Politics & Policy

Economic Reality Check

Critiquing three popular claims about housing, spending, and taxes.

In the raucous debate over how to boost U.S. economic growth and prevent a fiscal tsunami, it is not difficult to find politicians who subscribe to one or more of the following beliefs: (1) The depressed housing market should be allowed to reach its bottom without further government intervention. (2) Making large cuts to discretionary spending is vital to future American prosperity. (3) Comprehensive tax reform must not, under any circumstances, involve the adoption of a federal value-added tax (VAT).

Three claims: each of them popular among a hefty chunk of the political class, and each of them either misguided or misleading or both.

Start with housing. CoreLogic estimates that more than 22 percent of all U.S. residential mortgages were in negative equity (or “underwater”) as of September, and that another 5 percent were “near negative equity.” This massive debt overhang is severely hampering investment (both residential and nonresidential), business creation (because home equity is a major source of early-stage financing), and labor mobility (domestic migration has plummeted to “the lowest level since the government began tracking it in the 1940s,” according to the New York Times). After examining every U.S. economic recovery since World War II, Cleveland Fed analysts Timothy Bianco and Filippo Occhino determined that “weak household balance sheets have been an important factor behind the slower recoveries, especially the current one.”

Indeed, economists Atif Mian of Berkeley and Amir Sufi of the University of Chicago argue that household debt represents the single biggest obstacle to a stronger recovery. According to their recent survey of economic data from 238 U.S. counties with 100,000 or more residents, those counties that racked up the most household debt (relative to income) between 2002 and 2006 are now experiencing much slower growth in auto sales, residential investment, and employment than those counties that accumulated the least household debt. For example, the high-household-debt counties have seen residential investment fall by anywhere from 40 percent to 60 percent since the recession, whereas the low-household-debt counties “have almost completely avoided a decline in residential investment.”

Thus far, the Obama administration has very little to show for its efforts to stem the foreclosure crisis. As journalist Clive Crook wrote in the Financial Times earlier this year, “The administration’s housing market policies have failed because, through bad design and pitiful execution, they have modified loans mostly by cutting interest rates and extending repayments, not by reducing debt.” That must be the paramount objective — slashing household debt.

But how to do it? American Action Forum economist Ike Brannon has suggested allowing a mortgage cramdown via the bankruptcy process. Economists Glenn Hubbard and Chris Mayer of Columbia Business School (along with Absalon Project CEO Alan Boyce) have outlined a massive refinancing scheme for homeowners with government-guaranteed mortgages, predicting that it could yield up to $70 billion in annual mortgage savings. Writing in the New York Times, Harvard economist Martin Feldstein has touted a mortgage-principal-reduction strategy that would aid most underwater homeowners and purportedly cost less than $350 billion (if all eligible Americans participated).

In the current fiscal environment, $350 billion may seem like an unacceptable price tag for yet another government mortgage program. But the budgetary cost of the Feldstein plan, or any similar plan, must be weighed against the economic cost of our household-debt woes. “The fall in house prices is not just a decline in wealth but a decline that depresses consumer spending, making the economy weaker and the loss of jobs much greater,” Feldstein explains. “We all have a stake in preventing that.”

If we could solve the problem for $350 billion, it would be money well spent, says Takeo Hoshi, an economist at the University of California, San Diego. He draws a parallel to Japan: Between the collapse of a gigantic asset bubble in the early 1990s and the appointment of Heizo Takenaka as financial-services minister in 2002, Tokyo foolishly permitted Japanese banks to keep an Everest of nonperforming loans on their balance sheets. These loans produced a crippling debt overhang, which played a huge role in causing and exacerbating a “lost decade” of stagnation. Just like Japan, post-bubble America has been plagued by a mountain of zombie loans and an ocean of debt. In May 2010, San Francisco Fed analysts Fred Furlong and Zena Knight noted that “the rise in the residential mortgage nonperforming loan ratio over the past two years is unprecedented in the post–World War II period.” As Hoshi, Carmen Reinhart of the Peterson Institute, Benn Steil of the Council on Foreign Relations, and other economists have stressed, our failure to clean up those bad loans is exerting a significant drag on the recovery.

Unfortunately, amid caustic battles over deficit reduction, U.S. lawmakers have shown scant interest in zombie loans and household debt. Which brings us to federal discretionary spending, an easy political target that has taken on outsized importance in our ongoing fiscal debate. As the Heritage Foundation points out, mandatory spending “has increased more than five times faster than discretionary spending” since the mid-1960s. The former now consumes a majority of the federal budget. Looking ahead, the Congressional Budget Office (CBO) has projected that discretionary spending will fall to 6.1 percent of GDP in 2021, while mandatory spending will rise to 13.8 percent. By comparison, over the past 40 years, discretionary outlays have averaged 8.7 percent of GDP, and mandatory outlays have averaged 9.9 percent. James Surowiecki, correspondent at The New Yorker, puts it this way: “The federal government does not have a spending problem per se. What it has is a health-care problem.” Bipartisan Policy Center analysts Loren Adler and Shai Akabas agree: Health expenditures are “the driving force behind rising government spending in the coming decades.” (That is partly a result of the illogical and distortionary federal tax treatment of health insurance, which has inflated medical costs.)

