Five Steps to Bust the Deficit

Wednesday, October 12, 2011
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Taylor Jones

The tortuous negotiations last summer to raise the debt ceiling focused on deficit reduction. That’s progress—it’s imperative that we rein in spending, given the risks posed by our growing debt, ongoing deficits, and President Obama’s spending binge. But we should continue to be wary of “balanced” spending-cut/tax-hike proposals promising phony future savings. Lawmakers should pay heed to five vital lessons from the history of attempts to consolidate the budget and reform major programs:

1. Cut spending, don’t raise taxes. In a comprehensive study of post–World War II fiscal consolidations in developed economies published last year by the National Bureau of Economic Research, economists Alberto Alesina and Silvia Ardagna conclude that successful deficit reduction averaged $5 to $6 in spending cuts for every $1 of tax increases. Higher taxes more often led to recession. Recent proposals by Obama and Senate Budget Committee Chairman Kent Conrad to balance spending cuts with large tax hikes would thus be a recipe for failure.

2. Control spending with enforceable procedures. President Reagan twice negotiated large spending cuts in exchange for modest tax increases (after historic tax-rate reductions in 1981), but much of the spending control never materialized. The Gramm-Rudman-Hollings Act of 1985 required projections of gradual deficit decline to a balanced budget over several years. Not surprising, the result was rosy forecasts but little deficit reduction. So lawmakers revised and stretched out the targets, but fared no better.

Similarly, the European Union’s Stability and Growth Pact, which in 1997 set deficit and debt limits, was routinely violated long before the current financial crisis and recession.

Some say that balanced-budget rules have succeeded by requiring that any shortfalls be made up the following year, thereby decreasing the incentive to fudge in the first place. President George H. W. Bush’s controversial 1990 budget deal with a Democratic Congress included caps on discretionary spending and sequestration of funds if they were exceeded. President Bill Clinton and a Republican Congress later renewed the rules. New entitlement programs and tax cuts had to be “paid for”—i.e., there was a “marginal balanced budget” requirement.

3. Be wary of baselines and budget gimmicks. Projected savings are usually measured from baselines with rapid increases in spending and rising taxes. The current Congressional Budget Office baseline assumes large, automatic tax hikes, far beyond historic GDP shares. The hikes come from the expiration of the Bush tax cuts in 2013, growth of the alternative minimum tax, and continuing “bracket creep,” which pushes middle-income families into higher tax brackets. That’s how Obama can call a large tax increase (from today) a tax cut (from baseline).

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Conversely, propose slowing projected spending growth (say, to 6 percent from 7 percent, as the House Republican Budget Resolution did this year) and you are accused of draconian slashing. We should end autopilot budgeting and force justification of all spending or tax hikes.

4. Watch out for unintended consequences. Surprises tend to compound and, as Albert Einstein once said, compound interest is the most powerful force in the universe. In the 1970s, with little analysis or discussion, Social Security benefits at retirement were indexed to wage rather than price growth. Because wages generally grow more quickly than prices, price indexing has led to a higher rate of benefit growth. Today, with the baby boomers retiring, wage indexing creates trillions of dollars of future unfunded Social Security liabilities by projecting large benefit increases far beyond tax revenues. Switching to price indexing would eliminate this deficit while maintaining the real level of benefits.

Perhaps an even riskier consequence derives from the explosion, under Democratic and Republican administrations, in the number of people paying no income tax, in part because of refundable tax credits. Last year a majority of Americans paid no income tax. Also, partly because of the aftermath of the severe recession, transfer payments are at an all-time high as a share of personal income. These are ominous trends for budget dynamics in a democracy. We need both a broader base of economic activity and a larger fraction of the population financing government spending if we are to preserve a prosperous capitalist democracy.

5. Tackle fundamentals. If spending is projected to grow exponentially, modest cuts won’t help much. We need changes that compound and accumulate over time, especially in Social Security and Medicare, or they will crowd out all other federal spending or drive marginal tax rates over 70 percent.

We’ve had successful, farsighted policy reforms that also dealt with pressing short-run issues. Reagan’s 1981 reform of indexing tax brackets to offset inflation still pays dividends by preventing even larger automatic tax hikes. The 1983 Greenspan Commission’s phased-in gradual increases in Social Security retirement age were prescient. We can and must immediately address the debt-ceiling issue while focusing on long-term deficit reduction.

Events are rarely kind to those who keep kicking the can down the road, expanding spending and exploding the national debt. Payment ultimately comes from higher taxes, eroding the debt through inflation, or outright default and debt restructuring. The cost of any of these actions would be severe. Just ask taxpayers in Greece or Portugal facing a decade of depressed living standards. Or the Japanese, whose stagnation is measured in decades, not quarters or years.

Reprinted by permission of the Wall Street Journal. © 2011 Dow Jones & Co. All rights reserved.