Reports |
18 July 2019

Rethinking fiscal policy: Progressive US politics meets radical economics

Recognition of the need for greater government intervention in the economy is increasingly shaping the US political debate, with this shift paralleled among prominent economists.

Stephen Grenville
Stephen Grenville

Key Findings

  • The surprising success of Bernie Sanders’ 2016 presidential campaign has emboldened Democratic presidential hopefuls to advocate bold platforms involving larger government.
  • Coincidentally, some prominent economists are advocating greater government expenditure to address ‘secular stagnation’.
  • This is unlikely to result in a radical shift away from the post-Reagan small-government policies, but the centre of gravity has shifted towards recognising a role for more government intervention.

Executive Summary

The unexpected support for Bernie Sanders’ pioneering socialist platform in 2016 has encouraged other presidential hopefuls to offer a similar agenda as they seek the Democrat nomination for the 2020 election. For them, ‘socialist’ implies a more activist government, with more expenditure and intervention to address social issues. They affirm fiscal conservatism, so higher taxes are central in their platforms. However, the US economy seems to have lost its growth dynamic. In this environment, big-spending socialists may be ready to accept budget deficits and higher public debt.

Coincidentally, some prominent economists, concerned about this prospect of secular stagnation, are suggesting that the conventional wisdom advocating balanced budgets is inappropriate. They argue that the usual fears about public debt are unnecessarily alarmist.

An economic rethink of fiscal policy allows the political debate more scope to explore a role for government that goes beyond the post-Reagan small-government mantra. As the Democratic candidates skirmish for nomination, the overlap between the socialist agenda and the economic rethink will enliven and enrich the political debate.

Introduction

Leading progressive figures in the United States are proposing radical new ideas aimed at substantially reshaping the US economy and combatting rising inequality. Big-ticket expenditures and large tax hikes are all part of the mix as potential presidential candidates vie for public attention. Perhaps less conspicuous is a major rethinking underway in mainstream economics which suggests that such radical proposals may not be so extreme after all.

Behind the political grandstanding, some prominent economists are rethinking the role of fiscal policy. Economists have a reputation for being wet blankets for any politician wanting to spend money. Many economists are sceptical about the efficiency of government expenditures. Almost all are wary of deficit spending and government debt. But reality — in particular the 2008 global financial crisis and its aftermath — has been unkind to the conventional wisdom of policy and theory. These failures have opened the opportunity for new thinking. Some leading economists are rethinking the effectiveness of fiscal policy in smoothing the business cycle, the proper size and role of government, what constraints there should be on deficits, the dangers of too much government debt, and the threat of secular stagnation.

Progressive politicians making bold proposals

American ‘progressive’ Democrat politicians are talking about four broad ideas: more spending, more taxation, more budget deficits and, ultimately, more government.

More spending

The Green New Deal has become a catch-all proposal for a wide range of spending initiatives hoping to pick up the historical aura from Franklin D Roosevelt’s New Deal, which was a universally praised fiscal expansion in the 1930s to combat the Great Depression.[1] The ‘green’ part of this agenda is climate change. Characteristically, the approach is interventionist rather than market-oriented.[2] Pricing carbon is economically efficient, but the Green New Deal would supplement this through direct action: regulation, government investment, and subsidies. However, the proposal would also extend significantly beyond this. A still-evolving agenda so far encompasses a wide array of issues including employment guarantees with a minimum living wage (and potentially a universal basic income), universal health care and preschool, affordable housing, and better public transport and infrastructure.

More taxation

All this expenditure needs funding, and the proponents are ready to concede that this means more taxation. There are bold proposals here. Congresswoman Alexandria Ocasio-Cortez wants a tax rate as high as 70 per cent on incomes over $10 million.[3] Senator Elizabeth Warren wants a wealth tax on assets over $50 million.[4] These would be powerful revenue raisers. These proposals would also introduce more progressivity into the US tax system, addressing America’s parlous income disparities. Thomas Piketty brought the issue of wealth centre stage with his 2014 book, Capital in the Twenty-first Century.[5] Now it is common knowledge (and grievance) that wealth and income are both grossly maldistributed in the United States and that post-2008 policies exacerbated the problem.

