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Guns, Butter and Retired Boomers: How Do We Pay for It All?
Wall Street Journal Online
November 29, 2005

This is the first of three online debates that will look at some of the biggest issues weighing on American public policy. The federal budget deficit is the topic of this first installment. Joining the debate are Robert B. Reich, who was secretary of labor in the Clinton administration, and R. Glenn Hubbard, who served as chairman of the Council of Economic Advisers for two years under President Bush. The debate will be moderated by David Wessel, the Journal's deputy bureau chief in Washington.

MR. WESSEL begins the debate: Has the federal government bitten off more than it can chew by reducing tax rates at the beginning of President Bush's term and subsequently -- despite the costs of responding to 9-11, fighting the war in Iraq, rescuing and repairing New Orleans and environs and expanding Medicare to cover prescription drugs? Is current fiscal policy sustainable for the next three to five years, or is a major shift required?

MR. HUBBARD writes: The U.S. economy, with its strong underlying rate of productivity growth is in excellent shape, and it can absorb the tax changes, military and homeland security changes, and disaster relief. Two points are in order, though: More restraint is needed to ensure that domestic spending growth does not continue, and tax reform is needed to codify pro-growth policy that can raise the revenue required to fund the federal government.

The problem is not the next three or even five years; the problem is the long-run fiscal picture. For example, the nonpartisan Congressional Budget Office tells us that in a generation, if we make no changes, we will spend about 10 percentage points of GDP more on Social Security and Medicare than we do today. To frame that, the Bush tax cuts amount to about 1 percent of GDP. And, to pay for this with tax increases would require raising taxes by about 50 percent across the board, crowding out economic growth. (Indeed, estimates from studies of tax policy and economic growth suggest that a tax increase of this magnitude would force us to give back the entire growth dividend we have received from the recent productivity boom.)

Having said this, the Medicare expansion without substantial reform of the system was unwise fiscal policy. The current Social Security and Medicare systems are on an unsustainable path. In both cases, sound fiscal reform should involve slower benefit growth for high-income households. In addition, fiscal reform for Medicare must be accompanied by reform of health-care markets.

The bottom line issue is less guns v. butter today (the next three to five years) than whether the butter will crowd out guns tomorrow (think the fiscal situations of continental Europe today) or indeed whether the butter itself will be affordable on the same terms tomorrow.

MR. REICH writes: Undoubtedly yes. But we should distinguish between deficits that occur when the economy has lots of unused capacity -- which was the case in the first two years of the Bush term -- and deficits that become part of the long-term structure of the federal budget. If the tax cuts and spending increases that occurred at the start of the administration were temporary and stayed temporary, there'd be little to complain about. In fact, they might have helped get the American economy moving. But the administration wants to make the tax cuts permanent. And much of its new spending -- especially on national defense, homeland security, and Medicare prescription drugs, will go on for years. The drug benefit is a new entitlement. This isn't sustainable over the long haul and I don't think it's sustainable even over the next five years.

While we're at it, let me make one additional distinction often left out of debates about the federal budget. There's a vast difference between tax cuts and spending increases that merely add to the nation's overall consumption, and tax cuts and spending increases that add to the nation's productive capacity. Most spending on education, basic research and development, the health care of our children, and infrastructure, for example, builds the nation's capacity to be productive in the future -- as long as it's well targeted. This kind of spending makes enormous sense. By contrast, it makes no sense for the House of Representatives to cut student loans, for example, while extending tax cuts that mostly benefit the wealthy and have shown to have nothing to do with improving long-term productivity.

MR. HUBBARD writes: I agree wholeheartedly with Bob that dividing the timeline of fiscal worries into two parts -- short-run and long-run is important. I also agree that we must distinguish between running deficits when the economy is not at full employment versus when it is (read now).

Tax cuts that add to the nation's productive capacity include reductions in the tax burden on saving and investment and reductions in marginal tax rates on entrepreneurial activity. Recent tax cuts have accomplished these, but added other tax cuts with much smaller effects on economic growth. The near-term tax debate should be about tax reform so that we can maximize the opportunity for pro-growth policy.

On the spending side, a strong case can be made for continued basic research support and support for individualized training programs. What often goes under the heading of investment -- highways, for example -- is a tougher case to make from an economic perspective.

