May 24, 2010


The End of Peter Pan Fiscal Policy: How to think about America’s budget problems. (Duncan Currie , 5/24/10, National Review)

America’s public-debt-to-GDP ratio is already higher than it has been since the 1950s. Writing in National Affairs, economist Donald Marron, who served as acting CBO director and a White House economic adviser under Pres. George W. Bush, says the most immediate objective of U.S. fiscal policy should be to stop that ratio from rising. He stresses that this would not require balancing the federal budget; indeed, it would be possible to run moderate deficits while simultaneously trimming the debt-to-GDP ratio, provided the economy was expanding at a fast enough pace.

Think of it this way: To maintain a constant debt-to-GDP ratio, we would have to maintain an identical deficit-to-growth ratio. For example, writes Marron, if we had a debt-to-GDP ratio of 60 percent and a deficit equal to 3 percent of GDP, then nominal GDP growth (that is, real growth plus inflation) would have to reach 5 percent in order to keep the ratio from increasing. The fact that such a humble aim — holding the debt-to-GDP ratio steady — seems so quixotic in the short run indicates the severity of America’s fiscal plight. Marron, who is now director of the Urban-Brookings Tax Policy Center, believes a practical, attainable medium-term goal should be to reduce the ratio to 60 percent by 2020. But over the long haul, he adds, even 60 percent would be unacceptably steep. From the mid–20th century through the early 2000s — until the Wall Street panic — the average ratio was roughly 40 percent.

Given the magnitude of our budget problems, it is unrealistic to think that tax hikes alone, or spending cuts alone, or economic growth alone, would be sufficient to fix them. Let’s say that real annual GDP growth averaged 3.8 percent over ten years. That hasn’t happened since the 1960s and 1970s, Marron reminds us, and it is very unlikely to happen in the decade ahead — but even with that level of growth, the federal government would still see only modest deficit reduction without serious fiscal reforms.

No, we don’t have a “silver bullet,” but we do have empirical evidence to guide our policy decisions. Marron cites a paper by Harvard economists Alberto Alesina and Silvia Ardagna, who studied OECD data from 1970 to 2007 and concluded that “spending cuts are much more effective than tax increases in stabilizing the debt and avoiding economic downturns.”

Are there any specific countries whose fiscal achievements offer grounds for optimism? In an April 16 New York Times article, George Mason University economist Tyler Cowen pointed to Canada, which was forced to address its persistent debt woes after being rocked by spillover effects from the 1994–95 Mexican peso crisis. Prior to the recent global financial shock, our northern neighbor had balanced its federal budget consistently for more than a decade. According to government projections released in early March, Canada’s deficit-to-GDP ratio will peak at 3.5 percent in the current fiscal year before plunging to 0.1 percent of GDP by 2014–15. The Canadian parliamentary budget officer, an independent federal watchdog, puts the latter figure at 0.6 percent of GDP, which is still comparatively low.

Indeed, at a time of surging debt burdens in the U.S., Europe, and Japan, Canada stands out as a beacon of fiscal stability. It now boasts the lowest ratio of total government net debt to GDP among all G7 countries. Since the mid-1990s, its federal debt has dropped from 68.4 percent of GDP to around 35 percent of GDP. Meanwhile, Canada’s rating in the Index of Economic Freedom (compiled by the Wall Street Journal and the Heritage Foundation) has improved markedly. The 2010 Index ranks Canada ahead of the U.S., owing to its superior scores in the categories of business freedom, trade freedom, fiscal freedom, financial freedom, property rights, and freedom from corruption. Doesn’t the Great White North have a lavish welfare state? Yes, but as a share of GDP, aggregate Canadian government spending is significantly lower today than it was 15 years ago.

Of course, Canada enjoys certain structural advantages. For one thing, the oil-rich country is a net energy exporter; for another, it has a relatively small defense budget, thanks to the U.S. security umbrella. Its fiscal gains were driven partly by a massive commodity windfall. Those gains were diminished somewhat by the global credit bust, but Canada was insulated from the turmoil by its conservative banking system, which weathered the storm quite impressively and did not require a state bailout. As Cowen writes, Canadians tend to have a more benign view of government than do Americans, which arguably made it easier for Ottawa to enact painful spending cuts in the 1990s: “Citizens were told by their government leadership that such cuts were necessary and, to some extent, they trusted the messenger.”

We should also note that Canada introduced a federal value-added tax (VAT) in 1991. However, the VAT effectively replaced a manufacturing sales tax that had been hampering Canadian exports, and it has been slashed from 7 percent to 5 percent by the incumbent center-right government of Prime Minister Stephen Harper, which has also scheduled reductions in corporate-income taxes. Today, Canada’s combined corporate-tax rate (31 percent) and its top personal-income-tax rate at the federal level (29 percent) are both lower than the equivalent rates in the U.S. (39 percent and 35 percent, respectively). On balance, household taxes are more progressive in the U.S. than they are in Canada, according to the OECD.

Posted by Orrin Judd at May 24, 2010 5:59 AM
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