscal policy is like trying to steer a supertanker by moving the deck chairs around.

Chait, however, is committed to the "Clinton's tax hikes made the economy grow" story--and therefore to the notion that fiscal policy really, really matters. So we don't get the bigger story. Indeed, we don't get much context at all, not even the obvious point that supply siders have been so successful because the public still thinks of them as the antidote to the Keynesian managed economy that tanked in the 1970s.

I'm still working on my roundups of the various candidates economic policies. But the big thing to remember is that none of these policies will make almost any difference to the size of the economic pie. The politicians don't bake the pie; the best they can do is slightly alter the size of the pieces.

Comments

"The really interesting thing about the supply-side movement is that it is part of a larger, more important story: the discovery, over the last few decades, that how you finance government policy just doesn't matter very much."

Um, Megan_McArdle ... what the hell are you talking about? Where was the big realization that marginal tax rates don't matter? (There was none; most countries have reduce marginal tax rates in realization of the damaging effects of the marginal, as compared to the average tax.)

Where was the big realization that capital gains taxation isn't uniquely damaging to long-term growth? (There was none, economist believe capital gains taxes do exactly that.)

Where was the realization that taxes on demand-elastic goods are dandy? (There was none, predominant tax incidence theory advises taxing demand-inelastic goods because it causes the least deadweight losses.)

Where was the realization that complicated, subjective tax codes don't enrich accountants and lawyers, drawing bright minds away from sectors where they can innovate for the benefit of all?

You get the point.

Posted by Person | January 3, 2008 5:44 PM

Megan,

Please tell me your entire post was a massive typo. Are you kidding?????!!! We are on an unsustainable fiscal course that, under current policies, will most likely produce an enormous fiscal imbalance that will devastate our economy over the next couple of decades and/or (most likely "and") force draconian cuts in spending that will hurt the elderly, national security, and everything else we spend money on, as well as force sharp, very substantial tax hikes. And the longer we wait to make the necessary sacrifices to reduce this imbalance, the worse the ultimate pain will be. My goodness, have you seen the charts and analyses by CBO, think tanks, advocacy groups, academics and others from right, left, center and non-partisan, all of which illustrate and conclude exactly what I'm saying???!! There is little disagreement on these points among economists and other policy experts.

"Should we care" about fiscal responsibility?Megan, are you still hung over from New Year's Eve???!!! If you want to find "nuttiness", read your own post. If I had never read your blog before and just read this post, I would never bother reading your blog again, because it's quite obviously -- to put this in technical terms -- mind-bogglingly stupid, astonishingly ignorant, or both.

Posted by Brooks | January 3, 2008 6:10 PM

I would second Person's comment.

Brooks,

So, what are the options outside of the draconian cuts in spending and the very substantial tax hikes that you expect to occur simultaneously?

I would interpret Megan's argument that it is the spending level of government that matters, not how you get the money to do it. However, I think she was pretty unclear in her writing, and left it open to misinterpretation.

Posted by Yancey Ward | January 3, 2008 6:52 PM

I agree with you 100%. The only difference between tax and spend and borrow and spend is when you pay it back. Spending IS taxing. So there is a political question involved, but it’s demographics more than economics.

Not by accident, demographics is what’s driving our (for now) modest budget deficit. Our federal budget model was designed for a country with a much large young-to-old ratio. Well, we no longer have that.

By the way, the best way to measure the budget deficit isn’t by ratios or aggregate numbers, it’s by long-term interest rates. That’s the only thing that matters. As long as we can grow faster than our interest rate, we’re OK.

