Illustration by Devin Rochford
Short-Term Stimulus Won’t Help U.S. in Long Run: Glenn Hubbard
Joblessness and sluggish growth are hampering the economic recovery and Barack Obama’s political standing. Raising taxes on the rich, as the president called for yesterday, isn’t going to turn things around.
To get a sense of how severe the situation is, consider this: Bringing the unemployment rate back to pre-financial- crisis levels by end of the president’s second term (or his opponent’s first term) would require real Gross Domestic Product growth of 4 percent a year over that period -- a rate we have not reached in more than a decade.
What sort of fiscal policy can turn things around?
The president’s announced jobs plan centers on the need for additional short-term stimulus designed to boost aggregate demand and jump-start economic growth. In some recession scenarios, such action, if timely, can indeed raise output and employment.
In our current state, however, calling for additional spending and temporary tax relief without addressing longer-term economic challenges may exacerbate the likelihood of another recession in the coming year.
This is because the U.S. economy suffers from structural problems predating the financial crisis, particularly an excessive reliance on household consumption and government spending, and insufficient attention paid to business investment and exports. The financial system and the economy need to adjust in the face of this structural shift.
This observation points out two problems with the case for stimulus being made by Obama. The first is that near-term and temporary support for household incomes does little to counterbalance the chilling effect of announced future policies. Uncertainty becomes the enemy.
Hurting Job Creation
This is particularly true for the president’s proposal to reduce the employer portion of the payroll tax for small- business owners, while proposing to raise marginal tax rates on those same business owners. The president’s advocacy for higher marginal tax rates on the well-to-do dampens both job creation and asset prices.
And, it is a collapse in job creation that lies at the core of the present unemployment problem. Uncertainty over future tax and spending policy -- How much will taxes need to rise to finance rising spending? If spending is to be cut, how and on whom? -- weighs heavily on household and business spending decisions.
A second problem with the president’s plan is that repeated efforts to use stimulus to revive the economy increase the federal debt. The ratio of federal debt held by the public to GDP, now at almost 60 percent as opposed to less than 40 percent at the beginning of the financial crisis, is likely to rise to 90 percent by 2020, according to the Congressional Budget Office’s Long-Term Budget Outlook, published last summer. Without addressing longer-term fiscal concerns, new stimulus is likely to lead to a loss of investor confidence.
The key, then, to any effort to boost the economy is to craft a short-term “stimulus” in the context of a longer-term structural reform plan that clarifies the deficit and debt path for the U.S. This can be accomplished in four steps.
The first is to outline a plan to bring down the federal debt-to-GDP ratio toward its pre-financial-crisis level. This decline can be accomplished by economic growth and spending restraint.
The second is to acknowledge, as the Congressional Budget Office’s projections do, that the nation’s long-term fiscal problem relates principally to spending, with a gradually rising share of federal revenue relative to GDP dwarfed by rapidly rising federal spending relative to GDP. The main culprits here are growth in Social Security, Medicare and Medicaid. Absent a change in policy, these programs could consume an additional 10 percentage points of GDP in a generation.
The third is to clarify how future deficits will be reduced. Recent economic research argues that deficit reduction through reducing transfer spending is more likely to promote economic growth and stabilize the debt-to-GDP ratio than by raising tax rates. In particular, studies led by Alberto Alesina of Harvard University suggest that successful fiscal consolidations have been overwhelmingly driven by spending reductions and that credible consolidation can raise growth quickly.
The fourth is to understand the centrality of tax reform to any structural reform the U.S. economy. Fundamental tax reform - - broadening the tax base and reducing marginal tax rates -- promotes saving, investment and economic growth. Any number of proposals have shown -- ranging from the Treasury Department’s comprehensive business income tax (which I helped design in 1992) to the Flat Tax to the X Tax to the Bowles-Simpson committee -- it is possible to reduce marginal tax rates substantially if one surrenders most or all deductions and exclusions.
Fundamental Tax Reform
Indeed, research by Alan Auerbach of the University of California at Berkeley suggests that tax reform can add between one-half and a full percentage point to GDP growth over the next decade. And tax reform is an essential precondition for any solution to use higher revenue in a substantial way to reduce future deficits. The president’s own Bowles-Simpson Commission advocated fundamental tax reform.
Other areas of longer-term policy need rethinking, too: including housing, energy, trade and (financial and nonfinancial) regulation. But it is the long-term fiscal reforms that allow the greatest opportunity for structural reform and faster economic growth and job creation.
Bear in mind that these structural reforms do not imply that all near-term stimulus must be off the table, only that any stimulus proposal be linked to longer-term fixes.
For example, suppose that policy makers announced a credible reduction in future deficits caused by Social Security through a combination of gradual increases in the retirement age and slowing the growth in benefits for higher-income households. The enormous fiscal improvement from such a change would give leeway to strengthen Social Security benefits now for the least well-off and provide substantial incremental resources for training and re-employment of the long-term jobless.
Likewise, credible, gradual broadening of the base in the tax system by reducing tax expenditures on, say, housing and health insurance would give leeway to support business investment now with investment incentives and a much lower corporate tax rate. Or, as Obama has proposed, an infrastructure spending program could be made a high priority, but coupled with longer-term reductions in social spending.
Much of the debate over the stimulus paints economists and officials like myself, those concerned about the long term, as favoring inaction for (and perhaps indifference to) pressing short-run problems. This is a false choice: Enhancing a recovery in productivity and employment is a pressing policy need. Yet turning around the economy now also depends on grasping our structural problems and defining a policy for long-term reform and growth.
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