Change the Focus to Long-Term Growth

The fiscal policy debate between the need for stimulus to support flagging public demand and the need for austerity to right budget imbalances is center stage in Washington.

The Obama administration argues that additional federal spending--on top of the nearly $800 billion stimulus--is needed to spur economic activity and employment. Opponents argue that budget austerity is the right way. Then there is a tug of war within the austerity camp between proponents of tax increases and supporters of federal spending cuts.

But the more important question for the economy is how to encourage growth. Faster economic growth lifts employment, living standards and federal revenues; slower economic growth does the opposite.

A bold move toward fiscal consolidation would improve long-term growth by easing the pressure of mounting government debt on interest rates and reducing the need for higher taxes.

The growth question is essential, shifting our focus to innovation, investment and trade. Some critics argue that the administration's agenda shows a lack of interest in economic growth. It includes diffidence about trade agreements, promotion of tax increases and tax policy uncertainty, promulgation of more burdensome regulation in health care and plans for larger increases in federal spending. This all raises the specter of tax increases.

For today, the key growth question is, Are there policy changes--politically acceptable ones--that would bolster near-term growth (stimulus) and allow for fiscal consolidation (austerity) in a way that enhances long-term growth?

The answer is yes.

Why? First, over both medium- and long-run horizons, falling revenues are not the problem. Second, spending restraint can provide the positive answer--beginning with Social Security reform.

Is There a Revenue Gap . . .

Start with the so-called revenue gap and the case for raising taxes. This year's federal revenues are likely to be 15 percent of gross domestic product--less than the 40-year average of 18 percent.

With no policy action, revenues are on track to exceed 23 percent of GDP in 25 years--a bigger share than in World War II. How so? Even a gradual recovery is likely to boost revenues. And rising incomes lift taxpayers into higher brackets--"real bracket creep."

Moreover, the 2001 and 2003 tax cuts--and the 2009 stimulus--are due to expire. Recent new taxes can help pay for Obamacare, while the alternative minimum tax, not indexed for inflation, may hike taxes for millions of individuals.

About one-third of the tax revenue growth comes from expiring tax provisions, one-third from real bracket creep and one-third from remaining tax increases. But Congress is unlikely to let all tax cuts expire or let the AMT take such a big toll--making the revenue gap a real possibility.

. . . Or Not?

We can extend the 2001 and 2003 tax cuts and limit AMT growth and still have revenues of more than 19 percent of GDP by the end of this decade. Extensions of low marginal tax rates on income from working and saving offer a cushion to growth, and clarifying the extensions blunts the negative effects of uncertainty on growth. The question is whether we can keep federal spending in check, giving breathing room to support near-term economic growth through tax relief as well as long-term growth.

There is much to cut in discretionary spending, which has been at binge levels for a decade. But the big opportunities lie in entitlement reform. Reform can be done in steps, increasing the political likelihood of success--and signaling credibility to get breathing room.

Can Social Security Reform Support Growth?

While Social Security is not the biggest contributor to long-term budget costs--that distinction is held by health care--it is a big deal.

The good news is that we know ways to reduce the Social Security debt while retaining its important role as a floor for retirement income. One step is to increase the retirement age to match recent improvements in longevity.

Benefit growth for middle- and upper-income households can also be trimmed. One fix is progressive indexing, in which lower-income workers' benefits are indexed to growth in wages (as under current law), while benefits for higher-income workers are indexed only to growth in prices. This focuses Social Security more sharply as a safety net and would generate a large improvement in America's long-run fiscal picture.

A bold move toward fiscal consolidation would improve long-term growth by easing the pressure of mounting government debt on interest rates and reducing the need for higher taxes. More important, the adjustment would grant breathing room for near-term fiscal action to improve growth.

Two good candidates for so doing are (1) a temporary payroll tax holiday for firms and for lower-income workers to reduce hiring costs and boost household spending and (2) a cut in America's high corporate tax rate.

Further fiscal consolidation could also improve long-term growth prospects, while focusing entitlement spending on a "social safety net" role. Reducing Medicare subsidies for nonpoor individuals could be a large step. Shifting the federal contribution to Medicaid to a block grant, in which payments to states grow with inflation and low-income population, could be another key step.

These changes--important for fiscal consolidation and keeping tax rates low to encourage growth--are key. But they need not happen right away. The refocusing of Social Security can provide the critical first move, buying time both for near-term fiscal action to boost growth and for economic and political consensus on reducing the adverse effects of rising health care costs.

Shifting this stimulus versus austerity debate to a discussion about growth would give us the chance to improve the important (our long-term growth) without sacrificing the urgent (support for near-term growth).

We can do this without raising taxes and with safeguards for low-income households in entitlement reform. We can do so in practical steps. And we should start now.

Glenn R. Hubbard is a visiting scholar at AEI.

Photo credit: iStockphoto/Stefan Klein

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