Tag Archives: GDP

Is the United Kingdom Savagely Cutting Spending?

In new Mercatus research, UK-based economist Anthony Evans goes in search of the data. He finds:

  • The UK government’s response to the recession has been to eliminate the structural budget deficit over the medium term.
  • There are changes in the composition of government spending but not a fall in the absolute level.
  • Forecasts of falling government spending as a proportion of GDP are due to implausible growth forecasts rather than an absolute reduction in spending.
  • History indicates that the government overestimates its ability to fund austerity through spending cuts, and therefore above-expected tax rises are likely.

Much more here, including lots of great graphs.

Do Taxes Affect Economic Growth?

The CRS has a new report by Thomas Hungerford that has attracted some attention. It seems to suggest that taxes do not affect economic growth. To be precise, it seems to suggest that the top marginal tax rates of two taxes in particular—the personal income tax rate and the capital gains tax rate—have little statistically significant effect on economic growth.

A few comments:

First, as William McBride of the Tax Foundation notes in an excellent post, the study only examines two taxes.

The largest tax on investment is the corporate income tax, but the CRS report ignores corporate rates, even though other studies have found corporate taxes to be the most economically damaging.

Second, Will also rightly notes that the study focuses exclusively on the statutory rates of these two taxes, ignoring their actual incidence.

Because Congress has larded up the tax code with piles of credits, exemptions, and deductions, statutory rates often have little relationship to the rates people actually pay (just ask GE). For that, we need an estimate of effective marginal tax rates. As it turns out, many (most?) researchers who study taxes in the U.S. do attempt to get at this. Barro and Redlick’s piece is one example. It employs a tax model which accounts for the “complexity of the federal individual income tax due to the alternative minimum tax, the earned-income tax credit (EITC), phase-outs of exemptions and deductions, and so on.” Using this measure, Barro and Redlick find taxes do have “significantly negative effects on GDP.”

Third, the piece makes no attempt to account for reverse-causality (what economists call endogeneity).

Put simply, tax rates do not change randomly. If they did, that’d be great for researchers because randomization is the gold standard of the scientific method. But because policy makers are not so keen to let economists experiment with the national economy, tax rates don’t change randomly. Instead, governments tend to change rates in response to changing economic conditions; they cut taxes when the economy is weak and they raise taxes when the economy is strong. This makes disentangling cause and effect quite difficult.

Imagine we studied new drug treatments this way. Instead of large scale controlled experiments with randomized treatments and placebos, what if we only had one patient, and we only gave her a treatment when her condition worsened? If, after the treatment, her condition deteriorated further, would we conclude that the drug did her in? A simple statistical test would say so: drug applied, condition worsened. But such a test would ignore the fact that she only got the drug because she was sick to begin with! The point is that it’d be irresponsible to conclude anything from such a small sample and without trying to control for reverse-causality.

That’s why economists go to great lengths to mimic the conditions of a controlled, randomized experiment. In the case of tax studies, the best example of this is the study by Christina and David Romer. They painstakingly combed the archives of presidential speeches and government documents to identify tax changes that came about for reasons other than the condition of the economy. They found that these sorts of plausibly exogenous tax changes had quite significant macroeconomic effects. In their words:

Our results indicate that tax changes have very large effects on output. Our baseline specification implies that an exogenous tax increase of one percent of GDP lowers real GDP by almost three percent.

Fourth, I also take issue with the way the report characterizes some of the existing literature. For example, Hungerford writes that:

There is substantial evidence…to suggest that labor supply responses to wages and tax changes are small for both men and women.

This is only true if the question is whether people who already have jobs change their labor supply in response to tax changes. Increasingly, however, the literature has identified another margin that matters: lifetime decisions about schooling, fertility, and work experience. If taxes affect these things, then they still affect labor supply, even if they don’t seem to affect short-term decisions about how much labor to supply. As Michael Keane’s recent piece illustrates, taxes have a very pronounced effect along this margin, especially among women.

The CRS report is interesting. And its results should be added to the body of literature on taxes. But it is hardly reason to throw out decades of other research which suggests taxes do harm growth:

 

“The last thing we can do is go back to the same failed policies that got us into this mess in the first place.”

