Rubinomics Revisited

Speculation that the new Republican Congress may propose a sizeable tax cut as its first order of business in the New Year has lead many to question whether our nation can “afford” to reduce tax rates. A steady drumbeat of opposition has manifested itself in the pages of left-of-center publications and on Wall Street, where bankers fear increased deficits will reduce the price of their agglomeration of Treasury notes and depress corporate borrowing and the underwriting fees associated with it.

In the context of the late 1990s’ 4 percent growth and unemployment, budget surpluses look like an excellent roadmap for economic policymakers. But what are we to make of the collapsed asset price bubble, extraordinary level of private sector debt, and record trade deficit the Clinton-Rubin economic record left us with? Are we to somehow pretend that their policies had nothing to do with this outcome?

What if it was the budget surpluses produced by the increased revenue of the boom that caused the economic problems we now face? L. Randall Wray and other Institutionalist monetary policy thinkers currently pursue this line of thought. They argue that in a world of fiat currencies, floating exchange rates, and relatively few controls on capital flows between developed nations, the relation between the federal government’s budget position and that of the private sector is an accounting identity: Public sector surpluses necessitate private sector deficits and vice versa. While currency values and the balance of payments between nations complicate this equation, its logic is self-evident as the surplus represents money sucked from the private sector and not redistributed anywhere but the treasury.

It is also supported by recent evidence in the U.S. economy. Just as the 1980s boom produced a record amount of outstanding debt for the U.S. public sector, the 1990s record federal budget surpluses produced a record private sector debt-to-income ratio.

The differences in the constraints to deficit financing faced by the private versus public sector played a role in the end of both economic expansions. Record budget deficits – and high treasury yields – created a political constraint for more debt issuance during George Bush senior’s administration. This led to the 1990 budget agreement where taxes were increased in exchange for slightly slower spending growth.

By contrast, the financial constraints of individual firms ended the 1990s expansion. As debt service eats a larger portion of prospective income flows, private sector businesses retrench, business investment dries up, corporate bond yields widen, and bankruptcies increase; all outcomes the U.S. economy has witnessed over the past few years.

As PIMCO managing director Paul McCulley argued in a recent “Fed Focus” column, “many, far too many, balance sheets in Corporate America are not just infected with illiquidity, but are reeking with the gangrene of default risk.” Lower fed funds rates have failed to compensate for this difficulty, which is not surprising. Monetary policy has little impact on the debt service burden, which is not (primarily) due to rising interest rates but rather growth of debt at a pace faster than income flows.

Of course, Corporate America is not alone. The other part of the private sector balance sheet is also reeling. Household and consumer savings fell to a record low since the federal budget began to shift its posture from deficit to surplus. Unsurprisingly, evidence suggests that consumer savings has increased during the past year as consumers have reached their own debt-finance constraint.

If the record federal budget surpluses of the late 1990s are responsible for the abundance of debt Corporate America and consumers are choking on, now is the time to shift the debt burden from the private to public sectors through a sizeable tax cut. Because taxes debit bank accounts, by reducing the amount the government debits through an income tax cut, the government can replenish private savings and influence directly the debt service burden by increasing income flow. The same would be true for corporate income taxes, either through a cut in the effective rate, to say 30 percent, or through reform of capital depreciation rules that require new projects to earn an artificially high rate of return to be profitable.

Further, Congress should eliminate the taxation of dividends issued to investors. If, as many critics contend, corporate tax cuts will do little to boost investment with the economy operating at 75 percent of capacity, dividend tax cuts would free-up capital from cash-flow generating businesses to be used by consumers or to finance smaller businesses not facing overcapacity or hyper-competitive foreign rivals. The double taxation of dividends forces companies like Microsoft, with over $40 billion in cash, to retain their earnings, acquire other businesses, or shed nearly 60 percent of accumulated earnings to the government by issuing a dividend.

If a large federal budget deficit – $300 billion, or 3 percent of GDP would be less than that of Germany and France – is the cost of these tax measures, so be it. Or, if fiscal discipline is a concern, we could direct our attention to the public goods supplied by the federal government and decide whether there are too many services, or how the existing services could be delivered more efficiently. Either way, it is high time to rethink the orthodoxy that suggests budget surpluses are a good thing in and of themselves.

If Wray and others are correct and fiscal posture at full employment is really a choice between public and private debt, it is easy to see why Rubin and his devotees are so loath to cut taxes: Treasury note auctions do not provide the lavish underwriting fees of the corporate debt market that have made him and his associates so rich over the years.