A ‘Debt Limit’ Compromise

Sometime soon, politicians in Washington DC will decide whether to lift the statutory limit on federal borrowing, the so-called ‘debt limit.’ In thinking about this monumental issue, it would be inappropriate to side completely with either the Democrats or the Republicans. The whole matter has careened so far out of control that the abundant blame for this unfortunate impasse has to be shared on both sides of the aisle.

Nonetheless, before assigning blame, it is best to chart the correct course of action. Here, the first question is not how to fund government expenditures, but what in principle is the proper size of the federal government? It is not sufficient to simply argue that government is either too large or too small. Rather, the challenge is to take each class of expenditures separately, in order to determine whether the last dollar spent on any particular area produces a gain that is greater than the next best use of those dollars. It could be the case, therefore, that the overall size of government is too large, even if certain types of expenditures are too low.

Illustration by Barbara Kelley

Thus, although there is constant pressure on both sides of the aisle to cut defense spending, it seems that the current four percent of gross domestic product spent on defense is too low for a nation that faces dire threats around the world. An expenditure cut could easily lead to dangerous confrontations, requiring the nation to ramp up its military strength at great cost and in a desperate hurry.

At the same time, the present inefficiencies in defense spending need prompt correction. The proper function of the defense establishment is to defend the United States. It is not to raise labor costs, which it does by allowing civilian employees to join unions or by insisting that defense contractors meet various affirmative action quotas. Price and quality of service are the only two factors that should determine how the Department of Defense spends its money. Thus cutting the budget on the civilian side might in fact lead to more efficient military operations.

Unfortunately, by treating defense spending as a black box we are likely to continue along our present reckless path by cutting in the wrong places, no matter how the present budget crisis is resolved. On this issue, it is really up to the Democrats to confess their error on an entrenched set of employment and procurement policies that have been the bane of all labor markets, both public and private.

A similar drill is surely required for dealing with the far larger sums that are devoted to entitlement programs. These programs have, by common consent, grown beyond sustainable levels. Once again, a good place to start is by reforming inefficient labor policies that, for example, allow the unionization of hospital workers and other health care providers—positions that are explicitly protected in the misnamed Patient Protection and Affordable Care Act.

What in principle is the proper size of the federal government?

Beyond improving labor policies, the needed cuts must penetrate entitlements at their core. This awkward job cannot be done by confining the cuts to those who have yet to receive program benefits. The only form of immediate relief will come when some current recipients are forced to bear a larger portion of their own costs—itself a challenge that will generate a new set of deep divisions that may not break cleanly along party lines.

In grappling with these various government programs, we should not first ask how they should be to be funded—we should ask instead: what is the proper size of these programs? On this issue, it is clear that neither the Democrats nor the Republicans have kept faith with the key principle of sound government, which is the presumption that dollars used for ordinary goods and services go a lot further when the money is left in private hands.

The appalling waste of both the Bush and especially the Obama stimulus programs was based on the fatal Keynesian presumption that it makes sense for the government to make expenditures that everyone would deem wasteful, even farcical, if undertaken by private parties. It makes no sense for any private firm to hire workers first to dig holes and then to refill them. It makes no more sense to tax private firms an amount that allows government employees to undertake those same useless acts.

Protectionism is an equally foolish economic policy. The "Buy American" legislation that the Obama Administration built into its stimulus program represents a short-sighted policy that denies American consumers and firms that use of low priced goods and services from abroad that could make matters better at home. Equally pernicious are the mindless government regulations of private enterprise, which could be cut as an overdue cost saving measure.

The Republicans are on solid ground by insisting that shrinkage in the size of government is the key to any sustainable policy. But what is the best way to achieve the goal of smaller government? Start with the simple proposition that government can pay for its expenditures in three and only three ways. It can raise taxes; it can borrow money, which can be paid back only with taxes raised at some future time; or it can print more currency, at which point the rapid inflation cheapens the currency and thus works as an implicit tax on anyone who holds American dollars or any creditor (including creditors of the United States) whose debt is denominated in dollars.

Government can pay for its expenditures in only three ways, and all three forms of funding rely on either explicit or implicit taxes.