More budget deficits

Democrats, despite being characterised as the activist spending party, have traditionally been constrained by their concern to demonstrate their conservative financial credentials. Their tax proposals allow them to retain these credentials and avoid too much discussion of bigger deficits. However, if these new taxes don’t gather as much revenue as hoped, deficit spending would be back on the political agenda.[6] In addition, full employment is a high priority for the progressives: if the economy is falling into secular or long-term stagnation, with growth chronically slow because of weak investment and excessive saving, this might justify deficits.

More government

Higher expenditure would give the government a larger and more active role. The term ‘socialism’ is now being used by both proponents and critics to describe this new world. Bernie Sanders described himself as a “democratic socialist”, perhaps subtly different from the Social Democrats of Denmark who he cites as a model to be emulated.[7] For Republicans, socialism conjures up visions of Lenin, Five-Year Plans, and the government seizing the commanding heights of the economy. US President Donald Trump seems confident that the very mention of ‘socialism’ will be enough to win the day: “We believe in the American dream, not in the socialist nightmare”, he said at the Conservative Political Action Conference in March 2019.[8] Yet surveys suggest that many, especially the millennial generation, view ‘socialism’ far more favourably — without Lenin but with a more interventionist government directing larger sections of the economy and actively addressing social issues.[9]

Traditional American economic cleavages are in flux

Republicans ostensibly favour small government and oppose discretionary countercyclical policy, deficits, and government debt. In practice, however, they have been ready to allow substantial deficits if these resulted from tax reductions rather than increased spending. Often there is a ‘starve the beast’ rationalisation: if tax cuts create an unsustainable deficit (as happened under the Reagan administration in the 1980s), this in turn becomes the motivation for later expenditure cuts. Even then, the big business wing of the Republican Party gives small government a higher priority than deficit discipline. As former Republican Vice-President Dick Cheney put it: “Reagan proved that deficits don’t matter.”

Republican complicity in Trumpian policies, however, represents a departure from the party’s traditional mentality. Trump’s 2017 corporate tax cuts were neither needed nor appropriate, with the US budget deficit now running at 4.3 per cent of GDP, debt growing, and few plans for expenditure reductions.[10] Moreover, Trump’s blue-collar worker supporters might benefit from more active publicly funded labour-market programs and industry policies, but they are being sold a different ‘solution’ — corporate tax cuts, tariffs, and managed trade.

The Democrats have, until recently, seen the need to establish themselves as careful stewards of the budget: it was Bill Clinton who repaired the budget deficit created by the Reagan tax cuts.[11] Clinton was supported by a majority of the public (both Democrat and Republican) who were uncomfortable with deficits. Obama’s presidency was a time of fiscal repair after the deficits associated with the 2008 crisis. Even Obama’s signature program — health reform — fell well short of universal health coverage, as a ‘single-payer’ system in which the government pays for all health care would have required far more government expenditure than the hybrid Obamacare system.

Bernie Sanders advocated a move away from this fiscal conservatism, promoting big-ticket expenditure items and praising the Danish model.[12] Note, though, that the extra expenditure came with discussion of new taxes. Democrats are still more prepared to propose new taxes rather than risk their reputation for fiscal rectitude.

Reconciling the political zeitgeist with new economic thinking

Fortuitously, these new progressive ideas come at a time when macroeconomics, disoriented by the 2008 crisis, is in flux and open to rethinking. Some of this reappraisal would fit neatly with the policy directions Democrats are now espousing.

First, the larger role for government that progressive Democrats envisage needs to be examined.

The combination of small-government Republicans, deficit-sensitive Democrats and a public wary of government debt has left America with one of the smallest government shares in the economy in the advanced world. The United States has a total tax revenue of about 27 per cent of GDP, while the Scandinavian countries — Norway, Sweden and Denmark — have tax revenues of over 40 per cent of GDP.[13]

The size of the government sector doesn’t have any discernible effect on growth: the Scandinavians have done about as well as the United States. GDP per capita in the Scandinavian countries is less than that in America, but they work shorter hours and this seems a societal choice rather than involuntary unemployment.[14] The Scandinavians consistently lead ‘happiness’ and longevity indices.[15] Importantly, the institutional arrangements that provide health care and aged pensions can result in two countries having very different shares of government in the economy while delivering much the same outcomes for their citizens.

