26 November 2012

No Nude Taxes - The Naked Truth About Deficit Reduction

Two quick points about current negotiations to avoid falling off the fiscal cliff. One has to do with simple math and the other with simple economics. Together they suggest that deficit reduction needs to come from a mix of tax hikes and spending cuts and that neither should be rushed.

Some still cling to the notion that we can erase the deficit through budget cuts alone. This the last gasp of a movement designed to radically shrink government, one that got this far in large part by arm-waving about how tax cuts stimulate the economy. Let's take them at their word and ask by how much the economy would have to grow to compensate for the tax cuts of the last decade.

In the decade from 2000 to 2009, taxes as a percentage of GDP fell from 20.6% to 15.1%. I'll just simplify that to say that taxes fell from 20% to 15% of GDP. 

Our GDP is nearly $15 trillion this year so it's simple enough to calculate how much more GDP should have grown to compensate for such a cut in tax rates.

A 20% tax rate on a $15 trillion economy would have given us $3 trillion in federal revenue.
To get that same $3 trillion in revenue with a 15% tax rate would require a $20 trillion GDP.

In two simple equations:
  $3 trillion in revenue = 20% of $15 trillion
  $3 trillion in revenue = 15% of $20 trillion

Tax cuts would have had to stimulate economic growth by another $5 trillion in the last decade in order for revenues to remain constant. Is that reasonable? Well, the second and third largest economies in the world - China's and Japan's - are $5-point something trillion dollar economies. Every other national economy in the world is considerably smaller than $5 trillion. (The economies of France and the UK combined are roughly $5 trillion.) 

In other words, had tax cuts stimulated our economy by an amount equal to the whole of China's economy, we'd have enough tax revenue to leave rates unchanged. If not, we might have to consider the fact that we'll simply have to raise tax rates back to what they've averaged for the last half century: roughly 18% of GDP - give or take a point or two.

Now what about the contention that raising taxes will be bad for the economy? 

On this, the GOP faithful are right. But so will cuts to government spending. Cut the money investors get in tax returns or that social security recipients or government contractors get in payments and you will contract spending and hence the economy. 

The real issue is that the deficit is not the real issue. Not yet. Like a kid in the kitchen excited about baking bread who keeps hollering, "We have to put it in the oven now!" the voices chirping about reducing the deficit are both right ("We have to cut the deficit!") and wrong about timing. Bread dough has to first be mixed and then let to rise before we can put it in the oven without ugly results. The same is true of the economy: we have to first stimulate it with spending and tax cuts (deficit spending) then let it rise (unemployment falls as the GDP rises) before we put it in the oven (begin to cut spending and raise taxes). To get this order wrong is to go the way of Greece and Spain. Austerity measures in a bad economy don't just make the economy worse; they make the deficit worse as well. As it is with something as simple as baking, so it is with something as complex as a modern economy: sequence is critical.

The right solution to deficit reduction won't just cut spending and raise taxes. It will time these budget changes with certain milestones (e.g., unemployment rate at 7% and 6% and 5% triggering different combinations of tax hikes and spending cuts, for instance). 

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