On Federal Policy and Economic Growth

Federal Policy and Economic Growth
Dean Douglas Elmendorf
Harvard Kennedy School
May 7, 2017

Note: This essay is based on a panel discussion at the annual policy conference of the National Association for Business Economics on March 6, 2017.

I am delighted to be here with Glenn Hubbard and Michael Peterson and to offer my perspective about a number of aspects of federal policy and their implications for people’s incomes and well-being.

The Budget Outlook and Appropriate Policy Responses

When I look at the budget outlook a decade or two in the future, I am quite concerned about the high and rising levels of federal debt we will have unless our policies are changed. We have shown no ability as a country to adopt policies to address that challenge. Indeed, we have not even had an informed, honest discussion of that challenge outside of groups like this one.

But as I look out to the next several years, I am much more worried about the prospect of sharp cuts in federal spending that would be damaging to the country’s long-term growth prospects through reductions in federal investment and would be harmful to lower- and middle-income people’s well-being through reductions in federal services and benefits. I think that economic policy in this country should be oriented explicitly toward raising living standards for lower- and middle-income people because they have gained the least from overall economic growth during the past several decades, and there are a number of steps we can take to do that. But the first thing is to do no harm—to not take away services and benefits that people depend on. So I worry a lot in the short term about inappropriate cutbacks in government spending.

Beyond that, we can make changes to put federal debt on a more sustainable path. Those changes are less urgent than they might otherwise be because interest rates are so low and are likely to stay below their historical averages for a prolonged period. I have written a paper with Louise Sheiner from Brookings that will appear in the Journal of Economic Perspectives shortly about the implications of low interest rates for fiscal policy. There are a number of possible contributing factors to low interest rates, and those factors have somewhat different implications for policy. But on balance they imply that it is appropriate to have more debt and more federal investment than if interest rates were higher.

For the federal budget as a whole, and this is not a new line for me, we need to design a set of deficit-reducing changes that would phase in gradually over time. Because interest rates will probably remain significantly lower than their historical averages for an extended period, this phase-in process can happen more slowly and t we can do more crucial public investment over the next decade. But ultimately, we will need a combination of cutbacks in Social Security and Medicare benefits relative to current law and increases in tax revenues relative to current law. It is much better to put those changes into law now. Remember that we are still in the midst of an increase in the retirement age for social security that was legislated in 1983—34 years ago. So if we will cut spending for certain programs 10 or 20 years from now, this would be the best time to put those cuts into law.

However, I see no prospect of that happening. There is a persistent delusion—fed by some elected officials who do not know better, and some who do know better—that the way to tackle the federal budget imbalance is to cut the so-called waste. I am not against cutting waste, but that is not where the action is. The action is in benefit programs that people like. President Trump was elected in part because he promised not to cut Social Security, Medicare, and Medicaid benefits. So I see no prospect that Republican leaders will try to cut spending on those programs beyond bills that can be labeled “repeal and replace the Affordable Care Act”—a subject to which I return below.

Prospects for Economic Growth

Even if federal policy were more oriented toward economic growth, there are limits to what can be achieved given the current demographics in this country. The Trump Administration has reset some people’s expectations for growth, but in a totally unrealistic way given those demographics.

Moreover, there is no evidence that this administration’s policies will lead to faster economic growth, on balance, than the previous administration’s policies. On one hand, tax reform might boost growth—although we would need to see an explicit reform proposal to judge—and regulatory changes might boost growth. On the other hand, cutbacks in federal investment, restrictive immigration policies, and restrictive trade policies would all diminish growth. Whether those considerations will, on balance, raise or lower growth relative to the policies we have had in place is not at all clear. If we could achieve sustained growth in the low 2-percent range—sustained growth, meaning not for a year or two but over a decade—that would be a real accomplishment. Setting expectations of 3 or 4 percent, as this Administration has tried to do, does not advance the national discussion.

Tax Reform

Tax reform can certainly boost economic growth. But let me offer a caution about how much extra growth we can reasonably expect. When Dave Camp, then-chairman of the House Ways and Means Committee, and his staff produced a very thorough tax reform bill a few years ago, the staff of the Joint Committee on Taxation (JCT) estimated that the legislation would raise the level of gross domestic product (GDP) by 1 percent or so after a decade. That is just a tenth of a percentage point on annual growth.

