The Three Choices for Tax Reform

The Three Choices for Tax Reform

September 13, 2017

Trump administration officials and GOP leaders in Congress are still putting together their tax plan. Nevertheless, the early signs point to decisions that could sink the project or produce changes that would jeopardize economic growth.

Congress can approach changing the corporate tax in one of three ways. It can try to simplify the code, it can reform it, or it can cut it back. The GOP’s current approach appears to start with simplification. Simplifying the corporate tax normally means phasing out a package of tax preferences for particular industries or business activities, and using the revenues to bring down the current 35 percent tax rate to 28, 25 or even 20 percent. This model shifts the burden of the tax among industries but not among income groups, since shareholders continue to bear most of the burden. Such simplification can also attract bipartisan support and produce real economic benefits. At a minimum, it lowers tax compliance costs for most businesses; and if it’s done thoughtfully, it can increase economic efficiency. To be sure, any efficiency benefits will be marginal unless the simplifications are fairly broad and sweeping.

The record also shows that serious tax simplification is very hard to achieve. Support from President Obama and congressional GOP leaders wasn’t enough to advance it in 2014, for the simple reason that most companies prefer their tax preferences to a lower tax rate. They’re not wrong economically: The Treasury calculated in 2016 that tax preferences lower the average effective corporate tax rate to 22 percent, and companies in many industries pay substantially less. Why give up those preferences for a 28 or 25 percent rate? A 20 percent rate could solve the problem for most industries, if anyone had a plausible way to pay for it. Of course, financing a deep rate cut was the border adjustment tax promoted by Speaker Paul Ryan, and which the White House and big importers and retailers quickly squashed.

The second option is genuine reform, where Congress changes the structure of the corporate tax. Economically, the most promising reform would give U.S. companies a choice of tax treatments when they invest in equipment. They could deduct the full cost of those investments in the year they make them (“expensing”) while giving up the current deduction for interest on funds borrowed to finance the investments. Or they could stick with the current depreciation system for their investments, including the deduction for interest costs. If enough companies choose the first route, as they likely would, this reform would spur investment and sharply reduce the tax code’s nonsensical bias towards financing business growth with debt rather than equity. Such a structural reform would make sound economic sense. It also seems as unlikely as serious simplification, because it foregoes the pixie dust of marginal tax rate cuts that GOP supply-siders demand.

That leaves the Trump administration and Republican leaders with option three: Cut the corporate tax rate without paying for it. The President seems to favor this approach. He has called repeatedly for slashing the corporate rate to 15 percent, a multi-trillion dollar change, and paying for a small piece of it by limiting a few personal tax deductions for higher-income people. It’s also catnip for GOP supply-siders who continue to proclaim that a deep rate cut will boost economic growth enough to pay for itself. We’ve tried this t several times already, so we now have hard evidence to evaluate those claims. The actual record shows, beyond question, that such turbo-charged dynamic effects do not occur. The most recent example is George W. Bush’s 2001 personal income tax cuts. His “success” enacting them produced huge deficits and ultimately contributed to the financial collapse that closed down his presidency.

A largely-unfunded cut in the corporate tax rate in 2018 would boost corporate profits as well as budget deficits, but it won’t increase business investment, productivity or employment. Prime interest rates in this period have been lower than at any time since the 1950s, so companies have had easy and cheap access to funds for investment for years. At a minimum, this tells us that there’s no real economic basis to expect businesses to use their windfall profits from a big tax cut to expand investment.

Instead, they’re likely to use some of their additional profits to fund stock buy-backs. The rest will flow through as dividends and capital gains, mainly for the top one percent of Americans who hold 49.8 percent of stock in public companies, and the next nine percent who own another 41.2 percent of all shares. Those lucky shareholders will use much of their windfall gains to buy more stock; and coupled with the corporate stock buy-backs, the boost in demand for stocks will pump up the markets. To be sure, those shareholders will also spend some of their unexpected gains, which will modestly stimulate growth. Once that stimulus dissipates, as it will fairly quickly, the ballooning budget deficits will drive up interest rates and slow the economy for everyone else.

The worst scenario is that large, deficit-be-damned cuts in the corporate tax rate could produce a stock market bubble that could take down the economy when it bursts. The good news is that the current Congress would never enact it. The odds of Democrats supporting Donald Trump on a tax plan to make shareholders richer are roughly the same as winning the Powerball; and the certainty of soaring budget deficits should scare off enough conservative Republicans to sink the enterprise.



It’s Still the Economy, Stupid!

July 24, 2017

Republicans know that the terrain for next year’s midterm elections could be treacherous.  Off the record, they bemoan their inability to enact their agenda and mourn President Donald Trump’s unpopularity.  In principle, the GOP still might get its act together and pass a tax reform with new tax breaks for middle class taxpayers.  Events unforeseen and unimagined could offer Trump a platform to renew his poplar appeal.  Even so, they’re ignoring the signs that a sagging economy next year will dominate the 2018 campaigns.

The current expansion is old – it turned eight years old this month – and its fundamentals are weak.  Neither Trump nor Congress has done anything to perk it up.  Only the 1990s expansion lasted longer, and it expired two years after its eighth birthday.  Comparing the two will not cheer Republicans. At a comparable point in the expansion that defined the Clinton era, March 1999, GDP was growing at nearly a 5 percent rate; over the last year, GDP has edged up barely 2 percent.

