Closing the Fiscal Gap

by Josh Barro

My RealClearMarkets column this week responds to Peter Orszag’s debut NYT column on the fiscal gap. I agree with Orszag’s view that the gap-closing should be delayed and then done in one shot (though I’d wait three years rather than two) and I lay out broadly what I think needs to be done on the tax and spending side to get us to a sustainable budget deficit around 2% of GDP.

I was particularly struck by Orszag’s claim in his piece that a sustainable budget deficit is 3% of GDP or less, and his choice to sketch out budget measures that would get us to a deficit of almost exactly 3% of GDP. It’s OK to have a budget gap that large in some years. But a budget deficit of 3% of GDP on average would (assuming CBO’s GDP growth projections at 4% are right) lead to debt/GDP stabilizing around 75%. In my view, that’s too high a target; certainly, it would be a departure from the last 65 years of fiscal policy, where we’ve only moved north of 50% for a few years during and after World War II (until now).

So, I think we need to target a lower figure and therefore identify more gap-closing measures than Orszag does. My thought is that our long-range fiscal plan should aim to get the typical-year budget deficit below 2% of GDP. But I’d be interested to hear other folks thoughts on this: what’s a “sustainable” budget gap, and how much should we aim to reduce our debt/GDP ratio once we get it to stop exploding?

I would also, incidentally, be very interested to see a budget plan that (1) keeps the full Bush tax cuts and (2) gets the deficit down to a sustainable level (3) in a reasonable time frame so that (4) debt/GDP does not peak at an alarming level. I think that’s quite a tall order, which is why I haven’t seen such a plan. (You would need to cut federal spending by about 3.5% of GDP in 2020, or 15% of the total.)

The Ryan Roadmap is the closest, but it sets a revenue target of 19% of GDP, so it effectively involves a modest tax increase (assuming you revise the Ryan revenue plan to ensure that it meets its target); and even if it goes according to plan, it still takes 30 years to achieve sustainability and reaches a 100% debt/GDP ratio along the way, which are in my view respectively too long and too high. And it includes spending-side provisions of which Republican leadership is deathly afraid; yet a plan that made the budget sustainable in a shorter time-frame without tax increases would need to cut spending faster.

In response to Ramesh’s post (and similar thoughts that Reihan has raised offline), I want to clarify my comments about marginal rates generally and specifically my comment that the Clinton-era top rate of 39.6% is “acceptable.” I use this term advisedly: I believe that such a rate can be consistent with strong economic growth, as it was in the 1990s. It is not my most preferred policy. Ramesh is right that we can, and should, expand the tax base by (for example) ending deductions for mortgage interest and health insurance, and that this will allow lower marginal rates and lower dead weight-losses. This would be much better than returning to a top rate around 40%.

I do think, as a political matter, that combining fiscal adjustment and tax reform is probably not the best plan. Tax reforms designed to make the tax code more efficient tend to involve measures that are unpopular at first: taxing categories of income that people are used to receiving tax-free or the introduction of consumption taxes. This makes the public suspicious.

You saw this in Maine this year, where voters repealed a revenue-neutral reform that cut and broadened the income tax while expanding the sales tax to a number of categories. The Maine reform was imperfect, but it was a clear improvement on the status quo from an efficiency perspective, yet the public got very hung up on the idea of having to pay sales tax to go bowling. The mortgage deduction won’t go away without a lot of howling either.

So, I think tax reform becomes even harder to sell if you combine it with a fiscal adjustment on either side of the ledger: you have to simultaneously sell people the idea that they will pay strange new taxes and that they will pay more and/or get less. I think there is a good reason that the 1985 Social Security reforms (which started a rise in retirement ages and raised the payroll tax) and the 1986 Tax Reform Act (an essentially revenue-neutral reform that cut rates and expanded the tax base) were handled separately.

So, I think we absolutely need tax reform, but I’d say it’s a question that should be handled separately from fiscal adjustment. In fact, implementing a fiscal adjustment may make tax reform more politically plausible, because people will be more focused on the benefit of reform: cutting marginal tax rates.

Finally, I think Ramesh is right about the interplay between base-broadening and progressivity: a broader income tax base makes it easier to have tax progressivity with fewer bad incentive effects. I need to think on this a little more (particularly, how much running-room it gets you) but this should make the case for tax reform easier.