Dave Camp had imposed a constraint on himself in constructing his bill that it be revenue-neutral and distribution-neutral. If one were to abandon one or both of those constraints, one might achieve a greater boost to economic growth. But if one abandons revenue-neutrality, one needs to incorporate the long-term consequences of running up federal debt. And if one abandons distribution-neutrality, one needs to check whether the policy is boosting incomes of lower- and middle-income people. Those people would probably benefit to some extent if economic growth picked up, but a key lesson of the past few decades is that a rising tide does not necessarily lift all boats very much at all. Therefore, if tax reform lowered the tax rate on capital income, it could raise economic growth but would also shift the tax burden down the income distribution; taken together, those effects would probably make worse off the people who have benefited the least from economic gains in this country over the last few decades and whose economic plight has rightfully received more attention over the past year.

I want to add a thought about the border adjustment tax being considered by the House. Such a tax would have a number of advantages from the perspective of tax policy. However, we should recognize that part of the reason economists think this tax would not be protectionist is that the value of the dollar would rise substantially. Such a rise would have important macroeconomic consequences: It would reduce the value of foreign earnings to American corporations; it would reduce the value of U.S. ownership of foreign assets; and it would make any debts of foreign countries that are denominated in dollars much greater in their own currencies. Those shifts—of the magnitude that might accompany the tax being considered in the House—would be very disruptive in macroeconomic terms. And if the dollar did not rise as much as theory predicts, the effects of the tax from a tax-policy perspective would not be as favorable as tax experts hope.

Regarding the budgetary effects of tax reform, I think it should be revenue-neutral. I would include in that assessment the dynamic effects—that is, the macroeconomic effects—as estimated by JCT and the Congressional Budget Office. I wrote a paper for the Brookings Papers on Economic Activity in which I supported the idea of dynamic scoring by those organizations for legislation that would plausibly have significant macroeconomic effects. Comprehensive tax reform is clearly in that category.

Ultimately, we will need to raise taxes in this country. Although people do not like to pay taxes and may oppose more government spending in the abstract, they are quite supportive of benefits for older Americans. As we know, that is where much of federal spending goes today and where the vast majority of growth in federal spending will be. Under current law, the projected increase in non-interest federal spending over the next few decades is more than entirely explained by the effects of the aging of the population on spending for Social Security and Medicare. When push comes to shove, people will not cut those programs to keep their taxes down; they will raise taxes to pay for those programs. At the current moment, however, I would be content with revenue neutrality. But cutting revenue is so clearly going in the wrong direction that we should not support that.

Different approaches to comprehensive tax reform—or immigration reform, health reform, and other significant policy changes—can have very different macroeconomic effects. The value of dynamic scoring is that Members of Congress have information about those effects squarely in front of them when they choose among approaches.

Different approaches to comprehensive tax reform and other policy changes can also have very different distributional effects, and Members of Congress should base their policy choices on those effects as well. During the past few decades, we have seen a very striking divergence in the economic lives of higher-income Americans and lower- and middle-income Americans, with a profound impact on people’s material circumstances. Moreover, the economic divergence is being mirrored in a social divergence. We see diverging trends in life expectancy and out-of-wedlock births based on education level. We see a frightening rise in opioid abuse and deaths, concentrated among people who are being left out of our economy and society. So, the social consequences of diverging economic conditions are very clear. And both the material and social consequences have implications for the cohesiveness of our society, for the functioning of our political process, and for the ability of our country to lead internationally.

Therefore, as we make changes in tax policy, spending policy, or other sorts of government policies, we should give distributional concerns significant weight. Economic policy is not a zero-sum game. However, there are sometimes tradeoffs between what could be done to make the entire pie larger and what could be done do to make certain slices of the pie larger, and we should not focus only on making the overall pie larger.

