Our debate about fiscal policy — government taxing and spending — is so complicated and confusing that no one can be blamed for giving up on it. Chin-stroking pundits warn of crippling budget deficits, but in reality, the deficits (and the punditry) hardly seem to matter. Life seems to go on similarly with or without them. Politicians inveigh against reckless borrowing, except when it comes to legislation they like. In those cases, no level of deficit financing is too burdensome.
Let’s try to cut through this fog by making it as simple as possible, without being too reductionist. The key problem with our fiscal policy is that our tax structure does not collect enough revenue to support the government people need and want. Here’s what I mean.
First, the graph below from tax analyst Chuck Marr contains three simple numbers that get to the heart of the problem. The bars represent tax revenue as a share of gross domestic product. The historical average is 17.4 percent, yet because of the tax cut, that share is expected to fall almost a point next year, to 16.5 percent. That’s a revenue loss of about $200 billion.
But that’s not the right comparison. When the economy is near full employment, as it is today, the higher level of economic activity spins off more revenue. In those periods, revenues average 18.4 percent of GDP, meaning we’re about 2 percentage points ($400 billion) below where we should be.
To show how unusual that is, I built a simple statistical model that predicted the revenue share as a function of unemployment. The model does a decent job of predicting revenue, although it misses the big spike in the Clinton years (the dot-com bubble and its accompanying capital gains generated an upside revenue surprise). But the punchline is that the gap between expected and predicted revenue this year and next — circled at the end of the figure — is historically large.
In other words, our tax collection machine is broken. How that happened can be gleaned from a key diagnostic insight from Bobby Kogan of the Senate Budget Committee staff (whose Twitter feed is a font of useful information). He simulated our public debt as a share of GDP had we kept the Clinton-era tax code in place but let all the spending that occurred since then proceed apace — the wars, the Affordable Care Act, etc. The result is a debt/GDP ratio that’s 27 percentage points, or about a third, lower than it is today, about 50 percent instead of 77 percent.
That doesn’t get us back to the pre-2007 recession levels, but it’s a ton more fiscal space.
What about the spending side? In fact, we’re spending less (as a share of GDP) on many domestic priorities, including infrastructure, education, national parks, public health and scientific research. Our aging population and rising health-care costs are increasing our spending needs on retirees’ income and health security, but that’s my central point — the insight that I believe takes us out of the fiscal debate cul-de-sac that never seems to yield much clarity: As baby boomers age, we’ll need more, not less, revenue, not to expand government but just to meet current services.
Add in infrastructure, climate change, geopolitical threats, people and places left behind even at full employment, and you see why that circled part in the figure above is so problematic.
Why not just borrow to make up the difference? Here, let me attempt another end run around the endless arguments about the supposed limits to public borrowing and how the bond market will eventually punish our fiscal recklessness vs. how we can painlessly pump up our public debt forever. These questions are unanswerable. We simply don’t know if there’s an interest-rate tipping point or where it is. Warnings that servicing costs will skyrocket once your debt passes some line in the sand have little empirical basis and should largely be ignored. That said, it’s entirely possible that overheated fiscal policy could put upward pressure on interest rates and inflation.
But here’s what we do know: Our historically large debt and deficits will lead policymakers to be far more reluctant to fund what needs to be funded. They’ll argue that they’d truly love to protect Social Security/infrastructure/education or whatever public goods we need or want, or to offset the next recession, but that we just can’t afford it.
Of course, this is self-serving nonsense, because the reason we can’t afford it, as I’ve shown, is their tax cuts. In fact, that has been the strategy all along: Cut the revenue sources, forbid any tax increases, and the only solution is spending cuts and further shrinking of the government.
Borrowing has, of course, kept the strategy from being fully effective, although those domestic cuts noted above are already evident, especially in our infrastructure, which needs serious maintenance. But the political, and possibly economic, constraints on further borrowing will increasingly bite.
So, we must raise taxes. Progressively and incrementally, we must close the gap at the end of Figure 2 above. Analytically, that’s the simple route out of our tangled fiscal debate (economist Peter Orszag correctly adds that reducing the growth of health-care costs must be another part of the solution). Politically, it’s a huge challenge, one on which I’ll soon offer more thoughts.
But, contrary to much of what you hear, this is a lot less complicated than it’s made out to be: deeply and repeatedly cut taxes, and eventually you can’t afford the government you want and need.