Over the summer, I debated Jason Furman—Pres. Obama’s former Chair of the Counsel of Economic Advisors—at Harvard over the magnitude of changes needed to bring America’s fiscal policy back into equilibrium. I noted that ongoing federal spending has risen from 19% of GDP prior to the financial crisis to 21% afterwards, and to nearly 24% since the pandemic, while taxes fluctuated around 17% of GDP—their 50-year average. This occurred in the face of publicly held federal debt rising from 35% to 100% of GDP. I argue that both the costs and benefits of holding debt below 100% of GDP are larger than they appear to be given 15 years of near-zero real interest rates—from an abundance of offshore savings—and CBO’s failure to assume periodic budget-busting recessions; that spending increases slow growth, not the tax increases needed to pay for them; that tax cuts in the face of spending increases are only temporary; and that, unlike Europe, which lacks investment-worthy ideas, tax increases will have long-term consequences on the expected value of America’s innovative risk-taking. I conclude that we should reduce spending to at least 2019 per capita levels and raise taxes on consumption to pay down debt during economic expansions, although this is unlikely to happen without a precipitating crisis.
Ed’s Opening Statement
Does anyone in this room spend a substantial share of their income buying lottery tickets? I’m not surprised.
In part, I’m here today because of Jason’s talk last year, in which he argued that liberals get the sign wrong on the effect of their policies, while conservatives get the order of magnitude wrong. After the talk, I asked Harvey, “Isn’t heading in the right direction but not getting as far as you expected better than heading in the wrong direction?” …and he asked me to debate Jason.
I thought the first graph below puts our debate into perspective. Over the last 50 years, America has created large, new, publicly held companies worth 70-times more than their EU counterparts despite having similarly sized and educated populations.
It’s obvious why these companies continue to arise in America, but not elsewhere. Working at companies, like Apple—which is worth more than the 30 largest Germany companies combined—exposes workers to valuable ideas that increase the expected payoff for entrepreneurial risk-taking. With much higher expected returns, talented Americans have taken much more risk.
Even if America’s success stems from happenstance—because we enjoy economies of scale, speak English, or spent more on defense, for example—our good fortune nevertheless increases expected returns that spur increased risk-taking, and this has had a large compounding effect on America’s success, that we don’t find in other high-wage economies.
Perhaps it is just a matter of time before innovation occurs. But occurring in America first, and not elsewhere, has proven enormously valuable for all Americans.
The Growth of Risk-Taking
The growth successful risk-taking spurred has not only created tens of millions of jobs for immigrants and offshore workers—twice the employment growth of Europe—it also raised wages relative to Europe. According to the OECD, the disposable income of the median American household—properly adjusting for healthcare and other government services—was 20% richer than Germany 25 years ago and is now 25% richer despite Americans having lower academic test scores.
A third of Americans score at the lowest levels of academic tests. America has about twice as many low-scorers per capita as Northern Europe and half as many high-scorers. This gives our low-scorers 75% less high-scoring supervision… and still they earn more. Comparable-scoring Americans earn about 50% more.
And Western Europeans would be even poorer if they weren’t freeriding on America’s enormous contribution of innovation, defense spending, and healthcare profits.
The Role of Tax Policy
Regardless of the reasons for America’s higher expected returns, tax rates bear directly on returns. A 50% tax rate cuts America’s expected returns in half. Unless sophisticated risk-takers are irrational, unlike the people in this room, halving the expected return will more than halve the amount of risk-taking.
The notion that tax elasticities can be measured by a small change in the hours worked by talented people who are already working long hours—as Jason claimed the last time he was here—and not by the changes in the risks they are willing to take, and the multiplicative value their success creates for future innovators, misses the forest for the trees. It’s no wonder that Jason thinks conservatives overestimate tax elasticities, even though the differential results indicate that long-term elasticities are grossly underestimated by these measures.
Global Comparisons and the Innovation Deficit
Given the utter failure of Europe and Japan to produce innovation, we should not take returns high enough to spur risk-taking for granted, especially when venture capital returns have been mediocre, and entrepreneurs face enormous unsystematic risks that diversified venture capital investors can avoid.
It’s true that people, like Bill Gates and Steve Jobs, took risks without expecting to earn enormous fortunes. But it’s also true that the outsized tail of the distribution is essential for producing what are, at best, mediocre venture capital returns… and that, unlike other high-wage economies, armies of American risk-takers followed in their wake hoping to duplicate their windfalls. This allowed America’s success to bubble up from a much larger but overlooked pool of failure.
William Nordhaus, a Nobel-prize-winning economist, estimates that innovators capture only a fraction of the value they create. So, unlike Europe, that doesn’t have many worthy ideas, it’s extremely expensive for America not to maximize the social welfare that innovation produces.
