Tax increases are driving America’s lack of spending
U.S. policymakers pursued deficit reduction twice in 2013. As economists have shown in dozens of papers, how a country goes about reducing deficits matters a lot in determining the economic impact.
As Alberto Alesina of Harvard, Daniel Leigh of the International Monetary Fund, and Kevin Hassett of the American Enterprise Institute all argued at The Heritage Foundation’s symposium last month, deficit reduction based on tax increases can cause deep and immediate economic losses.
The U.S. implemented both tax increases and spending cuts in 2013, but the tax increases were two to four times larger. Taking into account that the tax increases were larger and that tax increases have larger economic effects, we can safely conclude that any “austerity”-induced slowdown is due primarily to tax increases. Neither the basic historical facts nor the economic research on the topic give support to the idea that sequestration is the villain in 2013’s poor economic growth.
Several tax increases took effect in January 2013: new Obamacare taxes, the expiration of the payroll tax, and “fiscal cliff” tax increases. During the fiscal year (which ended on Sept. 30), those together increased taxes by $188 billion.
The spending cuts (i.e., sequestration) took effect in March 2013. Sequestration reduced fiscal year 2013 budget authority by $85 billion, but only $42 billion of the cuts took effect during FY 2013.
In addition to immediate economic costs, deficit reduction has benefits, most of which are felt in the long term. When deficit reduction is undertaken through spending cuts, it frees up human resources and capital for private-sector growth. Though the transition is not immediate, the costs of spending cuts are relatively brief and mild, and the benefits remain in the long term.
In addition, successful deficit reduction lowers the ratio of debt to gross domestic product, keeping interest payments down and allowing stronger economic growth. For the U.S., deficit reduction should be a major priority over the next 10 years: The retirement of the baby-boom generation will add to the government’s costs and shrink the tax base.
How different would economic performance be in the short run if sequestration had been replaced with tax increases? The effects over the first two years — according to four scholarly assessments — show large costs, ranging from $57 billion in output and 320,000 jobs to $240 billion and 1.3 million jobs
Conversely, what if the payroll, Obamacare, and fiscal cliff tax increases had been replaced with immediate spending cuts in the same amount? There would be significantly higher output and job creation. And what we know about longer-term growth tells us that the gains would be even greater over time.
Reducing the deficit by $188 billion using spending cuts instead of tax increases would have generated from $130 billion to $520 billion more in GDP by the end of 2014 and added between 700,000 and 2.9 million jobs. By comparison, employment rose by 1.3 million in FY 2013 and 2.8 million in FY 2012.
The question is not whether tax increases are more costly than spending cuts; it is how much more costly they are.
Those who favor higher taxes and spending look for a variety of creative deviations from straightforward economics in order to justify their preferred policies.
One argument is that “hysteresis” — the decay of skills and opportunities among the long-term unemployed — is severe right now, so the short-term costs of spending cuts will be magnified by interacting with hysteresis. Those who sincerely think hysteresis is the biggest economic problem today should be arguing loudest against tax increases, given the evidence that the short-term costs of tax increases are even larger than the short-term costs of spending cuts, and should also oppose Obamacare on the grounds that it increases the fixed cost of hiring workers.
Another argument is that taxes should be raised on specific groups that “can afford” to pay. But this slippery form of redistributionism does not have any bearing on the economic impact of a tax. In fact, the literature shows that deficit reductions based on spending cuts outperform tax increases most prominently in investment. Economies with spending cuts invest more than economies with tax increases. Those who can “afford” to pay taxes can also afford to save and invest. Higher investment raises wages and creates jobs. Redistributionism does not help economic growth.
A third objection is that sequestration was not the best way to cut government spending. That is certainly true, and funding should be shifted from the least effective government functions to the most effective. But that is always true: Government spends too much on boondoggles all the time. Trading poorly designed sequestration cuts for elimination of useless programs and reforms that help put Social Security, Medicaid, and Medicare on a permanently sustainable trajectory would be welcome. And the need to improve government efficiency in no way diminishes the economic evidence that tax increases are vastly more harmful than spending cuts.
The Obama tax increases are the clearest answer to the question of why economic growth has been sluggish. Those who argue that sequestration is to blame for the poor economic performance of 2013 are ignoring tax increases that are two to four times as large and a broad research consensus that the short-term costs of tax increases far outweigh the short-term costs of spending cuts. The negative impact of President Obama’s tax increases is made worse by the simple fact that the tax increases are much larger than the spending cuts.
Policymakers can allow higher growth and more jobs without adding to the deficit by replacing taxes with spending cuts.
Brian Lucking and Daniel Wilson of the San Francisco Fed show that taxes will continue to rise rapidly in 2014 if Congress does not act and that “nine-tenths of (the) excess fiscal drag (through 2015) comes from tax revenue rising faster than normal.”
Salim Furth is senior policy analyst in macroeconomics in the Center for Data Analysis at The Heritage Foundation.