To Revive the Economy, Cut Federal Spending

Obama and Boehner are both big spenders. That's the problem.

Note: This article originally appeared at Bloomberg View on December 18, 2012. Read it there by clicking here.

In negotiations over the so-called fiscal cliff, U.S. President Barack Obama is calling for $1.4 trillion in new tax revenue over the next decade.

The Republican opposition, led by House Speaker John Boehner of Ohio, has signaled that the Republicans could stomach generating as much as $800 billion in new revenue over the next decade.

Such a large difference obscures a more fundamental agreement: Neither side is interested in addressing the central role federal spending plays in creating persistent deficits and, more important, damping economic growth.

The deficit for fiscal 2012, which ended on Sept. 30, came in at about $1.1 trillion, marking the fourth consecutive year that the nation has posted a trillion-dollar-plus spending gap. Contrary to what Dick Cheney said when he was vice president, deficits do matter.

Under the most recent budget plans of House Republicans and Obama, the federal government will spend from $40 trillion to $47 trillion over the next decade. Yet in the current negotiations, Boehner has called for only $800 billion in spending cuts and Obama $400 billion, most of which would be pushed off until 2022 or later—tantamount to saying they won't happen at all. Neither side's long-term spending plans envision a balanced budget in the next 10 years.

Reduced Growth

In a paper released this year, economists Carmen M. Reinhart, Vincent R. Reinhart, and Kenneth Rogoff said that periods of "debt overhang" – when accumulated gross debt exceeds 90 percent of a country's total economic activity for five or more consecutive years—reduce annual economic growth by more than one percentage point for decades.

Over 20 years, the authors write, there can be a "massive cumulative output loss" that reduces gains by 25 percent or more. The U.S. went over the 90 percent threshold after the 2008 financial crisis. At $16.3 trillion, our current gross federal debt represents more than 100 percent of 2012's total economic activity or gross domestic product.

Obama hasn't explained precisely how higher tax rates on a small fraction of the population will do much to improve the country's balance sheet. According to the Congressional Budget Office, increasing taxes on the wealthiest Americans to Clinton-era levels will raise $220 billion over four years—$55 billion a year on average through 2016, the last year of Obama's presidency.

Over that same period, the White House Office of Management and Budget estimates federal spending at $15.8 trillion, or almost $4 trillion a year on average, and annual deficits of $700 billion.

A little history: 2000 was about the best year ever for federal revenue since 1950. The government raked in slightly more than $2 trillion in nominal dollars and $2.3 trillion in inflation-adjusted (fiscal year 2005) dollars. When measured as a percentage of GDP, revenue reached 20.6 percent, the highest fraction ever recorded in peacetime. Although it's true that receipts in 2006 and 2007 topped the $2.3 trillion mark in constant 2005 dollars, those totals represent smaller fractions of GDP, 18.2 percent and 18.5 percent, respectively. So it's fair to call the $2.3 trillion in constant dollars a high-water mark. (All these figures are drawn from the 2013 Historical Tables generated by the OMB; see table 1.3.)

The high level of revenue—both in constant dollars and as a percentage of GDP—was reached in a roaring economy. And all Americans were taxed at significantly higher levels than they are now.

Income Pyramid

Whatever you think about the decline of rates under President George W. Bush, it made the U.S. tax system more progressive by reducing the burden on middle- and lower-income people. That's one reason that singling out high-income earners for increases this time will yield such little revenue: All of us paid higher taxes then. It wasn't just the swells at the top of the income pyramid.

Even if government could attain the revenue levels of seven years ago, it wouldn't come close to covering spending, which crossed the $3 trillion mark, in inflation-adjusted dollars, in 2009. Neither Republicans nor Democrats are suggesting reducing total year-over-year spending.

The OMB estimates that annual government spending from 2013 to 2016 will average $3.25 trillion in 2005 dollars, or 22.7 percent of GDP. Whether measured in constant dollars or as a percentage of the economy, the government has never once reached that level of revenue, much less sustained it for a number of years.

Given low estimates for economic growth over the coming years, any attempt to reduce the debt-to-GDP ratio before Obama leaves office will thus require significant spending cuts in the near term.

Both the president and members of Congress worry that rapid spending cuts would cause a new recession or slow down the recovery. Such fears are overstated.

In the 1990s, Canada, for instance, reduced debt-to-GDP ratios through an aggressive combination of actual, year-over-year spending cuts and higher taxes. The result wasn't malaise but a burst in activity.

The same happened in the U.S. right after World War II. In 1944 and 1945, annual government spending (in 2005 dollars) averaged about $1 trillion and represented more than 40 percent of GDP. By 1947, it had plummeted to $345 billion in 2005 dollars and 14 percent of GDP. Even facing the demobilization of millions of soldiers, the economy soared and unemployment fell despite almost universal fears that the opposite would happen.

Such outcomes are not flukes. Research by economists Alberto F. Alesina and Silvia Ardagna underscored that fiscal adjustments achieved through spending cuts rather than tax increases are less likely to cause recessions, and, if they do, the slowdowns are mild and short-lived.

Spending Reductions

What's more, when spending reductions are accompanied by policies such as the liberalization of trade and labor markets, they are more likely to have a positive impact on growth.

While many economists—and certainly all politicians—worry that turning off the spigot of public spending will shrink an economy (and anger constituents receiving the cash), the opposite is likely to be true.

In an October 2012 study published in the National Bureau of Economic Research, Alesina and Ardagna point to Canada (1993-1997), Sweden (1993-1998) and the U.K. (1994-2000). In these cases, spending cuts had a positive effect on private investment while improving consumer and business confidence by reducing the expectation of higher taxes.

Obama said in September that he would cut $2.50 in spending for every new dollar of tax revenue—what he has called a "balanced approach." Yet his proposal for dealing with the fiscal cliff—$1.4 trillion in new tax revenue and $400 billion in spending cuts—represents a $3.50 increase in taxes for every $1 of cuts, assuming the reductions take place.

As the history of deficit-reduction frameworks (including those signed by Republican Presidents Ronald Reagan and George H.W. Bush) has shown, when immediate rate increases were "balanced" by spending cuts down the road, the spending cuts are never made.

In any case, recent experience shows that even if Obama's 2.5-to-1 ratio of spending cuts to revenue increases came to pass by some miracle, it is far too timid. Economist David Henderson estimates that during the 1990s retrenchment in Canada, the government cut spending by $6 to $7 for every new dollar of revenue it raised.

Obama and Boehner have been largely silent on the specifics of their cuts, though both seem bent on slicing off parts of old-age entitlements such as Medicare and Social Security long after they are out of office.

The best holiday gift the president and Congress could give the country is to spend the final weeks of 2012 working on an honest plan to cut spending here and now.

Note: This article originally appeared at Bloomberg View on December 18, 2012. Read it there by clicking here.