I’ve heard this a great deal lately. I suspect I’ll hear it even more over the next three months. Whatever could it mean? Presumably, the speaker is worried about the sorts of micro and macro policies that were pursued in the years prior to the Great Recession:

  • Perhaps he thinks it was bad policy for federal spending as a share of GDP to leap from 18.2 percent in 2001 to 25.2 percent in 2009 (this was the largest such increase in ANY 8 year period since WWII).
  • Or perhaps he thinks it was bad that net federal debt went from 32.5 percent of GDP in 2001 to 54.1 percent of GDP in 2009 (a post WWII high).
  • Or maybe the speaker thinks it was ill advised for the Bush Administration to be far more aggressive than its predecessors in pursuing discretionary, Keynesian-style countercycle fiscal policy. There were no fewer than four such measures during the Bush years: cash rebates in 2001, investment incentives known as “bonus depreciation” in early 2002, tax rebates in 2003, and of course, the 2008 stimulus bill which included more rebates.
  • Perhaps the speaker thinks it was a bad idea for the Bush Administration to impose 30 percent tariffs on imported steel.
  • Or maybe he thinks it was bad for the Bush Administration to introduce (an unfunded) Medicare prescription drug benefit, the first major entitlement program since the Great Society.
  • Perhaps he thinks it was bad for the Bush Administration to reintroduce industrial policy by signing the Energy Policy Act of 2005, creating the Department of Energy loan program that ramped-up the government’s adventures in venture capitalism.
  • Perhaps the speaker thinks that in the years leading up to the crisis, monetary policy became unhinged from a restrained, rules-based approach?
  • Or perhaps the speaker thinks that the government sponsored enterprises, Fannie Mae and Freddie Mac, systematically encouraged over-leveraging in the housing industry?
  • Or maybe that capital requirements encouraged investors to load up on mortgage-backed securities.
  • Or maybe he thinks that, once the crisis hit, the Bush Administration shouldn’t have undertaken the most comprehensive and far-reaching bailout of private industry in U.S. history, one that resulted in the federal government buying stake in or bailing out hundreds of financial firms.
  • It must be that the speaker was worried that in aggregate these policies had seriously undermined the economic freedom of the U.S., as evidenced by the precipitous fall in measured economic freedom from 2001 to 2009:

If this is what the speaker was getting at, then I couldn’t agree more! Hopefully, he’s proposing ideas to reverse course: spending reductions to bring spending in line with taxation, entitlement reform to put the nation’s budget on a sustainable course, tax reform to close loopholes and reduce rates such as the corporate tax rate, financial reforms to finally end too big to fail, regulatory reforms to reduce distortions in the marketplace, health care reforms so that market forces can actually operate in that industry, and other economic reforms to restore a level playing field in American business.

….Or, maybe the speaker is just focusing on one policy that marginally moved the nation in a market direction, the temporary reduction of all personal income tax rates, including the top marginal rate from 39.6 percent to (gasp!) 35 percent. And maybe the speaker is hoping that no one will notice that on just about every other policy dimension, the previous administration was anything but laissez faire.

Fewer Government-Granted Privileges Means More Economic Growth

When governments dispense privileges to particular firms, businessmen and women learn to play politics. They lobby, campaign, and engage in other political activity in order to obtain and maintain privileges. Economists call this rent-seeking. Because these activities are of little or no social value, rent-seeking is socially wasteful. It is estimated that in any given year, somewhere between $1 and $3.5 trillion in national output is wasted in rent-seeking.

Large though these costs are, they actually understate the problem with government-granted privilege. That’s because privileges do not simply waste resources at a particular point in time, they also slow the growth of an economy over time. And changes in growth rates add up over time.

Think of a healthy economy in which firms compete on a level playing field. In such an economy, entrepreneurs busy themselves creating new products and services, new production techniques, and new ways of creating value for customers.

But now consider a sick economy, one that has succumbed to the pathology of privilege. In this economy, entrepreneurs busy themselves in what economist William Baumol has called “unproductive entrepreneurship.” Instead of devising new ways to create value for customers, they devise new ways to obtain government-granted privileges: new legal gambits to hobble their competitors, new regulations that will help them secure market share, new ways to ingratiate themselves to politicians handing out favors.

