Tuesday, August 29, 2006

Da mihi castitatem, sed noli modo

If you look through my July archives (the early part of the month, which is lower on the page), you can see discussions of various arguments for cutting the US federal deficit and why I don’t find those arguments convincing. I’ve come up with an argument now that I do find convincing. That is, I would have found it convincing a few months ago, but now I think it is outweighed by other considerations. Here’s the gist of it:

Under current law, Medicare is going to become prohibitively expensive in another 10 or 20 years. The government will have to find a solution, and the solution will almost certainly involve either means testing or taxes. Economically, means testing is equivalent to a tax. Therefore, high taxes in the future are a virtual certainty. Optimal taxation theory says that, the higher a tax is already, the more damage is done by increasing it, and the more advantage there is to reducing it. Since taxes in the future will be high, there is a great advantage to anything we can do to reduce those taxes. One thing we can do to reduce those high future taxes is to cut the deficit today so as to reduce the debt burden that will have to be paid out of those taxes.

In general, I can’t argue with this logic, but the thing is, there is a good chance the US will go into a recession some time in the next year, and it could get quite ugly. Based on recent experience, I wouldn’t rule out a liquidity trap. So I have rather reversed my earlier position. My earlier view was, “All my logic says the arguments against the deficit are unconvincing, yet I still favor deficit cuts, because it seems intuitively like the right thing to do.” Now I would say, “I have a solid logical argument against the deficit, but I nonetheless oppose cutting it. Save the fiscal responsibility until the danger of recession has passed.”

Some people would say (1) a recession is the Fed’s problem, and the Fed can compensate for fiscal tightening, and (2) as for a liquidity trap, we can cross that bridge when we come to it, so (3) we should cut the deficit now, which will give us more of a chance to increase it later when it may be really necessary. But that strikes me as just the kind of timing mistake that has given macroeconomic fine tuning a bad name. Except for the dumb luck of the 2001 tax cut, fiscal stimulus during the post-World-War II period has always been applied much too late and succeeded only in accelerating already strong recoveries. This time around, why not try to prevent a recession? Or at least don’t deliberately make it worse. The Fed may need to bring the US to the brink of recession to maintain its credibility, but Congress has no credibility to lose. Somebody has to be the good cop.

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27 Comments:

Anonymous happyjuggler0 said...

[Bold emphasis added by yours truly of course]

Optimal taxation theory says that, the higher a tax is already, the more damage is done by increasing it, and the more advantage there is to reducing it. Since taxes in the future will be high, there is a great advantage to anything we can do to reduce those taxes. One thing we can do to reduce those high future taxes is to cut the deficit today so as to reduce the debt burden that will have to be paid out of those taxes.

Well, since the goal is to enable future tax hikes to be less damaging than they otherwise would be, it seems that instead of saying "cut the deficit", what you really ought to have said is "cut spending" since you can only cut a deficit by adding revenues or decreasing spending. (Granted, holding the line on spending as a % of GDP while revenues are increasing involves neither, but in practical Beltway terms it is a spending cut).

Increasing current taxes so as to "make room" for future tax increases would of course be absurd.

Tue Aug 29, 01:03:00 PM EDT  
Blogger knzn said...

happyjuggler0, I disagree. The argument was mostly based on tax smoothing, which applies even if you take spending as exogenous. For example, suppose that the interest rate equals the growth rate, and suppose that over 100 years, we need revenue equal, on average, to 34% of output. You could do that with a 34% tax rate all along, or you could start with a 30% tax rate and raise it to 35% after 20 years. The first possibility will produce less distortion than the second.

You could point out that output is not exogenous, and it will be affected by the tax rate. However, if I take spending as exogenous, it’s not clear in which direction output will be affected. A lower tax rate in the early years would mean a bigger deficit and therefore more crowding out of private investment, which in a closed economy would almost certainly outweigh the increased growth due to the incentive effect of lower taxes; in a large open economy, it’s anybody’s guess.

The other issue is that, right now, the interest rate is probably less than the growth rate, which means maybe you wouldn’t need to go all the way to 35%. There is going to be some kind of tradeoff between tax smoothing and taking advantage of growth, but I suspect that the optimal result would involve at least a little bit of tax smoothing.

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