Where Bob and I disagree regards his characterization of "tax cuts that mostly benefit the wealthy." Reductions in the taxation of saving and investment show up in current tax distribution analysis as benefiting savers -- generally well-to-do savers. Yet, over the long run, those tax changes raise capital accumulation, productivity, and wages. Economists generally believe that the best tax rate on capital income is zero (though there are some quite well respected economists who believe it should be negative!). It is hard to imagine what tax changes Bob has in mind that would add more to the nation's productive capacity.

MR. REICH writes: I'm not adverse to tax cuts on savings and investment, but in my view the growth we get from such tax cuts is far less than the growth we get from well-targeted public investments in education at all levels, on health care (especially for our young), infrastructure, and basic research and development. Relative to our needs, the nation is woefully behind in all these domains of public investment.

On the other hand, we're hardly suffering from a scarcity of financial capital. Indeed, the world seems to be enjoying something of a glut of it. Over the long term, capital flows to places around the world where it can get the highest return -- either because production is very inexpensive there, or because of natural resources located there, or (and here's where our future should come in) because people there are enormously productive. And they're productive because they have high skills, good health, good infrastructure linking them together, and an excellent scientific base from which to draw.

Obviously, we can't do it all. We can't extend the tax cuts and at the same time carry out all the public investments that are necessary -- while at the same time we fight wars in Iraq and Afghanistan, build up homeland security, give the middle class some relief from the Alternative Minimum Tax, and dole out Medicare drug benefits (not to mention the rest of Medicare) to early boomers. Deficits do matter, and choices do have to be made.

I'm skeptical of claims that continued tax cuts on capital gains and dividends have such a hugely positive effect on the economy that these should get priority of place in those choices. This recovery, for example, is weaker than the average post-World War II recovery, the 2001 and 2003 tax cuts notwithstanding. Indeed, those tax cuts appear to have been a major cause of our current budget deficit. So I see no reason to extend them. According to the Joint Committee on Taxation, the proposed 2-year extension of capital gains and dividend tax cuts would reduce revenues by $51 billion between 2006 and 2015. (Of course, if made permanent, much more.)

MR. WESSEL, Moderator, asks: On taxes, do either of you believe that a significant tax increase is either wise or inevitable either in President Bush's term or in the first term of his predecessor? If so, what tax and on whom?

And on spending, what one or two things would you have the government spend more -- a lot more -- on? And what one or two things would have the government spend less -- a lot less -- on?

MR. REICH writes: The president's former Secretary of the Treasury, Paul O'Neill, wrote that the White House's prevailing orthodoxy when he served seemed to be that "deficits don't matter." Apparently that's still the philosophy. I don't anticipate any concerted move by this administration to tame the deficit by proposing to Congress realistic spending cuts or tax increases unless bond markets get so rattled by the size of pending deficits that the White House is forced to come up with something. The best we can hope for is that a coalition of fiscally-responsible Republicans and Democrats on the Hill refuse to extend the temporary tax cuts of 2001 and 2003. That will still leave a fiscal mess for the president's successor, who will have to attack several things right away, starting with the ballooning costs of Medicare.

What would I have the government spend more on, notwithstanding the above? Early-childhood education. The evidence is clear and compelling that these expenditures provide very large social returns, in terms of young people who subsequently finish high school, avoid teenage pregnancy, stay out of trouble with the law, and assume productive roles in society. I'd also have the government spend more on K through 12 in poor communities where classrooms now often contain 28 or more kids, are inadequately equipped, and are run by teachers without adequate training. I'd even be in favor of a progressive voucher system, where the amount of the voucher was inversely related to family income (I've proposed such a plan on the Journal's editorial page).

What spending to cut? Start with subsidies and tax breaks directed to specific companies and industries -- what's now commonly termed "corporate welfare." Depending on whose estimate you believe, it now runs between $60 billion and $120 billion annually. Last summer's energy bill was a cornucopia for the oil companies, for example. Why do they need it when their profits are soaring? Also, get rid of all earmarked spending on specific projects. It's pork. Look at the disgrace of last summer's highway bill if you want to see how irresponsible and wasteful such spending can be. We need a capital budget that establishes clear priorities for infrastructure spending. Medicare savings are possible by using case management techniques to focus on the relatively small percent of beneficiaries who are responsible for most of the costs. I'd also amend the new Medicare drug benefit to allow the government to use its huge bargaining power with pharmaceutical companies to push down costs.

