Hoover Daily Report

How to Grow Out of the Deficit

via Wall Street Journal
Monday, September 27, 2010

As Washington debates the fate of the 2001 and 2003 tax cuts, many lawmakers have fallen into a logical trap of their own making. Although they recognize that tax increases hurt the economy, they argue that our huge deficit requires Congress to raise revenue through a tax hike.

This argument rests on the flawed premise that we can reduce the deficit only by increasing taxes, as if high levels of spending are a given. Not so.

To reduce spending and reignite growth, this Congress or its successor should take two actions. First, immediately cut the level of spending that has been increased so dramatically since 2008. Second, institute an "inflation-minus-one" rule to constrain future spending increases.

Much public discussion focuses on the deficit, which is indeed at critical levels of around 10% of GDP. But even if President Obama succeeds at lowering the deficit to 4% of GDP by 2013, our public-debt-to-GDP ratio will still be dangerously high, at over 70%, or nearly twice what it was during the Bush years. As the economists Carmen Reinhart and Kenneth Rogoff have shown in the journal American Economic Review, such high debt-to-GDP ratios are associated with low growth.

Tax increases—which some suggest in order to reduce the deficit—also impede growth. But Americans don't have to choose between an enormous deficit or high taxes. If we returned to the relative fiscal restraint that prevailed during the Clinton and Bush years, when spending was 19.7% and 19.6% of GDP, respectively, we could avoid the entire mess.

Spending, not the deficit, is the most important measure of fiscal restraint. A fiscally irresponsible president could balance an out-of-control budget by taxing too much. That approach would hardly be conducive to economic growth.

To return to the healthier spending ratios of the past two decades, Congress should begin by enacting a budget that brings spending for fiscal year 2012 at least half way back to where it was in 2008. Republicans campaigning to take control of Congress should make such spending reduction a priority.

Second, Congress should begin limiting future spending according to an inflation-minus-one rule. That rule would hold that in any year when the ratio of government expenditures to GDP exceeds 18% (the 30-year average of tax revenues), Congress could increase spending only by the last three years' inflation rate, minus one percentage point.

This would reduce the ratio of spending to GDP, because GDP growth would almost always exceed budget growth. There would be wrangling over what gets funded, but the amount of budget growth would be constrained. Further, because growth is tied to a historic number (the prior year's budget) rather than a forecast, the rule would be tough to circumvent.

Coupled with the initial cut in spending, such a rule would get us back to 2008 ratios by fiscal year 2014. It would take three or four more years to get to a balanced budget. And if an aggressive Congress cuts spending even faster than the limit imposed, those additional cuts would be baked into future budgets.

In emergencies, Congress could pass a one-year suspension of the rule with a 60% vote of both houses. The base, then, would return to the budget levels of the year before the suspension. The ability to suspend the rule temporarily would help prevent the more draconian measure of repealing it as soon as the first emergency presents itself.

In addition, we should limit budget growth in any year that is under the target ratio to no more than twice the prior year's increase. And once the spending-to-GDP ratio again exceeds 18%, the rule would kick in and bring the ratio back down. Thus spending would stay constrained within a narrow band around historic revenue-to-GDP ratios.

The inflation-minus-one rule would allow us to grow our way out of our fiscal problems without taxing a higher proportion of GDP. Eventually the deficit would vanish—and with taxes remaining at historic levels, there would be no impediment to economic growth.

Calling for a rigid rule may seem wishful, but the alternative is a dangerous false choice between high deficits and high taxes. Failing to take a stand now will condemn subsequent generations to lower living standards and fewer opportunities.

Mr. Lazear, chairman of the President's Council of Economic Advisers from 2006-2009, is a professor at Stanford University's Graduate School of Business and a Hoover Institution fellow.