Deficit spending CAN be fiscally responsible. Here's how.

The deficit only keeps growing if we spend more than we bring in from tax revenue – but tax revenue depends on the nation's economic health.

I’m traveling all this week for work, so I probably won’t be blogging at my usual frequency. But I had to say at least something about this week’s big fiscal policy development.

The Bipartisan Policy Center’s (BPC) debt reduction plan was unveiled on Wednesday morning and is a good example of why pursuit of “fiscal responsibility” need not be in conflict with other economic goals, contrary to how opponents of fiscal hawkish policies like to portray them.

First, additional deficit spending can be fiscally responsible. How is that not an oxymoron? Because the fiscal outlook is only unsustainable if the debt grows faster than the economy. There are two variables in that comparison, both affected by policy choices. The debt grows each year by the size of the annual deficit, the difference between spending and revenues. But how the particular spending and revenue policies affect economic activity in turn affect how fast the economy grows. In other words, exactly how we spend and how we tax matters beyond how much we are spending and how much we are taxing (collecting in revenue), in determining what is winning this race between the debt and the economy.

In Wednesday’s New York Times, David Leonhardt makes the point that all else constant, a stronger economy reduces the budget deficit–that “one way to trim [the] deficit” is to “cultivate growth.” In an economy with high unemployment, even deficit-financed policies can produce an economic benefit (greater economic activity with more income to tax and less need for government safety net spending) that outweighs the economic cost (increase in the deficit which may increase borrowing costs and reduce national saving), provided that the deficit spending has high (and fast) economic “bang per buck.” Short-term deficit-financed stimulus is most likely to produce that high “bang per buck” when the policies follow the “three Ts” of being timely, (well) targeted, and temporary in nature.

As David explains, the plan put together by the BPC debt reduction task force actually includes a temporarily large increase in the deficit with a major new fiscal stimulus (emphasis added):

“Some politicians and economists present a false choice: reduce unemployment or stabilize the debt,” argues a new bipartisan deficit plan that will be released Wednesday, the second such plan to come out in the last week. As Alice Rivlin, a Democrat who oversaw the writing of the plan with Pete Domenici, a Republican, put it: “We can do both. We can put money in people’s pockets in the short run and trim government spending in the long run.” .

The plan calls for a one-year payroll tax holiday for employers and workers, costing $650 billion. But remember that’s a one-time sum, while the needed deficit cuts will be hundreds of billions of dollars a year. Relative to those cuts, a payroll tax holiday — or more spending on roads and bridges, as President Obama favors — is a rounding error. And, of course, putting people back to work has its own benefits.

Admittedly, that is a very big additional one-year stimulus and might be considered going overboard. (Today at my event at the Boston Fed, Mark Zandi said he thought it was more than necessary.) But if a payroll tax holiday (full or partial) is considered more effective stimulus than, say, temporarily extending the various parts of the Bush tax cuts, why not consider substituting the payroll tax holiday (or any other more effective fiscal stimulus) for the Bush tax cuts, rather than just piling it on?

After the first couple years, however, the BPC plan would begin to reduce deficits by both cutting spending and raising revenue. The particular policy choices the BPC task force recommends well address two other “false choices” that are often argued in opposition to “fiscally responsible” policies…

Raising more revenue as a share of our economy need not be detrimental to longer-term, “supply-side” economic growth. If we raise revenue by broadening and leveling out the tax base, then marginal tax rates (the rates that affect incentives to work and to save) need not increase–and can even be reduced. Then we get the direct increase in public saving (higher revenues and reduced deficit) without any of the higher tax rates that could cause a partially-offsetting decrease in private saving. The BPC proposal seems to follow this model, as does the co-chairs’ proposal of President Obama’s fiscal commission.

David Leonhardt explains the general principle as it can be applied to spending cuts as well (my clarification on the tax piece added):

Even more important than the next couple of years is the second part of a pro-growth strategy: the long term. A good deficit plan doesn’t simply make across-the-board cuts for years on end. It cuts funding for programs that do not spur economic growth and increases funding for those relatively few that do. Likewise, it raises tax rates [or otherwise includes more of such activities in the tax base] that do not have a clear record of promoting growth and cuts those that do.

Finally, opponents of deficit reduction efforts often argue that such policies would be unfair to lower-income households. This is another “false choice.” Deficit reduction can be achieved in a progressive manner–i.e., where higher-income households contribute larger fractions of their income to the cause and/or lower-income households are held harmless.

The BPC plan is thoughtful in this regard as well. The Tax Policy Center’s Eric Toder has analyzed the distributional effects of the tax changes in the BPC plan and concludes (emphasis added):

Overall, the BPC plan is more progressive than either current law or current policy. Relative to current law, households in the bottom quintile would actually experience an increase in their after-tax incomes of 0.7 percent on average, or about $100. Households in the middle of the income distribution would see a small tax increase, averaging 0.2 percent of after-tax income, whereas households in the top quintile would experience a tax increase equal to about 2.5 percent of income on average. At the very top of the distribution, the 130,000 households with cash income in excess of about $3.2 million would see a tax increase equal to 4.6 percent of income or close to $300,000 on average.

(The Tax Policy Center found the Bowles-Simpson tax proposals to be less progressive relative to current law but more progressive relative to current policy; this difference is due to the fact that the expiring Bush tax cuts confer benefits that go disproportionately to the rich so that letting them all expire as under current law represents a highly progressive policy change.)

Both the BPC and Bowles-Simpson proposals are also sensitive to the distribution of cuts to the entitlement programs, suggesting changes that would guarantee benefits to low-income households while relying on greater “means testing” to reduce benefits relatively more for higher-income households.

I’m sure I’ll have more to say about the BPC proposals as I see more data and have more time to digest and compare with the Bowles-Simpson proposals as well as other proposals that the President’s (full) commission may end up considering. So please stay tuned.

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