Two decades ago, economists Kevin Murphy, Andrei Shleifer, and Robert Vishny studied this phenomenon using data from dozens of countries. As a proxy for productive entrepreneurship, they examined the share of students in each country concentrating in engineering. And as a proxy for unproductive entrepreneurship, they examined the share of students concentrating in law. After controlling for other factors, they found that a 10 percentage point increase in the share of students concentrating in law was associated with 0.78 percentage point slower annual growth in per capita GDP. Economic growth was slower in countries where there seemed to be more rent-seeking.

In my chart this week I put their finding in context. If, since 1980, U.S. per capita GDP had grown 0.78 percentage points faster than it actually did, then 2011 per capita production would have been $54,000 rather than $43,000. Since compensation is highly correlated with productivity, this means that Americans could be making thousands of dollars more per year were it not for rent seeking.

The Murphy, Shleifer, and Vishny paper is now quite famous, taught in most public choice classes. Sometimes people refer to it and the large literature it spawned as the “are lawyers good for growth?” literature. I think this unfairly maligns lawyers. As I write in the Pathology:

Up to a certain point, lawyers are theoretically good for growth; they help delineate and define property rights and they help maintain the rule of law. But beyond some minimum point, more lawyers may lead to more rent-seeking. Even if lawyers themselves are not the cause of rent seeking, they may be an indication of it. In the same way that a large number of police per capita may be an indication of a city’s inherent violence, a large number of lawyers per capita may be an indication of a nation’s tendency to rent-seek.

 

Net Worth is Down and that May Explain Why Stimulus Wasn’t Particularly Effective

This week saw the release of the Federal Reserve’s Survey of Consumer Finances. The news isn’t good. Median net worth fell 38.8 percent from 2007 to 2010. Predictably, the unhealthy diagnosis has occasioned a healthy dose of political posturing. For its part, the White House was quick to note that “the entire decline in household wealth took place before President Obama came into office” and that total wealth “has risen every year since he came into office.”

E21, in turn, pointed out that it was a little odd for the White House to emphasize the aggregate numbers rather than the median:

The claims made by the White House are disingenuous (at best) because they ignore the median U.S. household and focus instead on the increase in overall wealth, which has largely come from gains in the stock market. The White House is essentially saying that we shouldn’t worry about the plight of the typical family because Warren Buffett’s stock holdings have gone up in value by tens of billions of dollars since March 2009. The focus on aggregate household net worth is extremely comical when compared to previous statements made by the President and others in his Administration about the country’s lamentable concentration of wealth and income in the hands of a “fortunate few.” Someone should ask President Obama if this means we needn’t worry about income disparities anymore because total household income is up nearly 20% on an inflation-adjusted basis over the past 10 years?

Framing aside, there is an important policy implication of such a large fall in net worth. Richard Clarida of Columbia University explained this point way back in March of 2009:

There is a second reason while the bang of the fiscal package will likely lag behind the bucks. Even if the global financial system soon restores some semblance of order and function, the collapse in global equity and housing market values has so impaired household wealth that private consumption (which represents 60% to 70% of GDP in G7 countries) is likely to lag – not lead – economic growth for some time, as households rebuild their balance sheets the old-fashioned way – by boosting their saving rates.

In our working paper last fall, Veronique and I explained this point further:

The current recession has resulted in an unprecedented collapse in net wealth. In other words, it is a deep “balance sheet”‖recession. But with personal wealth diminished and private credit impaired, some economists believe that stimulus is likely to be less effective than it would be in a different type of recession. This is because consumers are likely to use their stimulus money to rebuild their nest eggs, i.e., to pay off debts and save, not to buy new products as Keynesian theoreticians want them to.

The White House is interested in escaping blame for the collapse in median net wealth. That’s understandable; that’s what White Houses do. It is harder to escape from the policy implications of a balance sheet recession.

Trickle-Down Economics: Does Anyone Actually Believe In It?

I have heard a lot about “trickle-down economics” lately. The President has taken to using it in speeches. And pundits have increasingly invoked the idea. Back in February, I was asked about the term when I testified before a House committee and had to confess that I have never met an economist who has advocated anything close to “trickle down” economics.

The words “trickle down” imply that if you redistribute money to the wealthy, they will spend it (say, by hiring workers or by buying products) and it will somehow find its way into the hands of the poor. To the extent that any economists endorse such a notion, they are emphatically not free market economists.