In short, the size of the government sector is a political choice driven by what citizens want and how well policies and institutions are set up to deliver this choice. If the Democrats eventually succeed in expanding the role of government, how they do this will matter more than the resulting size of government.

Yet doesn’t the ability to raise revenue limit the government’s share? If tax rates are too high, won’t people stop working or spend all their energy on evading tax? This was essentially the argument behind the Laffer Curve: when tax rates are low, increasing them raises more revenue but as tax rates get higher, there may be a tipping point where the disincentive effect of higher tax rates is so strong that less revenue is raised even though the rate is higher.

The Scandinavian experience again offers some guidance. High marginal tax rates begin much lower on the income scale compared with the United States. This tax profile raises a lot of revenue, although at the cost of tax progressivity. The Scandinavian historical experience suggests that high income tax revenue is possible, and even substantial wealth taxes can be imposed effectively. That said, the political system often votes against this: the Scandinavians have reduced their marginal income tax rates somewhat, abolished their wealth taxes, and set their company taxes at internationally competitive levels.

Alexandria Ocasio-Cortez’ proposal for a marginal tax of up to 70 per cent on incomes above $10 million was greeted with widespread scepticism that such a rate would be practicable: it would deaden enterprise and promote evasion. In fact, the United States had marginal income tax rates at this level or higher during the post-war decades, when America’s growth rate was at its fastest, and there is academic support for such a degree of progressive taxation.[16]

The final 2020 presidential candidates are, however, unlikely to put such high rates on their election platforms. Nonetheless, the influence of Bernie Sanders and his new Congress colleagues has already changed the debate. After three decades in which the incentive-destroying effects of high tax rates were accepted unquestioningly by a majority of American voters, the mood has shifted. Concerns about income maldistribution, plus the obvious holes in the social safety net, means that it will be possible to explore the need for more revenue and more progressivity without being dismissed as a crank.

Economists’ views on deficits are shifting too. Mainstream economists have tended to be fiscal conservatives, unenthusiastic about budget deficits and government debt. For most, this conservative view is based less on deep theory and more on practical experience — governments find it too easy to run deficits (especially with approaching elections) and too hard to restore surpluses.

The post-2008 crisis period has upset this view in three ways. First, monetary policy doesn’t seem to work effectively to counter a weak economy: the historically low policy-rate settings have boosted asset prices much more than economic activity. Second, fiscal policy, which had fallen from active policy use following the stagflation of the 1970s, turned out to be effective in softening the 2008 downturn. Third, the substantially higher government debt accumulated since 2008 was readily absorbed by savers, without pushing up interest rates.

This third factor is changing the way economists think about deficits. In the standard academic model, deficits would push up interest rates, which would crowd out private investment expenditure. However, the experience since 2000 doesn’t fit the theory. Former Federal Reserve Chair Alan Greenspan noted the “conundrum” of low bond yields in the mid-2000s. The puzzle deepened after the 2008 crisis. Bond interest rates have remained at historic lows despite large deficits and rising debt.

Former Treasury Secretary Larry Summers saw this combination of weak recovery accompanied by low interest rates as a sign of secular stagnation.[17] This would justify the sort of fiscal expansion advocated by the Green New Deal — productivity-enhancing innovation subsidies, infrastructure, education, and active labour policies.

Olivier Blanchard, former Chief Economist at the International Monetary Fund, has noted that for much of the post-war period the rate of nominal GDP growth has been greater than the bond interest rate.[18] If growth outpaces the interest bill, governments can run modest ongoing deficits without this threatening debt sustainability or imposing an unfair burden on future generations. Blanchard goes further to argue that, if governments spend the deficits productively, this would be welfare enhancing for current and future generations. The message is: ‘don’t be too afraid of modest deficits’. With this message from a top mainstream economist, the traditional deficit aversion has been eroded.