Posted by Eddy Elfenbein | January 3, 2008 6:55 PM

Yeah, I think you're going to have to adduce some evidence that it doesn't matter how one finances government spending. In any case, you're arguing that it doesn't matter how one finances government spending as long as spending stays a little over 20% of GDP and taxes stay at a minimum of 18% of GDP, and the national debt doesn't go over 70% of GDP. US federal spending has hewed to those limits since the '70s, but largely because the US political system has been rather paralyzed by its very cautious structure and by usually divided government and partisan rancor. There are some very specific political conditions that have acted to restrain the amount of federal spending and the levels of taxation in the US. Within those limits, maybe it doesn't matter that much if we run a deficit of 5% of GDP or a surplus of 1%, but those limits are themselves the product of an argument over how to finance spending; remove that argument, let things swing dramatically in one direction or another, and then let's see whether it matters how one finances government spending.

Posted by brooksfoe | January 3, 2008 6:57 PM

(If you think the Republicans are the only ones hostage to this sort of thing, I suggest you go ask Democratic some politicians or policy activists whether legalizing abortions results in more women having abortions.)

It looks like you're making an analogy to the supply-side tax cut fallacy. Is this view even expressed, much less mandatory, among Democrats? I understand that some Democrats view "more abortions" as an awkward sign of success, but they don't lie and say that legalization causes fewer abortions. Why else would they complain about criminalization making abortion out of reach for working-class women?

Posted by Brittain33 | January 3, 2008 7:43 PM

Yancey,

RE: "So, what are the options outside of the draconian cuts in spending and the very substantial tax hikes that you expect to occur simultaneously?"

The alternative is to get started sooner with less severe spending cuts and less severe tax increases, rather than ignoring the problem as it grows.

RE: "I would interpret Megan's argument that it is the spending level of government that matters, not how you get the money to do it."

Yeah, I know that's what she was saying, and such a contention, particularly in the context of our enormous unfunded entitlement liabilities and resulting long-term fiscal outlook, is outrageously absurd. Sure, taxing more or spending less today reduces short-term aggregate demand and can, in term so of first-order effect, adversely impact the supply side as well, with a potential negative impact in isolation and perhaps even net of all direct and indirect effects (depending on the nature of the tax cut), BUT in the long term there is little question or dispute among experts that the most likely effect of many more years of continued deficit-financing under current fiscal policies (i.e., tax rates and spending, including current entitlement benefits & eligibility) would be disastrous for our economy and for the standard of living of the vast majority of Americans. Our fiscal imbalance would most likely grow so large over the next few decades (due primarily to growth in Medicare, Social Security spending, and interest expense). For anyone to suggest that how we finance our spending doesn't matter, as if the positive and negative effects under any scenario net out the same, is just grossly ignorant and/or stupid.

RE: "However, I think she was pretty unclear in her writing, and left it open to misinterpretation."

If your saying her "unclear" point was what you stated above, the problem wasn't clarity, but rather absurdity.

Posted by Brooks | January 3, 2008 8:18 PM

Deficit spending is great. Let's cut taxes and run up the national debt!

With deficit spending, I get to invest/spend an extra $90,000 (my share of the $9 trillion U.S. debt). I'll be dead and gone before any of this $90K has to be repaid -- and my investments yield a FAR higher return than government spending.

Yes, let someone else's grandchildren pay back this $9 trillion.

Posted by Larry G. | January 3, 2008 8:20 PM

Yancey,

To add to my response above, even if the point is simply that, at any given level of spending, it doesn't matter if we borrow to finance it vs. taxing to financing it, my point still holds. Yes, in fairness to her (and to your comment/question), if we continue on our current spending course (and if we assume that we will continue to do so indefinitely -- i.e., that political pressure won't eventually force substantial spending cuts) and we mitigate the imbalance substantially through tax increases, that would be terrible for our economy and standards of living for most Americans (particularly non-retirees), too, but (1) the longer we wait to raise those taxes, the more severe the tax cuts will need to be later, with results we'd all regret, and (2) we would still be much better off through such a policy (particularly if we implement the tax increases sooner rather than later) than if we try to deficit-finance this spending indefinitely, which is unsustainable -- probably literally, meaning I think the models actually blow up (i.e., overall insolvency) over the very long term, but even short of literal unsustainability, it would just wreck our economy as interest expense mounted, not to mention the impact on interest rates and resulting depressive effect on GDP and expense to private borrowers.