This is not to say that there is no case for low taxation. There is a strong theoretical case for low taxation (so long as it is accompanied by low spending!). And it is backed by good empirical evidence.

But the case for low taxation is not—as the phrase “trickle down” implies—based on the idea that we should give money to a wealthy person so she can spend it. Instead, it is based on the idea that if we take money away from either a rich or a poor person when they engage in some activity, they will tend to engage in less of that activity.

If we tax work, people will tend to work less. If we tax consumption, people will tend to consume less. If we tax saving, people will tend to save less. The idea is rooted in basic microeconomics. Taxing labor, for example, makes leisure less expensive. So people choose more leisure. This is called the substitution effect.*

All this theory is well and good, but is there any evidence to back it up? Yes. Michael Keane offers a nice survey of labor supply and taxation studies in the December issue of the Journal of Economic Literature. He identifies at least two major patterns in the evidence:

  1. Women are more responsive to taxes than men (most economists think men are relatively unresponsive to labor taxes, especially in the short run).
  2. People—particularly women—are more responsive to taxes when they consider whether to work than they are when they consider how much to work. In the average study, the long-run elasticity for female labor is 3.6. This means that if a tax hike reduces after tax wages by 10 percent, female labor force participation tends to fall by about 36 percent. As Keane puts it, this is a “very large” effect.

In my view, both of these patterns make sense. Historically, women have been more likely than men to work at home and so higher taxes seem more relevant for them than for men (as more women work outside the home and as more men stay home, I’d expect this gender difference to narrow). It also makes sense that taxes have a larger effect on the decision to work at all than on the decision to work a certain number of hours. Most of us can’t tell our employers that we want to work 30 hours a week rather than 40. But we can tell our employer that we don’t want to work at all. And evidently a lot of people—particularly women—do tell their employers this when taxes are high.

So far, I’ve only discussed how taxes affect labor supply. But they may also depress consumption and investment. What is the overall effect on the economy?

One of the best recent studies is that by President Obama’s former economic advisor, Christina Romer and her husband, macroeconomist David Romer. The Romers set out to understand the effect of taxation on an economy. But they knew that there was a major problem: taxes are not randomly increased or decreased. Instead, politicians tend to keep taxes low when the economy is in recession and raise them when the economy is booming. This makes it very difficult to disentangle cause and effect. So the Romers painstakingly analyzed decades of presidential speeches and government documents to identify exogenous tax changes (i.e., changes that were undertaken for reasons other than the condition of the economy). They then compared the performance of the economy following such exogenous changes. They concluded that exogenous tax increases are “highly contractionary.” As they put it in the conclusion:

Our results indicate that tax changes have very large effects on output. Our baseline specification implies that an exogenous tax increase of one percent of GDP lowers real GDP by almost three percent.

Now here is the irony: As I note above, few if any economists advocate redistributing resources to the wealthy in the hopes that they will trickle down to the rest of us. But over the objection of economists—particularly free market economists—policy makers do this all the time. Think of President Bush’s TARP. Or President Obama’s decision to extend TARP to the auto companies. Or his excursions into venture capital. In each case, money was actually transferred from taxpayers to the (mostly) wealthy managers and shareholders of private firms.

If words mean anything, each of these policies—and not, say, an across the board reduction in marginal income tax rates—should be labeled “trickle-down economics.” But in politics, words often mean nothing.

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*  You might be thinking that the income effect offsets this: By taxing income, you not only make leisure less expensive, you also make people feel poorer. In response to feeling poorer, they may feel that they need to work harder to make up for the loss income. This works for an individual, but as economists James Gwartney and Richard Stroup long ago explained in the American Economic Review, it does not work for society as a whole. This is because governments do something with the money they collect in taxes. And the income effect of spending government revenue makes people work less. So at the economy-wide level, the income effect from spending offsets the income effect from taxing. All you have left is the substitution effect and that unambiguously reduces labor supply.

 

Government Spending Has Shrunk…When You Ignore 44 Percent of Government Spending

Floyd Norris has made an astounding discovery. When you don’t count 44 percent of government spending, it appears that government spending has shrunk in recent years.