Infrastructure Investment

We are on track to significantly cut federal investment in infrastructure relative to the historical pattern, and this would be a terrible mistake. Under the current caps on appropriations, federal nondefense discretionary spending will soon be a smaller percentage of GDP than at any point in my lifetime. About half of such spending is labeled investment by the Office of Management and Budget, covering infrastructure, research and development, and some education and training. So, those investments will be badly squeezed under current law unless we cut back dramatically on the non-investment categories—like veterans’ health care, the justice system, airport security, and so on—which is highly unlikely. That is not forward-looking, growth-oriented budget policy. Moreover, the Trump Administration has proposed cutting nondefense discretionary spending by an additional 10 percent, which would make the problem much worse. That is clearly the wrong direction for policy given the importance of investing in our future, and especially given the low level of interest rates that we expect to see for years to come.

It is true that we face other obstacles to infrastructure investment, including especially problems with local decision-making and with regulatory obstacles. However, it would be a mistake to downplay the role of federal spending. Some crucial types of infrastructure investment cannot be done with private capital, and some other crucial types can be done with private capital but only at a higher cost than if public funds are used. Consider the Capital Beltway here in Maryland and Virginia. Repairing bridges (like the American Legion Bridge) cannot be done with private capital because there is no way to collect revenue to pay private interests; much of our needed infrastructure investment, including work on local roads and schools, has similar characteristics. Adding high-occupancy vehicle lanes (as recently occurred in Virginia) can be done with private capital because tolls can be collected, but that approach will ultimately be more expensive than using federal funds because the federal government can borrow at a lower cost than private firms can.

I also worry about both the choice of infrastructure projects and the execution of those projects. If we could be more rigorous in our cost-benefit analysis—thereby building more crucial transportation hubs and fewer bridges to nowhere—that would be a good thing. If we could execute these projects more effectively, that would be a good thing too. Changes in the rules governing federal infrastructure spending could help to accomplish both of those goals.

Health Policy

On health policy, the Republicans face a difficult tradeoff now. There is no way to maintain the level of insurance coverage we have reached under the Affordable Care Act (ACA) without subsidies that are similar in scale to those under the ACA and a set of rules for insurance markets that are similar to those under the ACA. Therefore, if Republicans repeal the ACA, they will either have to replace it with something that looks a lot like the ACA or they will have to tolerate a substantial reduction in health insurance coverage. Both of those alternatives are politically unappealing. They have been unappealing since 2009, when I first started working with Republicans on health policy, and they remain unappealing, with no apparent resolution within the Republican caucus on which of those consequences or combination of consequences they prefer. Therefore, I am not at all sure that a large-scale change to health policy will happen.

Let me remind you about some budgetary aspects of the ACA. The ACA obviously included a significant increase in federal subsidies for health insurance. But we should recognize that those subsidies represent less than 10 percent of total federal subsidies for health insurance. The federal government provides very substantial tax subsidies for people who receive insurance through their employers, for people over the age of 65, for disabled people, and for many low-income people through Medicaid as it existed before the Affordable Care Act. As a result, the incremental subsidies under the ACA, as large as they may appear in dollar terms, are less than 10 percent of total federal subsidies. Therefore, when we talk about federal spending for health care, we should recognize that the ACA is actually a pretty small piece.

Moreover, the ACA raised money to pay for those subsidies in part by cuts in Medicare spending relative to previous law. Although the Republicans railed against those cuts at the time, they are quite content to keep them in law, as you can see in the budget resolutions they have produced in the past several years. If the Republicans attempt to repeal the ACA’s subsidies but keep the Medicare cuts, hospitals and other health care providers will be very unhappy because they accepted some of those cuts with less complaint than they would have offered otherwise since they were getting more revenue through additional people having insurance coverage. That is, the pieces of the ACA are difficult to disentangle.

Whether a Republican proposal to repeal and replace the ACA would make the budget deficit larger or smaller depends on the specifics of the bill. Clearly, if the Republicans roll back subsidies by a substantial amount, they will roll back taxes by a substantial amount as well. Thus, I would guess that repeal and replace would not make a big difference to the deficit, just as the ACA did not make a big difference to the deficit.