Posted by Brooks | January 3, 2008 8:33 PM

In thinking about how policy affects the economy, it seems to me you want to differentiate between the level of output and the growth of output. Let's say, for example, that you have very high tax rates and so people choose to work only half as much as they would under low taxes. To simplify, that means that GDP will be around half as big. (It's actually not that simple since capital and technology are other factors of production, but leave that for now.) Ok, but how does that high tax rate affect the GROWTH of GDP from year to year? Obviously it reduces GDP when it's initially put in place, but after that, not at all -- from year to year GDP will grow at roughly the same rate, based on increases in the capital stock and improvements in technology, but will still be only half as big due to tax-driven reduction in labor force participation. Pretty much the same thing goes with changes in saving; higher saving will produce higher growth for a while, but after that you resume the same underlying growth rate as before. All this derives from Robert Solow's economic growth model, which is pretty standard stuff. In the Solow model the main determinant of the long-run growth of GDP per capita is technological progress, which probably isn't affected a ton by tax policy.

All that said, the level of economic output matters a lot -- I'd rather be twice as rich than half as rich -- so policy matters even if it doesn't play itself out very much over the long term.

Posted by Anon | January 3, 2008 10:28 PM

funny, she can find time to go on about Chait's polemic-"it's that Chait's own political beliefs keep him from writing about the big story", though can't bring herself to cover: http://www.amazon.com/Israel-Lobby-U-S-Foreign-Policy/dp/0374177724 "I'm still working on my roundups of the various candidates economic policies...".

And, this: "But the big thing to remember is that none of these policies will make almost any difference to the size of the economic pie. The politicians don't bake the pie; the best they can do is slightly alter the size of the pieces."
is, absolutely, another piece of utter nonsense in her post...

Posted by MEH | January 3, 2008 10:40 PM

"The history of the various attempts to financially engineer our way to above-trend growth over the last fifty years--supply-side economics being only the most theatrical of these--seems to indicate that it doesn't matter how you finance government spending."-MM

Megan is essentially restating Robert Barro's "Ricardian Equivalence" theorem. Barro is a fine economist, but very few of his colleagues agree with him about this. Moreover, even Barro concedes that Ricardian equivalence only holds when the taxes used to finance spending are lump-sum.

I agree with Megan that the main concern is the level of government spending, but it certainly does matter how we finance that spending. As Person implies above, captial gains taxes cause much larger deadweight losses than consumption taxes. Again, Robert Barro accepts this. Here he expresses his enthusiasm for the Reagan tax cuts, for example:

Peter Robinson: Do you value the Reagan tax cuts in and of themselves or because the deficits to which they led constrained the growth of government?

Robert Barro: There's two different parts to it. One is on the supply side. The tax cuts really were aimed at creating more incentives to have more jobs and to have more investment. I think that worked. I don't think it was primarily a stimulus in the sense of the usual demand stimulus. It was really more similar to the Kennedy-Johnson tax cuts in the '60s which also had important supply-side effects. But then on the other side, I think that tax cuts and the deficits were important as the mechanism for making the government smaller. It didn't work immediately. That's why we had the deficits but it worked over time. And I think it was quite successful in that respect.

So Barro--like just about every other economist--does believe that it matters how we finance deficits. And he thinks the Kennedy and Reagan cuts contributed to economic growth.

It's puzzling that Megan insists on stating Barro's theory in a form that Barro himself would reject.

Posted by rwe | January 4, 2008 12:40 AM

No, I am explicitly *not* arguing for Ricardian equivalence. I'm saying that the evidence from the last twenty years is that within the moderate ranges of American fiscal policy, the difference between tax financing and deficit financing of spending do not seem to be large enough to be reliably detected. The level of spending probably matters, but I don't know how much it matters. And I agree with you that capital taxation makes a difference, but this is not how the American government gets most of its money, and also, not where the meat of these debates is taking place.

