Monday, February 14, 2011

Yale Law School talk on "Tax Cuts and the Impending Budget Crisis"

St. Augustine famously remarked: “Give me chastity & continence, but not yet.”

Our current U.S. budget problems verge on being exactly the same. We need “laxity” now to address an ongoing down economy & almost 10% unemployment as Americans go through painful deleveraging.

But we need budgetary “chastity & continence” – that is, a massive retrenchment to head off an unsustainable public debt explosion – in the future.

Instead, however, we often get St. Augustine in reverse – calls for austerity now, alongside little willingness to face hard long-term choices.

This is especially true on the spending side, where President Obama and the Republicans are trumpeting dueling packages of large discretionary spending cuts at a time when this could do a lot of harm to the fragile economic recovery. Yet, if you try to restrain long-term Medicare growth, you’re accused of imposing “death panels.”

On the tax side, things at least superficially look better. The Bush tax cuts were extended for two years, but not as yet permanently.

But the problem is, the Bush tax cuts are poorly designed as stimulus, and no one is confident that they’ll actually expire in two years. Indeed, their possible continuation is a big contributor to the “Alternative Fiscal Scenario” on the handout [showing an exploding relationship of public debt to GDP by 2030 or so].

The long-term forecasts imply a disastrous credit market event. Let me quote economist Len Burman on the worst case scenario:

There’s “an immediate freezing of the U.S. Treasury market altogether & an inability of the U.S. government to roll over debt that is coming due … or to fund current activities…. No one is willing to lend to the U.S. government at any interest rate. Essentially, the Treasury holds a debt auction and no one shows up.”

The upshot might be that the Federal Reserve Bank decides or is told to print money, and uses it to buy the Treasury bonds, giving the government money to spend but via Weimar Germany-style finance.

All this would come with worldwide rejection of the dollar as a valuable currency, hyper-inflation, and massive waves of financial failure by firms and individuals holding U.S. debt that has now lost value. It would make the 2008 financial crisis look like a Sunday school picnic.

Plus, the U.S. government would be unable to provide fiscal backup as it did in 2008, if it had itself effectively become a governmental version of Lehman Brothers. And the shock to the entire world economy would be far greater than when a smaller country like Greece runs into such problems. The feedback effects of this would only increase the economic carnage in the U.S., while also potentially undermining global political stability.

But how worried should we be that this will happen?

Hypothetical projections like the one on the handout are just what I call “statements about statements.” They compute expected future cash flows under someone’s interpretation of current policy. If that’s easy to change, no sweat. Indeed, if current policy isn’t sticky at all, then the fact that it’s currently leading us off a cliff would be just as trivial as a car’s GPS system currently directing you due east towards the Long Island Sound, when you know that at some point you will need to head due south.

But when you look at the causes of the long-term problem, and the factors that make current policy sticky, you start to worry a bit more. I see 3 problems, one nestled inside the next like Russian Matryoshka dolls.

The main apparent cause of the problem is demographic and technological change. People are living longer, there’s been somewhat of a baby bust, and healthcare costs are growing faster than the economy although yielding genuine improvements in healthcare outcomes.

But these trends are well-known. In principle they’d be easy to adjust for, even if Congress hasn’t gotten around to it yet. Just slow the spending growth a bit and raise the revenue path a bit, and you can avoid a budget catastrophe, no matter what the forecasts look like now.

The problem is, it’s hard to believe our political system can handle this. I believe it’s grown seriously dysfunctional and will be radically unable to respond rationally. So we get to the second doll. In a sense, it’s not really a demographics and technology problem, but a political economy problem.

This is a big change. 30 years ago, when things were far less dire, Congress made bipartisan budget deals that either reduced the deficit or addressed other important and controversial issues, in 1982, 1983, 1984, 1985, 1986, 1988, and 1990.

Mainly the Republicans have changed since then. This is an important sociological story that remains poorly understood, and with likely implications for how Democrats play the game. (They don’t want to repeat the scenario of a Clinton-era surplus feeding subsequent Republican tax cuts.)

The problem is not just “partisanship” but that social and intellectual discord are so high now, undermining cooperative norms & yielding pervasive chicken games at the political party, interest group, & individual voter levels.

But shouldn’t financial markets respond to this? You’d think the bond markets would get nervous and that U.S. borrowing rates would gradually rise.

While this wouldn’t be good news as such, as least it would offer a signal, helping to encourage a course adjustment before the debt-to-GDP ratio reaches the stratosphere.

But the “bond vigilantes” have been silent about the long-term problem. This is partly from the short-term flight to quality – for example, would you rather hold Euros than dollars?

But is a wise and farsighted optimism also at work? Who’s to say the political system won’t solve things in time?

“The markets know best” might have been a more credible position before the 2008 crisis. But we’ve had repeated bubbles lately – e.g., Internet stocks before the great real estate crash.

It’s plausible that bubbles are a fundamental structural feature of today’s financial markets. They may be powerfully reinforced by key market players’ incentives, not just by myopia. (The issues here might include agency cost problems in public companies, reduced financial transparency in an age of derivatives, maldesigned incentive compensation schemes, and the fact that the players need not count on staying around for very long if they are getting rich so fast.) All this raises the prospects for a very bumpy hard landing, as the financial markets respond to the U.S. debt situation only belatedly and extremely discontinuously.

So arguably the third and innermost Matryoshka doll is a financial markets problem.

What are the tax policy implications?

At some point, taxes must and will go up. So in a sense the Bush tax cuts are toast, no matter what Congress does just before or after the 2012 elections.

Now, it’s true that we could get a long way by repealing tax expenditures. And if those rules are actually “spending through the tax code,” which we can discuss in the Q&A if people are interested, then repealing them wouldn’t really be a tax increase in substance – although people would certainly experience it as one. But repealing tax expenditures is very hard to do politically even in more harmonious times than these.

What else could happen on the tax side as the fiscal crisis approaches? Let me quickly mention some implications both for new tax instruments and for existing ones.

New taxes – there are plenty of ideas out there. They include value-added taxes (VATs), carbon taxes, and Tobin or turnover taxes on financial transactions. I’m personally a fan of the first two but not the third, and could discuss why in the Q&A. But clearly our revenue needs push in favor of all these ideas, whether they’re good or bad, so we’re likely to hear more about them at some point.

Existing taxes – I’m very skeptical about the current desirability of 1986-style tax reform, in which you broaden the base but then give away most or all of the budgetary gain by cutting tax rates. The repeal of tax expenditures should mainly finance narrowing the budget gap – not sharply cutting tax rates for individuals when we really can’t afford it.

[I here mentioned possibly disagreeing with my co-panelist Michael Graetz on his plan to use VAT revenues to greatly scale back the income tax. Though I can’t quote him or definitely confirm this, I interpret his view on this issue as being that revenue neutrality might merely be step 1, at the tax reform stage, with revenue-raising perhaps to come later on.]

On the business side, unfortunately, there are some good ideas that cost money. In particular, lowering the U.S. corporate rate because of global tax competition pressures, and eliminating most of the existing U.S. tax burden on U.S. companies’ foreign source income. For that matter, if we could, it would be nice to move closer to corporate integration, with corporate income being taxed only once, rather than duplicatively at the entity and shareholder levels. This might involve an “allowance for corporate equity,” so that equity as well as debt generates entity-level deductions.

But when your wallet is bare, it’s a lot harder to do these things – especially if we can’t or won’t make other, harder choices.

[I then declined to spread any more doom and gloom on Valentine’s Day, at least before the Q&A.]

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