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Fiscal policy is making a comeback in Washington. President Bush underscored this point with a recent economic policy shake-up that included replacing the Treasury Secretary and the White House economic adviser. With a sluggish economy and the return of deficit spending, Republican Washington realizes that remaining in power will require an agenda broader than war in Iraq. Democrats, on the other hand, accuse the president of irresponsible tax cuts and a weak domestic policy agenda.
Curiously missing from this debate is any discussion of government spending, a primary cause of the current deficits, both at the federal level and the state level. In fact, in many ways the current debate over deficits masks this important component of fiscal discipline. Many politicians view tax cuts warily, while further federal spending to boost the economy is viewed more favorably. Some still believe government can spend its way out of the recession. With respect to taxes, however, the debate has become focused on the question of whether we can afford tax cuts, given the budget deficit. Ironically, the newfound concern over deficits and economic stimulus harks back to an economic framework whose policy prescriptions were biased towards larger, not smaller deficits.
Drawing on the work of John Maynard Keynes post-War economists developed technical models of the economy based on the concept of aggregate demand, or the sum of all spending by consumers, investors, and the government. During economic downturns, consumer and investor demand would drop, lowering output and weakening the economy. Keynes proposed boosting demand in such times through increased government spending. This spawned an era of fiscal management with government spending considered an important policy tool. Active fiscal management reached its peak in the 1960s, with economists developing elaborate models to evaluate the economy and prescribe the appropriate fiscal policies. However, by the 1970s—a decade marked by high unemployment and double-digit inflation—it was becoming clear that fiscal policy had important limitations.
As Nobel economist James Buchanan noted, the Keynesian revolution in economics altered the policy framework in ways that promoted increased deficit spending. Prior to the rise of Keynesian economics, balanced budgets were the goal, and governments were evaluated on their ability to manage the budget. Only during times of war were deficits common, and these were paid down quickly once hostilities subsided. Keynesian fiscal policies downplayed the importance of balanced budgets, spawning an era of increasing government spending and rising deficits.
The problem, as Professor Buchanan noted, was that the Keynesian approach created a technical model of the economy that ignored the underlying institutions and incentives confronting the politicians who make economic policy. With re-election as the primary goal, politicians will support policies that benefit their constituents. Typically this means avoiding tax increases and supporting spending, especially for projects in their home districts. Over time, this leads to recurring deficits, which have been the norm rather than the anomaly for the last 60 years.
So when the administration and the new Congress tackle fiscal policy in the coming year, it is important that they focus on what is important—strengthening the economy to promote long-term economic growth. This means providing individuals the incentive to produce more goods and services and thus expand output. Tax cuts, when they target these incentives at the margin, can improve the long-term outlook of the economy. This is an important point that should not be lost in discussions about the deficit. In the short-run, there is little that government can do to “jump-start” the economy. Alternatives to marginal tax cuts—typically one-time rebates that hope to spark consumption—provide little incentive to increase output. In the long-run, making the Bush tax cuts permanent, simplifying the tax code and eliminating the alternative minimum tax, and improving the tax treatment of capital make eminent sense.
Nonetheless, the deficit will be used as an excuse to avoid such tax cuts, which simply means that the government absorbs resources that could have been invested by the private sector, supporting a federal spending habit that now consumes 19.5 percent of the GDP. Deficits do raise concerns among taxpayers, who equate federal spending to balancing the household budget. But it is not the deficit per se that upsets taxpayers; it is the fact that the government is spending beyond its means that is the problem. Discussions over whether we can afford a tax cut detract from this important point. Fiscal reform should focus on taming spending in Washington. Beyond tax cuts, the administration and the new Republican Congress can consider measures such as a line item veto, a supermajority for all tax increases, and a balanced budget amendment to restore fiscal discipline.
The economy is sluggish and lower marginal tax rates would provide important incentives to expand output. Reducing the tax bite can push resources out of government to more productive uses. But only if Congress has the discipline to control spending. Otherwise, the spending will continue, with the federal government borrowing the money it needs—money that ultimately must be paid back by taxpayers. The president is correct to expand the agenda beyond Iraq to include the economy. But framing the policy question as a choice between deficit reductions and tax cuts loses sight of the ultimate goal of the president’s economic policy, which is to strengthen the underlying incentives in the economy and promote long-term economic growth. Tax cuts can provide those incentives, and a tighter reign on spending can address the problem of deficits.