Posted by Megan McArdle | January 4, 2008 9:31 AM

I would agree with both brooksfoe's and Megan's caveat in the comments that:

"within the moderate ranges of American fiscal policy, the difference between tax financing and deficit financing of spending do not seem to be large..."

Which is not precisely the same as "it doesn't matter how you finance government spending. All that matters is how much you spend, and that doesn't even matter all that much." but makes more sense once clarified for context.

Meanwhile, on a less controversial note, typo in the first paragraph: "too hell with" rather than "to hell with", and you seem to be referencing some post or statements from Matt (Yglesias, I presume?) but without any actual reference or link. Not sure what Matt is actually saying here that he's largely accurate about.

Posted by Geoff | January 4, 2008 9:48 AM

Okay, fine. You aren't arguing for Ricardian Equivalence Megan, but I still think you're mistaken.

Look at Ed Prescott's work. As he explains:

This issue is encapsulated in one question that is currently puzzling policy makers: Why do Americans work so much more than Europeans?...

Here's a startling fact: Based on labor market statistics from the Organization for Economic Cooperation and Development, Americans aged 15-64, on a per-person basis, work 50% more than the French. Comparisons between Americans and Germans or Italians are similar. What's going on here?...

Let's take another look at the data. According to the OECD, from 1970-74 France's labor supply exceeded that of the U.S. Also, a review of other industrialized countries shows that their labor supplies either exceeded or were comparable to the U.S. during this period. Jump ahead two decades and you will find that France's labor supply dropped significantly (as did others), and that some countries improved and stayed in line with the U.S. Controlling for other factors, what stands out in these cross-country comparisons is that when European countries and U.S. tax rates are comparable, labor supplies are comparable.

And this insight doesn't just apply to Western industrialized economies. A review of Japanese and Chilean data reveals the same result.

The difference in marginal tax rates is the most reasonable explanation for the differences in labor supply between France and the United States. What you are arguing is, essentially, that the elasticity of the labor supply is close to zero. Very few economists would agree with that and, anyway, Prescott's work shows it's not true. Look here for instance.

Posted by rwe | January 4, 2008 9:56 AM

Megan_McArdle: Now you're saying something different. Before, it was, "how you finance government spending doesn't matter". Now, it's "how much debt the government issues doesn't matter", a subset of the former.

Posted by Person | January 4, 2008 10:06 AM

For those who are interested, Martin Feldstein also explains why Megan is mistaken:

"Taxes on labor income have much larger effects than are generally recognized... A higher marginal tax rate reduces the net return to work and therfore depresses working hours."

Feldstein's reading of the evidence is the same as Prescott's and mine. The reduction in marginal tax rates under Kennedy and then again under Reagan had a large positive effect on the labor supply (as well as on entreprenuership) which has helped to propel American growth above that of France and Germany.

A similar effect has been evident in Ireland. QED

Posted by rwe | January 4, 2008 10:49 AM

MM,

with this: "...not where the meat of these debates is taking place." would you care to elaborate(?), or, are you sufficiently pleased by blowing more smoke up your skirts?(granted, it's chilly outside, but seriously)

"The level of spending probably matters, but I don't know how much it matters. And I agree with you that capital taxation makes a difference.."-MM

'capital taxation' makes a difference, though, 'level of spending probably matters, but I don't know how much it matters'--is self-refutation, the new 'critical thinking'?

ya know, MM, instead of toying with shooting craps, maybe a nice Econ refresher would pay better dividends..

Posted by MEH | January 4, 2008 11:19 AM

MM Initially: "It doesn't matter how you finance government spending." And Later: "No, I am explicitly *not* arguing for Ricardian equivalence."

