Commentary: The Smart Fiscal Policy That's Needed Now

It's not the time to worry about the deficit. Now is the time for decisive stimulus--$100 billion or more

By Margaret Popper

For the past 25 years, Americans have relied on the Federal Reserve to set the economy right. The Fed would raise interest rates when inflation threatened or lower rates when growth stalled. And because a rate cut could be implemented quickly and without political debate, it seemed like the ideal policy tool.

But more rate cuts may not be the right way to deal with the economic malaise of 2002. Low rates--already at the rock-bottom level of 1.75 percentage points--have done little to stimulate business investment. And while further rate cuts may do more to prod auto sales and housing demand, further inflating the already overheated housing market carries its own risks.

That's why it's time for Congress and the President to use smart fiscal policy--a combination of targeted tax cuts and spending--to pull the economy out of the doldrums. Tax cuts should be shifted from the future to the present and structured so that corporations and consumers are more likely to spend their windfalls now. Federal spending should be bolstered, especially in defense and infrastructure, which have the biggest impact on short-term growth, and shifted away from items such as farm subsidies (table).

Moreover, the stimulus needs to be $100 billion or more--large enough to make a difference. A new study by the Federal Reserve suggests that fiscal stimulus failed to work in Japan in part because the Japanese government doled it out in dribs and drabs rather than making a decisive move. That's a mistake the U.S. needs to avoid.

There are some things a smart fiscal agenda would not include. Politicians in both parties are calling for cutting spending to bring down the budget deficit, but that's the wrong thing to do in a slumping economy. Moreover, some policy measures that might be growth-enhancing in the long run, such as President George W. Bush's call for increasing the level of 401(k) deductions, could drag down near-term growth by increasing saving in the short run.

In the past year, the U.S. economy has been buoyed by a combination of tax cuts and increased defense spending after the terrorist attacks. That fiscal stimulus, however, will peter out in fiscal 2003 since increased spending on the federal level will be partly negated by tighter budgets on the state and local level. The federal budget is set to increase by about $79 billion for fiscal 2003--less than the $137 billion increase for 2002, according to the Congressional Budget Office (CBO). Under current law, income tax rates will not be cut again until 2004. And most economists expect states and cities to start raising taxes and cutting spending next year to meet balanced-budget requirements.

To boost growth, the first step could be implementing a sharp but temporary tax cut constructed to encourage spending, not saving. Princeton University economist Alan S. Blinder suggests paying the money to the states, which could in turn declare a month-long sales-tax holiday. "If you cut income taxes for only one year, people ignore it," says Blinder. But a sales tax that will go back up in a short time gives people an incentive to shop during the tax-break window, he says.

Another option may be to cut contributions to Social Security and Medicare. A payroll-tax holiday has the biggest potential bang for the buck of any other kind of tax cut, according to a January study by the CBO. Congress should also reduce the post-2004 tax cuts that are built into the current law to keep down future budget deficits.

Tax cuts alone, though, are not sufficient fiscal stimulus. That's because people often save part of a tax cut, particularly if they view it as temporary or are wealthy enough that they don't need to spend it immediately. When the Bush tax-rebate checks were sent out last summer, there was no blip up in consumer spending for July and August, notes Alan D. Viard, senior economist and policy adviser at the Federal Reserve Bank of Dallas.

So any tax cuts must be accompanied by direct spending on projects that build up defense and infrastructure. For every dollar the feds inject into the economy in this way, $1.80 worth of additional output occurs over the next year (table), estimates David A. Wyss, chief economist at Standard & Poor's.

Also useful would be a hike in unemployment benefits, which generate $1 in output for each dollar the government spends, according to Wyss. This is an area where state spending could bump up against constraints without some federal help.

There certainly is room to spend more. Government outlays are around 19.5% of gross domestic product--below the long-term average of 20.2%. And while the budget deficit of $157 billion forecast for fiscal 2002 seems scary, it's only about 1.6% of current GDP.

The key is to avoid the trap the Japanese fell into when they tried to stimulate their economy in the 1990s. According to the Fed study, "greater and more appropriately targeted fiscal stimulus would have been desirable." Additional fiscal stimulus of about 0.5% to 1% of GDP, the study concludes, would have substantially improved Japan's economic position. Instead, the Japanese government was relatively cautious in its fiscal stimulus because it didn't want to run up a huge deficit and because economic forecasters did not foresee the deep nature of Japan's problems. "They were simply too optimistic about prospects for future growth," says William C. Dudley, chief U.S. economist at Goldman, Sachs & Co.

But fiscal policy has pitfalls, too. Even if Congress manages to move fairly quickly to enact new policy--which is difficult because of the lengthy appropriations process--it can't easily reverse direction once the stimulus is no longer needed. The resulting deficits have to be financed by government borrowing, which hurts long-term private investment.

Even so, because it ran surpluses in the 1990s, the federal government has room to create the fiscal stimulus that is needed to ensure economic recovery. So now's the time to take advantage of this opportunity to boost growth. The current criticism of deficit spending and tax breaks will pale next to the charges of fiscal irresponsibility that will follow if Washington fails to act.

Popper covers the economy from New York.

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