Writing in the New York Times, Mr. Norris asserts:

Spending by the federal government, adjusted for inflation, has risen at a slow rate under President Obama. But that increase has been more than offset by a fall in spending by state and local governments, which have been squeezed by weak tax receipts.

In the first quarter of this year, the real gross domestic product for the government — including state and local governments as well as federal — was 2 percent lower than it was three years earlier, when Barack Obama took office in early 2009.

The operative phrase here is “real gross domestic product for the government.” What Mr. Norris neglects to note is that real gross domestic product for the government is only about half of what governments actually spend. And when you look at total spending, it is actually up over the last three years, not down.

Let’s begin with government gross domestic product (GDP). This is the portion of government spending which is counted by the Bureau of Economic Analysis (BEA) when it tabulates national GDP. It consists of government consumption expenditures and gross investments. You can think of it as the tab for all items that the government buys on the open market: salaries of public employees, purchases of weapons for the military, investment in infrastructure, etc.

Among other things, however, government GDP does not include transfer payments such as Medicaid, Medicare, Social Security, Unemployment Insurance, Earned Income Tax Credits, Supplemental Nutritional Assistance, Housing Assistance, Supplemental Security Income, Pell Grants, Temporary Assistance to Needy Families, WIC, LIHEAP…you get the point.

It turns out that real spending on everything other than government consumption and gross investment is up about 19 percent since Obama took office. And this is more than enough to offset what’s going on with consumption and gross investment. Thus, total spending is up 7.7 percent in real terms.

You can see this in this chart*:

There’s nothing wrong with using government GDP figures. They are used all the time to estimate things like the government purchases multiplier. And they are also helpful in understanding whether government is growing faster or slower than the private sector. But Mr. Norris does his readers a disservice to casually conflate government GDP and total government spending. How many people reading his column would know that he left out 44 percent of what government spends? Or that when you include that 44 percent, total spending actually rose over the last three years?

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*Technical note: when the BEA calculates real government GDP, it uses chained 2005 dollars. It does not calculate real total spending, offering only the nominal figures in Table 3.1. I have therefore used 2005 inflation conversion factors found here to convert total spending from Table 3.1 and government GDP from Table 1.1.5 into real figures. When you do it this way, real government GDP actually rose slightly (0.41 percent) under Obama. In other words, the 2 percent drop in real government GDP looks like a slight increase if you use a different inflation conversion method.

More On UK “Austerity”

There have been a lot of good things written about UK austerity since my post last week. Here is a quick round-up:


Yesterday, Veronique noted that the meanings of words often get jumbled when politicians and pundits talk about austerity. Tax increases, spending cuts, and structural reforms all fall under the label “austerity.” But only some of these measures actually work. And only some of them are actually being tried. Maybe it is time for some new words?

On Sunday, Anthony Sanders posted a number of informative charts showing recent trends in the UK economy, including: repeated dips into negative GDP growth over the past couple of years, massive sovereign debt, rising unemployment rates, and an over-built financial sector. On the plus side, the UK is still paying comparatively low interest rates on its debt and its housing market has not fallen as far the US’s.

Lastly, Anthony Evans sends me this Allister Heath piece which sheds some light on what has actually happened in the UK:

Current spending rose in cash terms from £604.8bn to £617bn in 2011-12. The OECD says UK public spending was 49.8 per cent of GDP in 2011. Public sector net borrowing remains at a catastrophic 8.3 per cent of GDP. All of this remains utterly unsustainable – yet the public have wrongly been told that the UK “is tackling its debt”. Osborne has been a disappointing chancellor – but not for the reasons cited by the left.

Photo by DoctorWho/flickr

Maybe We Need a Super Democrat?

The Super Committee has failed. What now?

As I have said before, it is very difficult to look at the long-run fiscal projections and conclude that the impending debt crisis is anything but a major spending problem. According to the CBO, when my daughter graduates from college, federal revenue will be right at its historical average of 18.4 percent of GDP. At the same time, federal spending will consume more than 35 percent of GDP—more than 15 percentage points above the 20 percent average that has prevailed my entire life.

So the long-run explosion in spending—which is driven almost entirely by entitlements and interest payments—must be arrested. How?

In my view, it takes a Democrat.