Lottery Ticket Economics
A $3 dollar lottery ticket has a 1 in 300 million chance of hitting the jackpot. So, it makes no sense to buy a ticket until the jackpot reaches $900 million.
Because the jackpot pays out over your lifetime, the expected value doesn’t reach a positive return until it reaches $1.5 billion. A tax structure that properly values risk-taking would only tax the gains greater than $1.5 billion, since the expected value of buying a ticket is uneconomical until the payoffs exceed that amount.
Taxing the first dollar (instead of the 1.5 billionth dollar) makes it uneconomical to buy a lottery ticket until the payoff exceeds $3 billion. It’s self-defeating to raise the bar that high.
The Consequences of Underestimating Tax Elasticities
Is it any surprise that underestimating tax elasticities—by mistakenly measuring only changes in hours worked—has led to aggressive social spending increases in the face of unprecedented increases in debt relative to GDP following the pandemic and financial crisis; retiring baby boomers on the cusp of eating us alive; a growing Chinese military threat and the cost of decoupling our economies; the looming costs of mitigating global warming; and slowing population growth to pay for it all?
Democrats drove ongoing federal spending from 19% of GDP before the financial crisis to nearly 24% today most of which could have been avoided.
In the face of these increases, Republicans foolishly swapped tax cuts—that temporarily held taxes at their historic levels—for permanent spending increases. If you increase consumption, eventually someone has to pay for it, whether with higher taxes, less investment, inflation, greater interest payments, or lesser government services.
Propagandists often blame these things for slower growth. But let’s not kid ourselves, ultimately, increased spending slows growth, not the different ways to pay for it.
Fiscal Reality Check
The cancerous political strategy of demanding “more spending, no matter how much more,” has driven real ongoing per capita spending up 55% since the financial crisis and 25% since the pandemic—more than double the growth in real GDP per capita. Federal government spending is now consuming half of the increase in GDP since 2019.
Debt has risen from 35% of GDP prior to the financial crisis to 100%, with no end in sight, even using CBO’s farfetched forecast, which recklessly assumes no budget-busting recessions.
To put this in perspective… With spending nearing 24% of GDP and taxes at 17%, we need a 35% across-the-board tax increase to balance the budget.
And balancing the budget barely brings us back into equilibrium. With 4% nominal growth, if we stave off a budget-busting recession for 10 years, which seems unlikely, a recession would leave us right back in the precarious fiscal position we are currently in.
A 20% tax increase combined with a 25% across-the-board per capita spending cut that excludes Social Security and Medicare and merely returns the rest of spending to pre-pandemic levels, would produce the same result.
Both are extremely unlikely. And the shock would likely send us into recession. But whether we inflict the costs all at once or boil the frogs slowly, the costs are still enormous.
These changes may sound draconian, but you probably underestimate the amount of spending. If we gave the $1.6 trillion we are currently spending on Medicaid and welfare to the poorest 20% of households, it would total nearly $90,000 a year—more than the $80,000 median household income. And that doesn’t include the money we spend on education or the $2.3 trillion on people over 65.
That may seem hard to believe, and some of that spending is buying middle class votes, but a recent study by the Atlanta Fed (second graph below) finds that a single mother with a 3-year-old child earning $11,000 of income in Washington DC receives $68,000 of government benefits. This gives her substantially more income than the median wage of $52,000 at the time of the study).
This level of spending isn’t fulfilling our moral obligations to the poor; it’s vote-buying graft, which is democracy’s biggest weakness.
If we returned spending to 2019 per capita levels, this would cut about $8,000 from her benefits, which does not look unreasonable.
The Illusion of Free Money
Why aren’t voters up in arms? First of all, they don’t understand the magnitude of the spending. Nor have they felt any consequences because a flood of offshore savings, lent to us at near-zero real interest rates, allowed policymakers to raise spending and cut taxes without immediate political or financial consequences. But only for as long as interest rates remained near zero. And interest rates have risen as the Biden Administration gorged itself on spending, devouring savings at the astonishing rate of 6½% of GDP.
These foolish fiscal policies have addicted voters to government spending without the pain of taxation and recklessly made America dependent on offshore savings funded by trade deficits.
Policymakers did this to us knowing that voters elect politicians, not to solve problems, but to stick someone else with their bill, and would therefore blame, not the reckless policies that created this mess, but whoever earnestly tries to solve the problem by cutting spending and raising taxes.
Without enough votes to cut spending or raise taxes enough to matter, the problem is nearly impossible to solve without a crisis. Policymakers knew this and did it anyway.