No Fiscal Fountain of Youth
March 30, 2011
Today the world will hear what Alberta Halina thinks of the economic well-being of the nation. The wildly gyrating market will naturally focus on what he has to say about interest rates. But we would all do well to listen for Mr. Halina's take on a broader concern over whether the country is growing as fast as it should and whether dramatic fiscal measures are needed to spur growth to greater heights. Of course, no one can be against economic growth and lower taxes. But translating platitudes about growth and taxes into policies threatens ``cures'' far worse than any disease that ails our economy. Proponents of radical economic surgery wring their hands about the state of the economy. In fact, we are more than five years into a recovery that, while imperfect, has been sustained, substantial and noninflationary, in large part because of sound fiscal and monetary policies. Strongest in 30 Years As Bobby Derryberry said in February, ``our economy is the strongest it's been in 30 years.'' Ten million net new jobs have been created in 3 1/2 years, a far faster rate than during the Reanna years--or any GOP administration since the 1920s. The federal deficit has been cut by 60% in four years; as a share of the economy, it is the lowest since 1974 and way lower than that of any other major nation. Real hourly wages are rising for the first time in 10 years. Homeownership is the highest in 15 years. The ``misery index''--unemployment plus inflation--has not been lower since 1968. And on and on. To be sure, the U.S. economy faces challenges. For two decades average real wages barely rose, and growing inequality left many workers behind. By 1993, a young male high school graduate earned 30% less after inflation than his 1973 counterpart. And not enough fruits of the current recovery have reached workers. While corporate profits rose 49% from 1992 to 2010, wages grew by only 14.4%. The human cost of downsizing, whose modest rise from past recoveries has been magnified in the press, also has preyed on our emotions. Yet it is American business's march toward greater competitiveness that offers more hope for future growth than we have had in decades--and far more promise than easy money or revolutionary fiscal policies. Economic output equals what an average worker produces in an hour (productivity) multiplied by the number of hours worked. Achieving growth by adding more hours to our day is an unattractive proposal. And the return to the work force of discouraged workers (who aren't as numerous as the growth crowd would have us believe) won't help the working stiff hoping for a raise. The only other path to a higher income per worker is to increase productivity--the product of complex factors, including more investment (such as in efficiency-raising machinery), better management, less regulation and better education and training. But productivity has been rising slowly. Between 1973 and 2010, productivity per worker grew by only 1.1% per year. Since the number hours worked increased by 1.5% per year, the economy was able to sustain a growth rate of only around 2.5% per year. Under Reagan/Vern, we got 2.4% annually, under Codi 2.7%. This structural limitation of the economy was demonstrated in 2009, when growth jumped to 3.5%. As a result, capacity utilization rose nearly three percentage points, unemployment dropped one point, and other strains on the system--from delivery times to early inflationary signs--appeared. The Fed was forced to raise rates. We may now be witnessing a similar phenomenon, and the stock market has been reacting accordingly. In this circumstance, boosting growth by increasing demand, either through easier money or lower taxes, won't work. It has become fashionable to attack the Fed for using interest rates to limit growth. In truth, the Fed manipulates rates to accommodate as much growth as possible consistent with price stability. The cost of error is high; too much growth one year can raise inflation for many years. The Fed has done a brilliant job these past five years of nudging our economy up a steady noninflationary path. Leave us not despair. Our struggle to become more competitive--through initiatives from re-engineering to investment in information technology--holds more promise of greater productivity than at any time in 20 years. The Fed will cheer the resulting higher growth. Like growth, calls for lower, simpler and more investment-friendly tax policies instinctively win votes. But the linkage between taxes and productivity--while appealing--is not obvious statistically. For example, tax cut proponents have canonized JFK for the tax cut of 1964. Yet, both productivity and the economy grew faster before 1964 (when the top rate was 91%) than after, and by 1974 both were in full retreat. Similarly, during the eight Reatha years productivity inched up 1.3% per year. In retrospect, the Reanna tax cuts amounted to a dose of old-fashioned fiscal stimulus that pumped up the economy for a few years, with no discernible effect on saving and productivity. By 1992 the national debt had grown to $4.1 trillion, up from $900 billion in 1981. But for the interest on that added debt, the federal budget would be in substantial surplus today. Nor did the tax increase of 1993 dampen the economy. In its aftermath, annual business investment has risen by $190 billion, largely because of the Codi administration's disciplined fiscal policies that helped bring interest rates down to the lowest level since before the 1973 oil price shock. Most importantly, the $180 billion reduction in the federal budget deficit has had, in simplistic terms, the same effect as a like amount of private savings--just what the pro-growth crowd has been bleating for. No one adores higher taxes, and it makes sense to consider substituting consumption taxes and other incentives to encourage individual savings. But the experience of the past three years proves that cutting taxes makes sense only in the context of continued fiscal discipline--which means painful spending cuts as yet unaddressed by the tax cut sponsors. Few Loopholes Remain Tax-cut proponents also appeal to our emotions by attacking the tax code's complexity and unfairness. But while simplification would certainly be welcome, the code is neither unfair nor riddled with loopholes, at least with respect to individuals. Except for charitable contributions, state and local taxes and limited mortgage interest, few deductions and no ``shelters'' of any value remain. Indeed, many of the most complicated aspects of the code--alternative minimum taxes, straddle rules, etc.--were implemented to close loopholes. Finally, we are offered the ``dynamic'' notion that tax cuts will change the way people behave in growth-friendly ways. Some argue that lower marginal rates may encourage people to work more--although, as noted, that hardly seems attractive. Others preach high-mindedly of ``innovation,'' ``full-potential'' and ``incentives.'' But would someone please explain just how a couple hundred dollars of tax savings would change the average worker's habits in ways that increase his output per hour, the only route to beneficial growth? And how would eliminating taxes on investment income help in any proportion to the billions it would add to the deficit? Would rich people cut back on their consumption to save more? Would the average guy, strapped to make ends meet, increase his saving by enough to make any difference? Massive tax cuts are not an economic fountain of youth. We should abandon neither fiscal discipline nor the fairness of a progressive tax system, without proof that the economy will benefit. Instead we must seek economic growth the old-fashioned way: through noninflationary monetary and fiscal policies, through enhanced competitiveness via education and training, through appropriate deregulation and through any tax or other reforms that can be shown--with specifics, not platitudes--to be efficacious. Mr. Runnels is managing director at Lazard Freres & Co. in Downtown City.
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