Only Nixon could go to China. Only Carter could deregulate. Only Reagan could sign the first arms reduction treaties. Only Clinton could sign welfare reform. Lasting and meaningful reforms often require politicians to cross the ideological divide. Given the partisan divide right now, it is very difficult for me to imagine that any Republican president would be successful in reducing entitlement spending. But a Democrat could do it.

And one piece of evidence for this is a 2004 paper in the Journal of Public Economics by the economist José Tavares. He writes:

In a panel of large fiscal adjustments in OECD countries during the last 40 years, we find evidence that left-wing and right-wing cabinets are partisan: the left tends to reduce the deficit by raising tax revenues while the right relies mostly on spending cuts. Our testable hypothesis is that cabinets can signal commitment by undertaking fiscal adjustments in ways that are not favored by their constituencies. In other words, the left gains credibility when it cuts spending while the right becomes more credible when it increases tax revenues. Probit estimates of the determinants of persistence in fiscal adjustments confirm that spending cuts by the left and tax increases by the right are associated with persistent adjustments.

So if it is spending cuts that we need, then these cuts are likely to be more sustainable (“persistent”) if they are executed by a left-leaning government.

Unfortunately, I don’t see much evidence that President Obama is keen to follow this course. His best shot at it came when his own deficit-reduction panel (the Bowles-Simpson Commission) endorsed a mostly-spending-cuts approach. He ignored them.

What Makes for a Good Balanced Budget Amendment?

Today, the U.S. House will begin debating a balanced budget amendment. This morning, the editorial board of the Wall Street Journal chastised Speaker Boehner for offering a “vanilla amendment that merely calls for a balanced budget, with no spending limitations or supermajority tax requirements.” Their worry is that, “Under Mr. Boehner’s amendment, spending could rise to 25% or 30% or more of GDP, so long as the budget is balanced.”

This is a misplaced worry. Right now, Congress is able to vote benefits for current voters while putting about 45 percent of the tab on non-voters (our posterity). It doesn’t take a complicated economic model to see that this arrangement systematically biases spending upward. And any amendment that requires current voters to pay for current spending will diminish that bias. As I told the House Judiciary Committee last month, in states where balanced budget requirements are stricter, spending is lower.

Moreover, the editors’ preferred amendment—one that includes some sort of spending limitation—is actually unlikely to achieve its goal. Last year, I examined the operation of various spending limits, using data from 49 states covering 30 years (I wrote about my research in an OpEd in the Journal). I found that those tax and expenditure limits “that limit budgets to some share of income had no statistically significant impact on either state-only spending or on combined state and local spending.” It may be that when states bind themselves with such limits, they make sure that the limit is set so high that it fails to actually constrain.

As far as supermajority requirements for tax increases are concerned, research does suggest that these can limit spending. I guess it is a political call as to whether such a requirement should be tied to a balanced budget amendment. In my view, a balanced budget amendment requires strong bipartisan support for it to be effective. But I don’t do politics.

I do agree with the editors in one regard. There is no need to settle for a “vanilla amendment.” There are many different varieties of balanced budget amendments and some of these have much stronger features than others. In my view, the most-effective amendments are those that:

  1. Require balance over some period longer than a year. This effectively disarms the strongest argument against a balanced budget amendment: namely, that it would force belt-tightening in the middle of a recession. In contrast, if budgets need to balance over a longer time period, then Congress is free to run deficits in particular years as long as they are countered by surpluses in others.
  2. Allow Congress some time to come into compliance. You don’t have to be a Keynesian to worry that a 45 percent reduction in the deficit overnight might be a shock to the system.
  3. Minimize the gamesmanship associated with revenue estimation: Across the country, states with balanced budget requirements have to estimate revenue throughout the year (I’m a member of Virginia’s Joint Advisory Board of Economists and our responsibility is to pass judgment on the validity of these estimates). But this invites all sorts of questions: what model to use for the economy, should revenue be scored dynamically or statically, etc. One way to sidestep all of these questions is to make the requirement retrospective: require that spending this year not exceed revenue from years past.

There are amendments that have these characteristics. For example, H.J. Res. 81 (which now has 54 cosponsors), has all three.

In other news, the amazing Cord Blomquist has managed to get my testimony on the YouTubes: