Economic Policies for the Next Administration

Remarks delivered by Dean Douglas Elmendorf
Belfer Center for Science and International Affairs
April 26, 2016

Thank you. I am delighted to be here. My goal today is to make the case for economic policies that I think the next administration should pursue.

The starting point is to ask what the goals of our economic policies should be. Graham Allison frequently quotes Nietzsche as having said: “To forget one’s purpose is the commonest form of stupidity.” To avoid that stupidity today, let me explicit: I think the principal goal of economic policies should be to increase the incomes of lower- and middle-income people.

Between 1979 and 2011, real gross domestic product (GDP) per person increased 67 percent. CBO has published estimates of the growth in market incomes—that is, incomes before taking account of taxes and transfers—for different groups over that same period. CBO estimated that market incomes rose 16 percent in the bottom quintile of the distribution, 9 percent in the middle quintile, and 77 percent in the top quintile. Within that top quintile, by the way, market incomes grew about 60 percent for the people not in the top percentile and 174 percent in the top percentile.

You should not put too much weight on those specific numbers because measuring income growth is difficult. In particular, those figures probably understate the increase in people’s standard of living because the data do not fully capture quality improvements or the development of new types of goods and services, especially online items. I think it is wrong to say that most people have experienced no increase in their standard of living. But it is right to say that most people have benefited relatively little from the growth of total output and income in the past few decades.

That outcome is unfortunate for those people. It is also unfortunate for our social cohesion and political process, because many people of modest means feel growing distance from higher-income people and growing frustration with the policy choices of the elites. And it is unfortunate for our international leadership because we are a less shining example to the world and because the distrust of elites hampers our ability to act in an international way.

Therefore, I think the primary goal of economic policy should be to boost incomes for people of modest means. Of course, there are other plausible goals. For example, one might focus on overall economic growth and not worry about distributional issues on the presumption that stronger overall growth would help everyone. But that presumption may not be right: The rising tide in recent decades has not lifted most people’s boats very much. Moreover, if we achieve faster growth through policy changes that directly hurt lower- and middle-income people, like certain sorts of changes in the federal budget, then those people would probably be worse off in the end even if their market incomes rose a little.

With that goal in mind, what policies do I suggest?

First, use monetary and fiscal policies to keep aggregate demand for goods and services high enough to achieve full employment. We are much closer to that objective today than we have been for most of the past 8 years, but we are probably not there yet, and maintaining sufficient aggregate demand to have full employment over the next several years will probably be difficult.

You can see that we are closer to full employment today than we have been for years by looking at the substantial declines in the unemployment rate and in broader measures of labor underutilization. But the broader measures still show more unused labor than before the recession, and wage and price growth have not picked up to any substantial degree, so we are probably not back at full employment yet.

And there are important economic and social advantages of achieving full employment. The willingness of the Federal Reserve to keep interest rates low for an extended period has created some risks. However, it has also pulled many people back into jobs and drawn back into the labor force significant numbers of people who had left out of discouragement. The combination of the ongoing drop in unemployment and the leveling out of labor force participation over the past few years has led the share of the population between 25 and 54 that is employed to rise markedly. That rise has generated income for people who badly need it and fulfilled our implicit commitment to have an economy in which willing workers can find work.

Maintaining full employment in the coming years will probably be difficult. In each of the past three recessions, the Federal Reserve has cut the federal funds rate by more than 5 percentage points. But with equilibrium interest rates in the United States now exceptionally low by historical standards—a phenomenon I will come back to shortly—the federal funds rate will probably not have reached 5 percent when the next recession hits, so the Fed will not have as much room to cut rates. When the Fed therefore uses alternative means to ease credit conditions, as I expect they will, the next administration should not object.

The next administration should also support expansionary fiscal policy when the next recession hits and should, in advance of a downturn, develop stronger automatic fiscal stabilizers and a set of discretionary countercyclical fiscal policies that could be put into action. I think a rush to “normalize” fiscal policy was the biggest policy error during this past economic recovery, and I worry that the same confusion between the impact of debt in the long term and short term that led to that past error will emerge again in the next recession. In fact, we will need more powerful countercyclical fiscal policy than we have needed in the past. That means larger deficits during downturns and smaller deficits or surpluses during booms. Variability in the federal budget can be costly, and those costs should be considered in deciding what components of spending and taxes should vary most. For example, variation in tax rates and in the federal share of Medicaid spending would probably have smaller costs than variation in infrastructure investment.

To be sure, expansionary monetary and fiscal policies cannot achieve faster growth on a sustained basis than the growth in labor, capital, and multifactor productivity can support. There may be long-lasting positive effects of the increases in employment, investment, and so on that arise from stronger aggregate demand for goods and services. I think the jury is still out in the economic profession on the existence and importance of these so-called “hysteresis” effects. But even if such effects are important, we cannot simply pick the growth rate we would like and amp up monetary and fiscal policies to get there. We need to use other policies that boost labor force participation, education, capital investment, and productivity.

That takes me to my second recommendation: We should increase public investment. Because I am focusing on the next administration, I will talk about federal investment, and nondefense investment in particular.

Most federal investment is funded through the discretionary appropriations that Congress approves each year. Under the current caps on discretionary spending, federal nondefense investment in infrastructure, education and training, and research and development soon will be smaller relative to GDP than at any time in at least 50 years. This picture shows nondefense discretionary spending as a percentage of GDP for the past 35 years; the picture looks about the same if you go back further, and by the way, the vertical axis labels are off by a factor of 10. Such spending is on a downward trajectory relative to GDP. Investments have represented about half of this spending nearly every year in the past 50. Therefore, unless the composition of nondefense discretionary spending shifts toward investments and away from other items to an extraordinary degree, the decline in that spending relative to the size of the economy will mean a decline in key federal investments relative to the size of the economy.

That is not forward-looking, growth-oriented budget policy. Spending for infrastructure like roads and airports decreases the cost of moving people and delivering good and services; spending for education and training enhances the skills of our workforce; and spending for research and development promotes innovation. Cutting those federal investments will reduce total output and income relative to what they would otherwise be. In particular, cutting federal investment in education and training will reduce the incomes of lower- and middle-income people who are dependent on government help to have a real opportunity to advance. To boost economic growth, we should raise the caps on nondefense discretionary spending substantially.

That is especially true because interest rates on Treasury securities are very low by historical standards and will probably remain low for a prolonged period. The yield on 10-year Treasury notes was 8 percent at the end of 1990, 5 percent at the end of 2000, and 2 percent at the end of 2015—with CBO and a number of other analysts now predicting that the 10-year yield will rise only to about 4 percent in the coming years, and many financial-market participants appear to expect it to remain below that.

That is a sea change in the economic backdrop for fiscal policy, and it has really come into focus just in the past few years. Louise Sheiner at the Brookings Institution and I are writing a paper on the implications of low interest rates for fiscal policy, and you can see a preliminary draft on the Brookings web site. The implications depend to some extent on the reasons why rates are low, and there are many possible reasons. But we are finding that most reasons imply that it is optimal to have more federal debt and more federal investment than otherwise. The intuition behind these results is just that interest rates show the direct cost to the Treasury of its borrowing and provide information about the indirect cost to the economy of Treasury borrowing, so if the direct and indirect costs will be persistently much lower than we are accustomed to, then more borrowing, especially for investment, passes a cost-benefit test.

We should also work to increase the return on federal investments. Sometimes we build critical transportation links, and sometimes we build bridges to nowhere; sometimes education funding supports a breakthrough in a person’s life, and sometimes it is dissipated. CBO’s central estimate is that additional federal investment yields half of the typical return on private investment, in part because federal investment can crowd out investment by private entities or state and local governments, and in part because federal investments are not always chosen with an eye to maximizing their effect on future income. We can do better. For example, we should increase the role of careful cost-benefit analysis in deciding which specific investments to undertake.

It is also important to understand that some federal spending outside nondefense discretionary spending represents an investment in future income, especially for lower-income people. There is a growing body of evidence that certain health-care benefits, housing subsidies, education subsidies, and other means-tested benefits raise future incomes of some young people. We should protect those investments as well.

The third item on my agenda is to allow federal debt to rise relative to GDP over the next decade as it will under current law, but to enact cuts in benefits and increases in taxes that are phased in later so that debt declines gradually relative to GDP in the long term.

Under current law, federal debt is projected by CBO to rise from 75 percent of GDP currently to 85 percent by the end of the decade and more than 100 percent 25 years from now. For comparison, debt averaged 38 percent of GDP over the past 50 years.

Federal debt cannot increase indefinitely relative to the size of the economy, so current law is not sustainable. Moreover, even if debt stops rising at some point, allowing debt to stay so high could crowd out private capital investment and reduce the “fiscal space” for responding to unexpected developments. For example, if we hit another financial crisis or severe recession with debt at 85 percent of GDP rather than 35 percent, our options will be more constrained. Those points argue, all else equal, for reducing federal debt by a lot and for doing so quickly. However, all else is not equal. As I just noted, exceptionally low Treasury interest rates imply that it is optimal to have a higher debt-to-GDP ratio than we would otherwise.

To be sure, interest-rate projections are very uncertain, and policymaking should be mindful of the risk that rates will rise above current expectations—especially because many large changes in fiscal policy are best made slowly. But we should not ignore a good deal of evidence that rates will probably be much lower than in the past for an extended period.

Given the increase in federal investment that I advocated, even allowing the increase in debt projected under current law would require other budgetary changes. I would pay for that increase in investment primarily with cuts in benefits for higher-income retirees and hikes in tax revenue from higher-income taxpayers. And in the years beyond the coming decade, I would put the debt-to-GDP ratio on a downward path with larger versions of the same sorts of changes.

My recommended changes come partly from the policy focus with which I started, namely the importance of raising incomes for people of modest means. Hiking their taxes or cutting their benefits would not help those people. My recommended changes come also from observing the evolution of the federal budget under current law. Spending for Social Security and Medicare is increasing considerably relative to GDP, mostly because of the aging of the population: By the time the last baby boomers become eligible for Social Security and Medicare, there will be more than 75 million beneficiaries of those programs, two-thirds more than the number just before the first boomers became eligible for early retirement benefits. Those beneficiaries will be more than one-fifth of the U.S. population. Meanwhile, defense spending is declining relative to GDP and in a few years will be a smaller percentage of GDP than anyone can remember. All other noninterest spending taken together—which includes all of the means-tested benefit programs—shows very little trend over the past 25 years or the next 25 years. Of course, there have been important shifts within this very broad category. Still, the rise in federal spending relative to GDP does not stem from general growth in the federal government relative to the size of the economy but instead from a dramatic increase in spending for Social Security and Medicare (with a rising amount of interest payments as well).

Therefore, I think that reductions in benefits should be focused on better-off beneficiaries of Social Security and Medicare. To be sure, that approach does not offer a free lunch. Making Social Security and Medicare more progressive would weaken the connection between an individual’s taxes and benefits, which could undermine the earned-benefit character of the systems if taken too far. Also, because people with higher incomes would face lower benefits, their incentives to work and save would be reduced. But I think this approach is the best of the available alternatives for restraining federal debt without unduly burdening those Americans who have fared the worst in economic terms in recent years. I would also note that focusing benefit reductions on better-off beneficiaries means that across-the-board cuts, such as increases in the age of eligibility, should be a last resort rather than a first resort.