Just for the sake of other readers I thought I'd post Robert Barro's explnation of Ricardian Equivalence:

To illustrate the potential pitfalls in what Ricardian equivalence says and does not say, one can consider the famous quote attributed to Vice President Cheney to the effect that President Reagan proved that budget deficits don't matter. The Cheney quote is often interpreted to mean that the level of government expenditure does not matter, and that surely is not what Ricardian equivalence says. The Ricardian proposition is about the consequences of paying for a given amount of public expenditure in different ways. Specifically, does it matter—or does it matter a lot—whether the government pays for its spending with current taxes or with current borrowing, which entails higher future taxes?

So, a central part of the proposition is that the amount of public expenditure—today and tomorrow—is being held constant. It's never part of Ricardian equivalence that the level of government expenditure doesn't matter. As [University of Chicago economist] Milton Friedman put it, the costs or benefits of government outlays depend on the amount and nature of what the government spends—there is no free lunch about paying for that spending. So whether you pay for it now or later is secondary.

As a first-order proposition, it is right that it matters little whether you pay for government spending with taxes today or taxes tomorrow, which is basically what a fiscal deficit is.-Interview with the Minneapolis Fed's Magazine The Region

Megan seems to have ducked out of the debate, so I just thought I'd add this one last clarification. It's clear from Barro's remarks above that Megan said initially was basically a statement of Ricardian Equivalence--that it doesn't matter how the government finances its spending (taxes or borrowing) and that only the level of spending matters.

As Person noted above, she later revised her thesis. That's fine, but she should admit the revision... Tangentially, I have to say I think she should bring Mindles Dreck back. He was more reliably sensible.

Posted by rwe | January 4, 2008 1:35 PM

rwe,

I thought the difference Megan was refering to was between current taxes and borrowing.

The top marginal rates seem to me more an argument about the tax structure not the general level of tax revenues.

Certainly the tax structure can influence behavior in ways that reduces the economy. But that is an argument about optimal tax structure not debt financing vs tax financing or the general level of spending.

Posted by eccdogg | January 4, 2008 2:04 PM

Meagan:

Your statement that the level of taxation doesn't much affect the size or growth of the economy is true:

http://trueconservative.typepad.com/trueconservative/2007/12/government-ba-2.html

(Well, within the 25-50% of GDP range.)

Two questions remain:

o Taxes or borrowing?

o Which taxes?

High borrowing during the good times precludes the options that are crucial in the bad times. Given American and world demographics, those bad times are coming, and we'll need to flexibility that we're currently consuming/have consumed.

Everyone agrees that government saving during the good times and spending during the bad times is excellent economic policy. That's why I am so in favor of Democrats--like Christine Gregoire and the democratic-controlled legislature in Washington State, who put a billion dollars in the bank last year for a rainy-day fund.

There's a lot of evidence that allocation of tax burdens can have significant effects on long-term prosperity. Not as great as the wild-eyed supply siders (in their marxist-intensity ideological fervor) would have you believe, but quite significant.

Posted by True Conservative | January 4, 2008 2:11 PM

are we kidding when we take this: "So whether you pay for it now or later is secondary."--as a Given ?

Posted by MEH | January 4, 2008 2:14 PM

rwe, I thought the difference Megan was refering to was between current taxes and borrowing.

eccdogg,

You know it's not clear to me what she was arguing now. If she was arguing, as you claim (and as I had thought initially) that it doesn't matter whether you finance spending through taxes or borrowing, then she's asserting Ricardian Equivalence.

But then she emphatically denied that she was asserting Ricardian Equivalence. Instead she seemed to be arguing that the changes made by Reagan, Clinton and Bush had no significant impact on growth; and that we could expect similarly ineffectual policies from the next President. And of course one thing Bush did was cut the tax on capital gains and dividends significantly.

But then she also said that it does matter how much we tax capital gains. So what does this leave? A mess. A muddle. I don't think she has thought it through.

Posted by rwe | January 4, 2008 3:30 PM