One step further away from deficit orthodoxy are the Modern Monetary Theory (MMT) proponents, currently receiving more attention in the American political debate because they seem to offer a completely painless way of funding big-ticket expenditures. Their views are hard to identify precisely but a key element is to boost slack demand by running budget deficits, funded by issuing more money. This might seem to be a ‘free lunch’: extra output without more public debt. However, the public will simply deposit any money it doesn’t want to hold in the banks, resulting in the accumulation of excess bank reserves at the central bank on which interest will still need to be paid. MMT would therefore simply see public sector liabilities shift from the government (in the form of bonds) to the central bank (in the form of excess bank reserves). Interest costs would still need to be paid and excessive central bank liabilities would present the same potential concerns as excessive government debt: undermining confidence in the government’s financial stewardship, with implications for interest rates, exchange rates, capital flows, and debt markets. It is these concerns that made Federal Reserve Chair Jay Powell so scathing of MMT, stating “the idea that deficits don’t matter … is just wrong”.[19]

Some popular criticisms are less valid. The idea of ‘money printing’ always raises the spectre of inflation. However, this is less relevant in today’s financial system where money is more likely to end up as excess bank reserves (as we saw with quantitative easing). Moreover, the MMT proponents themselves say that deficits would be contained to avoid inflation, which they see as resulting from excess demand.

The most intuitively attractive part of the MMT message is that if the economy is running below capacity, policy should aim at stimulus, and this should come through fiscal expansion. Put like this, it is not so far from the Keynesian ideas so relevant in the 1930s. Mainstream economists, however, are cautious or even sceptical, informed by the post-World War II periods when politicians proved reluctant to rein in excessive budgets. Nevertheless, MMT’s ‘free-lunch’ message of limitless budget funding will go on attracting advocates of big-ticket expenditure.

Implications

The rise of the Democrat’s ‘bigger government’ proponents coincides with a rethinking in economics that would support these plans.[20] Low interest rates constrain effective monetary policy, but open opportunities for bolder fiscal initiatives.

Does this set the stage for radical change? Will fiscal policy take over from monetary policy as the main macroeconomic instrument? Has the era of bigger government arrived in America?

Not quite yet.

One constraint on radical change is that America doesn’t start with a blank slate for deficits and debt. Thanks to the Trump administration’s company tax cuts, the budget deficit is already 4.3 per cent of GDP, and heading higher.[21] More fundamentally, the current political environment is not yet ready to embrace bigger government and bigger deficits. The forces of political inertia are strong and these ideas still have to develop a wider consensus.

President Trump’s priority is to lower taxes for the rich and reduce the role of the government in the economy. This is supported by the traditional business lobby of the Republican Party, and Trump supporters who might benefit from a more active fiscal policy will be misled by the doctrinal bluster of Trump’s confused economics.

The progressive Democrats, for their part, will need to find common ground with their centrist colleagues such as Joe Biden (currently the most popular Democratic primary candidate).[22] The Green New Deal is a catch-all of raw proposals that are not only anathema to Republicans, but still unattractive for the centrist Democrats who hope to forge allegiances with (admittedly rare) centrist Republicans. For this, big ideas will need to be refined into more modest proposals, softened by evolution and compromise. This process is not revolutionary, but it should enliven and enrichen the policy debate.

Notes

[1] Andrew Chatzky, “Envisioning a Green New Deal: A Global Comparison”, Council on Foreign Relations, 1 May 2019, https://www.cfr.org/backgrounder/envisioning-green-new-deal-global-comparison.

[2] Paul Krugman, “Hope for a Green New Year”, The New York Times, 31 December 2018, https://www.nytimes.com/2018/12/31/opinion/green-new-deal-democrats.html.

[3] Nathan Robinson, “Alexandria Ocasio-Cortez Is Right. A 70% Tax on the Rich Makes Sense”, The Guardian, 9 January 2019, https://www.theguardian.com/commentisfree/2019/jan/08/alexandria-ocasio-cortez-70-percent-tax-rich.

[4] John Cassidy, “Why Elizabeth Warren’s Wealth Tax Would Work”, The New Yorker, 31 January 2019, https://www.newyorker.com/news/our-columnists/elizabeth-warrens-wealth-tax-is-an-old-idea-and-its-time-has-come.

[5] Stephen Grenville, “The Income Inequality Story: Reviewing Piketty’s ‘Capital in the Twenty-first Century’”, The Interpreter, 23 April 2014, https://www.lowyinstitute.org/the-interpreter/income-inequality-story-reviewing-pikettys-capital-twenty-first-century.