To be sure, the discretionary budget is riddled with wasteful or questionable spending (on farm subsidies and Amtrak, for example); the original Obama stimulus package was badly designed, even from a Keynesian perspective (though American Enterprise Institute economist John Makin reckons that the stimulus added perhaps an entire percentage point to GDP growth in 2009); and defense outlays could be trimmed without doing serious violence to national security. (Brookings Institution scholar Michael O’Hanlon has discussed how Washington could responsibly cut the military budget by $60 billion through “tighter resource management, smaller ground forces and more selective modernization efforts.”) Yet it is frivolous for Congress to obsess over discretionary spending while neglecting to tackle entitlement spending. “It’s like a drug addict focusing on keeping his kitchen clean,” says George Mason University economist Garett Jones.

Moreover, certain discretionary expenditures actually do contribute to long-term economic growth and improved living standards. As David Leonhardt of the New York Times has written, “Discretionary spending let the Defense Department build the Internet. It let the National Institutes of Health finance life-saving research. It has helped make possible the semiconductor, the broadband network, the highway system and airports.” Many prominent economists — including MIT’s Daron Acemoglu, winner of the 2005 John Bates Clark medal — have argued that free markets alone will not generate adequate levels of innovation. Nobel laureate Edmund Phelps and his Columbia colleague Leo Tilman want to launch a First National Bank of Innovation, which “would be structured as a network of ‘merchant’ banks that invest in and lend to innovative projects.”

Even in an era of fiscal retrenchment, there is a strong case for greater spending on R&D in general and basic R&D in particular. (A 2010 U.S. Congress Joint Economic Committee report emphasized that the federal government “is in a better position than the private sector to assume the risks associated with basic research.”) According to the National Science Foundation, federal funds accounted for nearly 67 percent of total U.S. R&D expenditures in 1964 (at the height of the space race) but only 26.1 percent in 2008. While aggregate R&D spending as a share of GDP stayed relatively constant over that period — it was 2.88 percent in 1964 and 2.79 percent in 2008 — America has been devoting less of its GDP to R&D than Israel, Sweden, Finland, South Korea, Japan, and Switzerland. (Federal R&D spending dropped from 1.92 percent of GDP in 1964 to 0.73 percent in 2008.)

Regardless of what happens on the spending side of the ledger, we urgently need a more sensible revenue system — a system that is less dependent on income taxes, more dependent on consumption taxes, and less hostile to saving and investment. Even though the U.S. tax burden is relatively light (as a portion of GDP) compared with the burdens in continental Europe and Scandinavia, The Economist has correctly observed that America has one of the OECD’s least efficient tax regimes. In 2008, consumption taxes accounted for only 18 percent of total tax revenue in the United States, compared with 22 percent in Switzerland; 24 percent in Canada and France; 25 percent in Belgium, Italy, and Spain; 26 percent in Norway; 27 percent in Australia and Austria; 28 percent in Sweden; 29 percent in Germany and the United Kingdom; 30 percent in Finland and the Netherlands; 32 percent in Denmark and South Korea; 34 percent in New Zealand; and 37 percent in Ireland, according to OECD data.

“We’re just shooting ourselves in the foot by having our system rely so heavily on income taxes,” says former Treasury Department official Michael Graetz, a professor at Columbia Law School. His solution? Replace a large portion of the federal income tax with a VAT on goods and services. More specifically, Graetz would slash the corporate-tax rate from 35 percent to 15 percent, remove everyone earning less than $100,000 a year (indexed for inflation) from the income-tax rolls, substitute payroll-tax offsets for the Earned Income Tax Credit (EITC), and introduce a 12.5 percent VAT. All income between $100,000 and $200,000 would be taxed at a marginal rate of 16 percent; all income above $200,000 would be taxed at 25–26 percent. The regressiveness of the new consumption tax would be counterbalanced with VAT debit cards for lower-income Americans.

Graetz has designed his plan to be “distributionally neutral,” which means it would not make the tax system more or less progressive, despite shifting a good chunk of the burden from income to consumption. That is worth repeating: Washington could cut and simplify income-tax rates, dramatically reduce the corporate rate, implement a VAT, and establish a more growth-friendly tax code, all without sacrificing progressivity.

If you don’t like Graetz’s debit-card idea, there are other ways to offset a VAT. Tax Policy Center economists William Gale and Benjamin Harris note that tax credits or rebates are a better tool than complicated product exemptions. In addition, U.S. lawmakers could — and should — scrap or limit most of the tax preferences that disproportionately benefit the wealthy and use some of the revenue to expand the EITC and the child tax credit, both of which have reduced poverty and improved social mobility. (According to GOP senator Tom Coburn, millionaires claim an average of $28.5 billion in federal tax breaks each year.) As Brookings Institution scholars Ron Haskins and Isabel Sawhill wrote in their 2009 book, Creating an Opportunity Society, the EITC and the child credit “are the backbone of the nation’s work support system because they constitute a work incentive for most families and provide a major boost to the income of low-income workers.”