I want to add some thoughts about Medicaid block granting, which is often proposed by Republicans. I see a legitimate advantage in giving governors more flexibility to use federal Medicaid dollars in ways they think are best in their states. But we should recognize that current law has a fair amount of flexibility: There are a lot of waivers in Medicaid, in which states are doing a lot of things that are different from the core design of the program. Perhaps those rules should be loosened, but it is not the case—as some people assert—that the current program is “one size fits all.” Moreover, we should remember the discouraging history of shifting federal programs to block grants. In 1995 when we had the Aid to Families with Dependent Children program, two-thirds or so of poor families received benefits. Then the program was converted to Temporary Aid to Needy Families, was block-granted, and had federal spending capped in nominal terms; today, only about a quarter of poor families receive benefits. If Medicaid was block-granted and too little money was made available, the consequence would be a drop in the number of low-income people who would receive adequate health care. That would push us in exactly the wrong policy direction.

On the important broader question of how to reduce unnecessary spending on health care in this country, I would make two specific policy suggestions. First, we can increase individual responsibility for less-expensive health care procedures by pushing toward larger deductibles and co-payments. The so-called Cadillac tax in the ACA will encourage insurers and employers who are providing insurance for their employees to design insurance policies under which people pay somewhat more out of pocket. In addition, the less-expensive plans on the new insurance marketplaces under the ACA require larger out-of-pocket payments than most Americans with health insurance pay. Moreover, we can increase out-of-pocket payments by Medicare beneficiaries by restricting the ability of Medigap policies to fill in around the basic Medicare package. We can make these changes in ways that are sensitive to the problems faced by lower-income people.

Second, we can change the way that Medicare pays providers for health care. Medicare is the single largest payer for health care in the country, so it creates standards for good and for ill. A large collection of experiments to pay providers in different ways are underway now, partly through the Center for Medicare & Medicaid Innovation and partly through the general work of the Centers for Medicare & Medicaid Services. For example, there are experiments in paying providers for bundles of services rather than individual aspects of care. There is huge potential in this direction, but we need to let a thousand flowers bloom to see what could be most effective. And much of the important work will be undertaken in hospitals and medical practices across the country where people are trying to reengineer their systems to be more efficient.

Responding to Immigration, International Trade, and Automation

Less-skilled immigrants will tend to lower the wages of less skilled native-born workers, so we absolutely need to find ways to support the wages of those workers. Similarly, international trade can lower the wages of workers whose work is facing the greatest competition from imports, and we need to find ways to support their wages as well.

Economists have known for a long time that greater immigration and international trade generally raise a country’s average standard of living. Economists have also known for a long time that greater immigration and international trade can lower the standard of living for some people. When we teach economics, we teach that more trade can make everyone better off if we used some of the winners’ gains to subsidize the losers. We have seen significant growth in trade—spurred partly by trade agreements but much more by the growth and engagement with the world economy of developing countries—but we have not stepped up to bolster the incomes of the people who have been hurt. If we in this room, and people in rooms like this one, continue to support policies that are good for the economy as a whole but bad for lower- or middle-income people, we need to step up with practical policies to compensate those people for their losses. That means expanding the earned income tax credit, introducing wage insurance, expanding education and training, and so on.

Similarly, we should not fear automation, but we should respond to it actively and not just watch it happen without any policy response. Automation is very much like international trade in this way, and actually more important than trade in its impact on most American workers. We should not try to stop technological advances that make workers more productive. However, we should recognize that those technological advances will drive some people out of work, that their loss of incomes and loss of self-worth from not having jobs they are good at doing and enjoy doing are very harmful to them, and that we have a responsibility to help.

For example, there are now about 3½ million people who drive taxis, buses, or delivery vehicles in this country. Many of those people do not have a lot of education and now have good jobs and are earning enough money to be successful members of society. However, the rise of self-driving vehicles over the next few decades will, I presume, cost many of those people their jobs. I think the solution is not to ban self-driving vehicles but instead to develop policies that enable those people to find good jobs at good wages. Some of that can happen through wage subsidies and more education and training, as I have just noted.

Yet, there is also an important question of how to provide important forms of non-wage compensation for less-skilled people. Traditionally, many less-skilled workers were employed by large companies that also employed many more-skilled workers. Those companies provided pensions, health insurance, and other forms of compensation that were tailored for the bulk of their workforces but also provided valuable benefits for the less-skilled workers. As we have seen a breakdown in that sort of employment relationship, with more large companies outsourcing their less-skilled tasks and more people working in the gig economy, we have seen more people who do not receive those benefits from employers. We can and should develop ways to help those people build retirement savings, obtain health insurance, and so on.