[6] Eliza Relman, “Alexandria Ocasio-Cortez Says the Theory that Deficit Spending Is Good for the Economy Should ‘Absolutely’ Be Part of the Conversation”, Business Insider Australia, 8 January 2019, https://www.businessinsider.com.au/alexandria-ocasio-cortez-ommt-modern-monetary-theory-how-pay-for-policies-2019-1?r=US&IR=T.

[7] Chris Moody, “Bernie Sanders’ American Dream Is in Denmark”, CNN, 17 February 2016, https://edition.cnn.com/2016/02/17/politics/bernie-sanders-2016-denmark-democratic-socialism/index.html.

[8] “Remarks by President Trump at the 2019 Conservative Political Action Conference”, Gaylord National Resort & Convention Center, National Harbor, Maryland, 2 March 2019; see also Roger Cohen, “Socialism and the 2020 American Election”, The New York Times, 8 March 2019, https://www.nytimes.com/2019/03/08/opinion/socialism-democrats-2020-europe.html?auth=login-email&login=email.

[9] Tom Switzer, “Anxiety Plus Ignorance: Why Millennials Are Embracing Socialism”, The Sydney Morning Herald,
23 February 2019, https://www.smh.com.au/national/anxiety-plus-ignorance-why-millennials-are-embracing-socialism-20190222-p50zj5.html.

[10] Congressional Budget Office, “Updated Budget Projections: 2019 to 2029”, Report, 2 May 2019, https://www.cbo.gov/publication/55151.

[11] David Leonhardt, “The Democrats Are the Party of Fiscal Responsibility”, The New York Times, 15 April 2018, https://www.nytimes.com/2018/04/15/opinion/democrats-fiscal-responsibility.html.

[12] Moody, “Bernie Sanders’ American Dream Is in Denmark”. 

[13] OECD, “The Global Revenue Statistics Database”, Snapshot as at 1 May 2019, https://www.oecd.org/tax/tax-policy/about-global-revenue-statistics-database.pdf.

[14] Paul Krugman, “Are the Danes Melancholy? Are the Swedes Sad?”, The New York Times, 27 October 2018, https://www.nytimes.com/2018/10/27/opinion/are-the-danes-melancholy-are-the-swedes-sad.html.

[15] John Helliwell, Richard Layard and Jeffrey Sachs, World Happiness Report 2018 (New York: Sustainable Development Solutions Network, 2018), https://worldhappiness.report/ed/2018/.

[16] Peter Diamond and Emmanuel Saez, “The Case for a Progressive Tax: From Basic Research to Policy Recommendations”, Journal of Economic Perspectives 25, No 4 (2011), 165–190, https://www.aeaweb.org/articles?id=10.1257/jep.25.4.165&smid=nytcore-ios-share.

[17] Larry Summers, “The Age of Secular Stagnation: What It Is and What to Do About It”, published in Foreign Affairs, March/April 2016, available at http://larrysummers.com/2016/02/17/the-age-of-secular-stagnation/.

[18] Olivier Blanchard, “Public Debt and Low Interest Rates”, Peterson Institute for International Economics Working Paper 19–4, February 2019, https://www.piie.com/publications/working-papers/public-debt-and-low-interest-rates.

[19] Liz McCormick, “Jerome Powell Says the Concept of MMT Is ‘Just Wrong’”, Bloomberg, 27 February 2019, https://www.bloomberg.com/news/articles/2019-02-26/jay-powell-is-no-fan-of-mmt-says-the-concept-is-just-wrong.

[20] Lukasz Rachel and Lawrence Summers, “On Falling Neutral Real Rates, Fiscal Policy, and the Risk of Secular Stagnation”, Brookings Papers on Economic Activity, 7 March 2019, https://www.brookings.edu/bpea-articles/on-falling-neutral-real-rates-fiscal-policy-and-the-risk-of-secular-stagnation/.

[21] Congressional Budget Office, “Updated Budget Projections: 2019 to 2029”, Report, 2 May 2019, https://www.cbo.gov/publication/55151.

[22] Zack Beauchamp, “A Clinton-era Centrist Democrat Explains Why It’s Time to Give Democratic Socialists a Chance”, Vox, 4 March 2019, https://www.vox.com/policy-and-politics/2019/3/4/18246381/democrats-clinton-sanders-left-brad-delong.

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