Thursday, May 20, 2010

It's Agreed: Not All Deficits Are Equal

Budget deficits appear to be like the weather -- everyone talks about them, but no one does anything about them. The political will just isn't there.

At least one reason political will is lacking is that although everyone deplores the immense deficits we are running, no one deplores all deficits equally. Conservatives (at least movement conservatives) and liberals (at least economically literate liberals) see different kinds of deficits as qualitatively different.

Conservatives divide deficits into two types -- deficits resulting from tax cuts and deficits resulting from spending increases. While all deficits resulting from spending increases are deplored, (movement) conservatives don't see deficits resulting from tax cuts as a problem for two reasons:
(1) Starve the beast. Tax cuts choke off government revenue, precipitate a future budget crisis, and ultimately force spending cuts and reduction in total government.
(2) Supply side. Tax cuts spur so much economic growth that they ultimately increase revenue and avoid the need for spending cuts. Needless to say, these two theories directly contradict each other.

It should go without saying that the two conservative concepts of why deficits caused by tax cuts are acceptable are mututally contradictory, and that holding both of them in your head at once calls for a certain exercise in doublethink. As such, it's probably too much to ask for any one conservative to refute both of them. But recently two dissident conservatives have written two fine separate articles criticizing the two alternate theories.

Bruce Bartlett, writing for Forbes, takes on starve the beast. Although he briefly acknowledges the supply side view, he does not appear to take it very seriously. Rather, he hearkens back to the good old days when conservatives opposed any tax cuts not paid for by spending cuts and sees the embrace of tax cuts now, spending later as a mixture of political opportunism and hopes of starving the beast. Reagan justified his tax cuts in such terms and the junior Bush urged them as "a fiscal straightjacket for Congress." But so far attempts to starve the beast by running up deficits have signally failed.* Bartlett argues that deficits were only effective in forcing spending cuts in the past because people feared that the only alternative was a tax increase. But once conservatives adopted the dogma that taxes could never be increased, no matter what, all incentive for fiscal discipline ended. He goes so far as to suggest that tax cuts, by reducing the bite from spending, actually encourage spending increases.

Meanwhile, Kevin Williamson of the National Review wearily explains why tax cuts do not increase revenue. Tax cuts, by spurring growth, can partially pay for themselves. The Reagan tax cuts recooped about 30% of their revenue. This is a far cry from the supply side claim today that all tax cuts reclaim over 100%. Proponents grossly exagerate the value of tax cuts by assuming that any growth that follows a tax cut is caused by the tax cut. And, like Bartlett, Williamson acknowledges the basic problem: everyone hates government spending in the abstract, but no one wants to cut any particular program.

Both men do a fine job of refuting the respective theories of why deficits causes by tax cuts don't count, yet each leaves a little anomaly. Bartlett is left with the oddity that spending actually increases when taxes go down. And Williamson defends supply side economics as partly true -- tax cuts partially recover lost revenue. And here I would suggest that liberals who follow Keynesian economics would fully anticipate both outcomes.

Like movement conservatism, liberal (Keynesian) economic theory also distinguishes between different types of deficits. It divides budget deficits into "cyclical" and "structural." A cyclical deficit is the result of shortfalls in revenue and increases in payouts as a result of an economic downturn. Cyclical deficits will resolve themselves once the economy improves. Any attempt to cut them is undesirable, requiring either increasing taxes when the economy can least afford them or cutting services when the economy most needs them. Structural deficits, by contrast, are gaps between revenue and expenditures that remain even in good times. These are a problem and do need to be reduced, although the middle of a severe recession is the wrong time to address them.

This chart confirms Bartlett, that tax receipts and government expenditure rise and fall in almost perfect opposition to each other:
But the simplest explanation is a cyclical one. Revenues fall and payouts rise during economic downturns. Revenues raise and payouts fall in good times. As for Williamson, he failes to note that Reagan's tax cuts were made during a severe recession.** Keynesian theory predicts that during a recession, the economy is operating below capacity and deficits provide stimulus. It would, indeed, predict that tax cuts would partially pay for themselves during an economic downturn. It does not logically follow that they would be equally effective during good times. In fact Reagan's supply side economics were really just Keynes by another name.

Next post: Keynesian approach to the current deficits.
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*At least at the federal level. States, which have balanced budget requirements in their constitutions, can be forced by lost revenue to cut spending, or at least to shift it off onto municipal governments.

**Not quite as bad as the one we're having now, but until the current downturn it was often referred to as the Great Recession.

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