All three forms of government funding necessarily rely on either explicit or implicit taxes. The differences between these funding methods are all second order effects. If the size of government is not cut from its current unsustainable levels, it will not matter much whether the government defaults on its obligations today or two years down the road. Either way, government bankruptcy will create massive dislocations in both the economic and the political sphere.

On this view, Republican strategy to rail against all new taxes is a misguided negotiation position. The Republicans should break ranks with Grover Norquist’s tax advocacy group, Americans for Tax Reform, whose "no new taxes" pledge has been taken by many members of Congress.

The object of this pledge is to use the control on taxes to limit the size of government. So far, so good. But the means that Norquist champions are deficient for two reasons. First, the "no new taxes" pledge is too weak. Second, looking at only overall tax levels ignores the striking differences between various forms of taxation.

It is consistent with the pledge, for example, to raise the debt limit by letting the treasury borrow new money. Ultimately, those new obligations have to be paid off with either tax revenues or cheaper dollars, so that a "no new taxes" pledge that only addresses current taxes contains obvious loopholes.

The implications of this proposition are clear. First, Republicans should treat all three forms of government financing as functional equivalents, and thus push for that deal which, subject to the caveats raised above, works the greatest cut in total expenditures. Following this reasoning, it is better to cut expenditures by $5 trillion over the next decade and raise taxes by $1 trillion over that same period, than it is to cut expenditures by only $3 trillion, without any current tax increase.

On the second point, the Republicans should not only worry about the size of the total tax bill, but also its incidence. One point in the Norquist program is to "net out" tax increases in one area against tax reductions in another. Yet in principle this approach is far too crude, because it ignores the impact that any tax has on the overall economic position of the country. Thus if we cut out a real tax loophole (e.g. accelerated depreciation that systematically exceeds actual economic losses), and lower overall rates, both of these moves independently make sense, so that their combined effect is of course positive. But if we were to raise general tax levels in order to generate yet another unwarranted tax preference, the combination of the two moves is worse than allowing either of them separately. Looking at net effect ignores these allocative differences in changes in the tax law.

The Republicans should break ranks with Grover Norquist’s tax advocacy group, Americans for Tax Reform, and its "no new taxes" pledge.

That same point plays out in connection with the level of tax progressivity. The Democrats always equate tax fairness with steeper progressivity on the ground that the diminishing marginal utility of wealth makes it desirable to impose the taxes on the wealthiest individuals—those few who earn at least $250,000 per year.

If that one consideration were dominant, it would quickly lead to an equal incomes policy, regardless of differences in individual productivity and earnings. Clearly, even Democrats shrink away from that position, because at some point high tax rates will dull individual effort, which in turn will reduce tax revenues.

But how much progressivity is too much? Today, most Democrats set it higher than the current rates, which is way too high. Indeed, on this issue, my firm long-term conviction has been that a flat tax outperforms any system of progressive taxation for three reasons.

First, the flat tax is far easier to administer than any progressive system, which then has to decide what dollars of income are taxable to what persons in what period. Second, a flat tax produces the better incentives for higher output, which in turn translates into greater opportunities for all, given the higher rates of economic growth. And third, the flat tax cuts against the strong incentive for the bulk of the public, who currently pays no income taxes, to push for income tax increases on "the rich" in order to gain benefits for themselves.

These gains will lead to higher levels of growth, which in all likelihood will swamp the short-term distributional gains that entrance defenders of progressivity. Yet note that the "no new taxes" pledge is indifferent on the form of taxation so long as the various changes net out on some static model

The Republicans need to keep these fundamental truths in mind. Toward that end they should accept some tax increases, but fight hard to tie those increases to a flattening of the tax rates and to the largest possible increase in spending cuts. Starting from this framework, a tax deal should be possible with the Democrats, notwithstanding the philosophical gulf between the two parties. The current trajectory of taxation, regulation, deficits, and expenditures is unsustainable. With a bit of shrewd bargaining, the United States could take the first step in a long journey toward a return to fiscal and economic sanity. No general default will make that task any easier.