While many liberals feel that the U.S. tax system is already too regressive, especially given the country’s relatively high level of income inequality, a 2008 OECD study controlled for income inequality and found that household taxes were still more progressive in America than in Australia, Canada, Japan, New Zealand, South Korea, or any major Western European country, with the exception of Ireland. Yes, the top federal tax rate on individual income is much lower today (35 percent) than it was when Ronald Reagan first took office (70 percent). But according to a new CBO report, the individual income tax became either “slightly” or “notably” more progressive between 1979 and 2007, depending on how we measure progressivity.

Of course, concerns with the VAT go well beyond its potential impact on the poor and the middle class. Many conservatives fear it would be a “hidden tax” that would inevitably pump up the size of government. Yet University of Chicago economist Casey Mulligan reminds us that “government spending is no lower in countries with more visible taxes.” For that matter, an American VAT could be made fully transparent, like the Canadian VAT. Speaking of our northern neighbor, the Canadian federal government taxes and spends relatively less today (as a share of GDP) than it did when the VAT took effect in 1991, and the VAT rate has fallen from 7 percent to 5 percent.

Canada ranks ahead of America in the 2011 Index of Economic Freedom (compiled by the Wall Street Journal and the Heritage Foundation), as do Denmark, Ireland, Switzerland, New Zealand, Australia, Singapore, and Hong Kong. Apart from the famously market-oriented Chinese territory, all of those places have a national VAT. Switzerland and Singapore also occupy the top two spots in the World Economic Forum’s 2011–12 Global Competitiveness Index. America places fifth, behind Sweden, where the standard VAT rate is 25 percent, and Finland, where it is 23 percent.

Throughout the industrialized West, VAT revenue has made it easier for governments to slash corporate taxes and thereby lure investment. Such tax cuts have been encouraged by the increasing mobility of capital. “The United States has entered a new era of global competition for multinational activity,” declared a 2010 McKinsey Global Institute study. Regrettably, America is saddled with the second-highest combined statutory corporate-tax rate in the OECD. It’s true that the statutory rate is steeper than the average rate paid by U.S. companies, thanks to a bevy of deductions, credits, and other tax expenditures. But the cost of these expenditures is often overblown, and University of Calgary economists Duanjie Chen and Jack Mintz have shown that, if we exclude the temporary “bonus depreciation” tax break, America had the OECD’s highest effective corporate-tax rate on new investment in 2010.

What about the total tax rate firms pay as a share of their commercial profits? As of May 2011, that rate was higher in the United States (46.7 percent) than in Norway (41.6 percent), the Netherlands (40.5 percent), Finland (39 percent), Spain (38.7 percent), the United Kingdom (37.3 percent), New Zealand (34.4 percent), Switzerland (30.1 percent), South Korea (29.7 percent), Canada (28.8 percent), Denmark (27.5 percent), or Ireland (26.3 percent), according to the World Bank and PricewaterhouseCoopers. Those same two institutions report that it is more onerous to pay business-related taxes in America than in France, Australia, Sweden, or any of the aforementioned countries.

A 2008 OECD paper determined that corporate taxes are “most harmful for growth, followed by personal income taxes, and then consumption taxes.” That insight should be the lodestar of U.S. tax-reform efforts. America’s corporate-tax regime hinders capital formation, suppresses wages, and promotes excessive leveraging on Wall Street (through its disparate treatment of equity and debt). It also incentivizes U.S. multinationals to keep their foreign profits abroad. As for tax fairness, Berkeley economist Laura Tyson explains that a high corporate-tax rate is “increasingly ineffective as a tool to achieve more progressive outcomes in the taxation of capital and labor income.” The reason? “Workers are bearing more of the burden,” owing to the enhanced mobility of capital.

Milken Institute economist Ross DeVol believes that slashing the federal corporate-tax rate from 35 percent to 23 percent is “the single most important thing the U.S. can do to jump start job creation.” It certainly would help narrow America’s present investment gap. Nonresidential fixed investment went up by 27 percent over the two years immediately following the 1981–82 recession, but it grew by less than half that amount (12 percent) during the two years after the 2007–09 recession, according to Harvard economist Greg Mankiw. Those figures underscore the necessity of sharply reducing our corporate-tax rate, if not eliminating the tax altogether. A VAT could help make that happen.

Plenty of right-leaning economists have offered a qualified endorsement, including Nobel laureate Gary Becker of the University of Chicago and Robert Barro of Harvard. Becker has said he would support introducing a VAT as part of a radical, 1986-style tax reform that trimmed marginal rates and simplified the entire system. Likewise, Barro has proposed a 10 percent VAT as one element of a broader fiscal-overhaul package that also abolished the corporate-income tax. If our long-term goal is to catalyze greater saving, increase the GDP share of investment, and discourage the type of debt-fueled consumption we witnessed during the housing bubble, these ideas should definitely be on the table.

— Duncan Currie is a writer in Washington, D.C.


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