MR. HUBBARD writes: Let me echo Bob's call for a reduction in corporate subsidies and earmarked spending projects.

With due respect to Paul O'Neill, I never heard anything like "deficits don't matter" from administration officials, and certainly never from the President. At the same time, I think the administration is missing an important opportunity to talk with the American people about the enormous looming entitlement liabilities and the large implicit flow deficits (larger than the official deficit) that go with them. If we cannot bring these deficits (which conventional spending restraint and economic growth will not control) under control, we will have to raise taxes, with significant adverse consequences for economic growth.

I do not believe that a significant tax increase is wise or inevitable. In the context of my earlier remarks, I say this because I believe we should and will scale back the growth in the entitlement programs that are the clear and present fiscal danger.

I would like to see the government spend more on basic research and on training (because our employment policies are outdated) -- but these $$$ are not large in the context of the overall federal budget. While the discretionary budget offers opportunities for reductions, the real area for spending restraint is the entitlement programs.

Re: Bob's second reply: Blanket spending increases on health care, infrastructure, and education strike me as unwise. Our goal for health care should be to improve value -- this will require energizing markets (tax reform, insurance reform, Medicare administrative reform, litigation reform, and competition policy reform) before rethinking spending. The evidence on the effectiveness of infrastructure spending is, to put it mildly, mixed, as the evidence of CBO Doug Holtz-Eakin's work shows. Even with education, higher education in the US remains the envy of the world, while primary and secondary education lag; structural reform is a bigger deal here than a cry for more money.

There is substantial economic evidence that capital income taxes retard economic growth. Alan Auerbach and others have concluded, for example, that fundamental tax reform could raise household incomes by 9%.

MR. REICH writes: I'm not suggesting "blanket spending increases" on health care, infrastructure and education. To the contrary, I'm urging more and better-targeted spending in these vital areas. I've mentioned early childhood education and, for K-12, progressive vouchers whose value is inversely related to family income. We need a capital budget for infrastructure spending. As to health care, I'd recommend that the federal employee's health insurance system be made broadly accessible and affordable to all small businesses wishing to enroll their employees -- thereby giving the federal system far more bargaining leverage with providers and drug manufacturers, while at the same time enrolling a large portion of Americans currently without health care. This would be a first step toward a single-payer system.

As to entitlement spending, and contrary to what we've heard from the White House, Social Security isn't the biggest entitlement problem. It's Medicare. If nothing is done to constrain Medicare's costs, in two decades spending on it will surpass spending on Social Security. The reason Medicare spending is rising so quickly -- apart from the aging of the population -- is double-digit increases in annual health-care expenditures across the economy. So the key to containing Medicare is streamlining our whole health-care system. That's a big enough topic for a discussion all its own.

MR. HUBBARD writes: I couldn't agree with you more on Medicare being the more significant problem and that reform of health care markets is central. (Oprah moment:  John Cogan, Dan Kessler, and I offer a route to doing so in our new book "Healthy, Wealthy and Wise.")

So here we have it - the conservative argument for increasing deficits and debt with tax cuts and passing that debt to the next generation.

In less than five years Bush has created 2.3 trillion of debt or more debt than was created from 1789 - 1987. Conservatives live in a world of make-believe theories that have continually been proven false. If they had been right, the tax cuts would have been paid for with surpluses, but when the surpluses didn't happen they continued to cut taxes. The conservative mind seems incapable of dealing in fact based reality.

No solution is possible now after they've saddled the next generation with massive debt. Since the Reagan tax cut, we went from less than one trillion dollars of debt of over eight trillion. The conservative looks to the future but ignores what his party has done in the past. Until they accept their failed policies and accept responsibility for them, they should be ignored on all the other issues.

Btw, don't forget the GOP under Bush passed a massive new prescription drug plan and didn't put in place a mechanism to pay for it. Any fool can spend money they don't have. The tough part is paying for what they spend. Since the GOP is clueless how to pay our bills, they should be ignored.