I want to comment briefly on the Affordable Care Act, which is the biggest expansion of federal means-tested programs in decades. The ACA is increasing the number of Americans who have health insurance by about 20 million this year, and doing so at a direct cost of about $5000 per newly insured person and a collection of significant changes in insurance rules. That dollar cost is substantial, but not surprising given the high cost of health care. For context, the ACA subsidies will be less than 10 percent of total federal subsidies for health insurance over the next decade, with nearly 50 percent of total subsidies provided through Medicare, about 20 percent through Medicaid apart from the ACA, and about 20 percent through tax subsidies for employer-provided health insurance. Of course, there are alternative policies regarding health insurance that we could adopt. But there are no policies that would achieve the substantial increase in insurance coverage occurring under the ACA without subsidies and rules similar to those of the ACA—or an even larger federal role. Then there is a value judgment about whether the increase in insurance coverage is worth those costs, and my own judgment is yes, given my concern about slow income growth at the lower end of the distribution.

We also need to raise tax revenue above what will be collected under current law. Although people have a wide range of views about the desired level of federal benefits or other kinds of federal spending, but there is no evidence that most people wants cuts in spending of the magnitude that would be needed to avoid any revenue increases. For example, the Republicans have controlled the House of Representatives for more than 5 years, and the number of bills they have approved that would cut benefits substantially—apart from repeal of the Affordable Care Act—is zero.

To raise revenues, the natural places to start are: one, to tax carbon emissions; and two, to reduce the deductions and exemptions that narrow the tax base and thereby lower the revenue collected for any given tax rate. We can talk about specifics later if you would like.

My fourth suggestion for economic policies is to reform the tax code to increase the efficiency of business investment. Increasing the amount of business investment would be good, too, but that would be difficult to achieve through tax reform while still collecting sufficient tax revenue and not increasing the tax burden on people of modest means. Consider the comprehensive reform proposal put forward by Congressman Dave Camp when he was Chairman of the Ways and Means Committee. According to the staff of the Joint Committee on Taxation, his proposal was roughly revenue-neutral (excluding the budgetary feedback from the proposal’s macroeconomic impact) and roughly distribution-neutral. But to achieve those goals along with others that Chairman Camp had identified, the proposal would have raised the marginal tax rate on capital and thereby reduced business investment.

If one relaxed the condition of revenue neutrality, than naturally it would be easier to reduce the marginal tax rate on capital. However, the increase in federal borrowing would diminish economic growth. Instead, if one shifted the tax burden toward people of modest means, then again it would be easier to reduce the marginal tax rate on capital. However, people of modest means might well be worse off, even after accounting for the effects of additional capital.

Still, tax reform could increase economic growth by increasing the efficiency of business investment. The current tax code distorts businesses’ decisions regarding asset types, industries, organizational forms, and geographic locations. Reducing those distortions would boost future incomes. Therefore, we should enact revenue-neutral and distribution-neutral tax reform that increases the efficiency of business investment.

My fifth suggestion for the next administration is a collection of policies to enhance opportunity and innovation. These topics deserve more attention than I am giving them here, but I have talked long enough already.

To enhance opportunity, I would broaden access to preschool education and community colleges, and try to improve the links between community colleges and jobs. I would relax occupational licensing. And I would look for policies to increase labor force participation. A traditional approach to encourage participation is to reduce the effective tax on working, by adjusting either the tax code or benefit rules. However, international comparisons and other evidence suggest that other factors may be as important or more important for labor force participation than the structure of taxes and benefits. For example, this figure shows that female labor force participation in the United States has slipped a bit over the past two decades, while it has increased notably in a number of other advanced economies and now surpasses the U.S. rate.

To enhance innovation, I would increase immigration of high-skilled people and provide robust funding for research and for STEM education. I would note that an important puzzle in recent years is that innovation seems strong in some visible ways, but growth in total factor productivity has been quite weak. Nonetheless, over the long run, a faster pace of innovation should lead to faster productivity growth and thereby faster growth in incomes.

So, here are my recommendations for economic policy, with the primary goal being to increase the incomes of lower- and middle-income people: Use monetary and fiscal policies to keep aggregate demand for goods and services high enough to achieve full employment. Increase public investment. Allow federal debt to rise relative to GDP over the next decade but enact cuts in benefits and increases in taxes that are phased in later so that debt declines gradually relative to GDP in the long term. Reform the tax code to increase the efficiency of business investment. And enhance opportunity and innovation. Thank you.