The most important difference is what was happening then with productivity, and what’s happening now.  In the three years leading up to each expansion’s eighth birthday, productivity had expanded at a 2.4 percent annual rate in the 1990s, compared to 0.7 percent this time.  Without decent productivity gains to lift wages and fuel demand, incomes stall and growth slows.

The main reason we’re not in a recession today is the strong job gains of the last three years, and the current 4.4 percent unemployment rate is comparable to the 4.2 percent rate in March 1999.   Full employment normally presages a slowdown in job creation.  We avoided that in the late 1990s, because the strong productivity growth supported more demand by raising wages.    The best measure of that is personal consumption spending, which increased at a 5.9 percent rate in the year leading up to March 1999.  But our current predicament includes such weak productivity gains that personal consumption spending edged up just 2.6 percent over the last year.

It’s the same story with business investment, the other domestic source of new demand. In the year preceding the eighth birthday of the 1990s expansion, fixed business investment rose 8.5 percent; over the past year, it grew 4.2 percent or half that rate.

All of these measures presage a slowdown in the U.S. economy next year – GDP gains of 1.5 percent in 2018 is a fair guess — and we could slip into a recession if some adverse event provides the trigger.

Last October, I cautioned Hillary Clinton that she would face these same conditions if she won, but that three initiatives could breathe new life into this old expansion.  The first order of business is a dose of demand stimulus, preferably through large infrastructure investments paid for down the line.  Trump promised the same thing; but he and the GOP Congress moved quickly beyond it.

The second initiative would focus on energizing productivity growth.  My own recommendations last October started with measures to help average Americans upgrade their skills, by giving them free access to training courses at local community colleges.  The Trump and GOP budget proposals would cut the inadequate training programs already in place.

The third initiative is a companion piece to promote higher productivity: Jumpstart business investment in new technologies and equipment.  That will be harder for Trump than it would have been for Secretary Clinton, because it requires setting aside the supply-siders’ faith in the power of cutting marginal corporate tax rates.  Instead, we should focus for now on lowering businesses’ upfront costs to purchase the new technologies and equipment that make skilled workers even more productive.

The measure would offer businesses a choice: deduct the full cost of those new purchases in the year they buy them – it’s called “expensing” – or stick with the current system where businesses depreciate the cost and deduct the interest on funds borrowed to cover it. Expensing is a feature of the Trump and GOP tax proposals, but both plans offer more sweeping and much more expensive changes that appear headed for the same fate as Trumpcare.

The election of Trump and the GOP Congress buoyed business confidence precisely because investors believed they would follow through quickly with an infrastructure stimulus and business tax reforms.  Neither seems likely today; and even if one or the other somehow passes in some form late this year, it will probably be too little and too late to revive growth and wages by November 2018.  If neither happens, it will take more than tweets to explain to voters why Republican control of both branches of government has failed to improve their lives.



Trump’s Tax Plan is Aimed at the 2018 and 2020 Elections, Not U.S. Competitiveness

April 26, 2017

President Trump wants to cut the tax rate for all American businesses to 15 percent, and damn the deficit. If you believe him, any damage from higher deficits will be minor compared to the benefits for US competitiveness, economic efficiency, and tax fairness. The truth is, those claims are nonsense; and the real agenda here is the 2018 and 2020 elections. Without substantial new stimulus, the GOP will likely face voters in 2018 with a very weak economy – and tax cuts, especially for business, are the only form of stimulus most Republicans will tolerate. Moreover, if everything falls into place, just right, deep tax cuts for businesses could spur enough additional capital spending to help Trump survive the 2020 election.

Let’s review the economic case for major tax relief for American companies. It’s undeniable that the current corporate tax is inefficient – but does it actually make U.S. businesses less competitive? The truth fact is, there’s no evidence of any such effects. In fact, the post-tax returns on business investments are higher in the United States than in any advanced country except Australia, and the productivity of U.S. businesses is also higher here than in any advanced country except Norway and Luxembourg.

The critics are right that the 35 percent marginal tax rate on corporate profits is higher than in most countries. But as the data on comparative post-tax returns suggest, that marginal tax rate has less impact on investment and jobs than the “effective tax rate,” which is the actual percentage of net profits that businesses pay. On that score, the GAO reports that U.S. businesses pay an average effective tax rate of just 14 percent, which tells us that U.S. businesses get to use special provisions that protect 60 percent of their profits from tax (14 percent = 40 percent of 35 percent).

Tax experts are certainly correct that a corporate tax plan that closed special provisions and used the additional revenues to lower the 35 percent tax rate would make the overall economy a little more efficient. But lowering the rate alone while leaving most of those provisions in place would have almost no impact on the economy’s efficiency – and the political point of Trump’s plan depends on not paying to lower the tax rate.

Finally, would a 15 percent tax rate on hundreds of billions of dollars in business profits help most Americans, as the White House insists, since 52 percent of us own stock in U.S. corporations directly or through mutual funds? The data show that most shareholders would gain very little, because with 91 percent of all U.S. stock held by the top 10 percent, most shareholders own very little stock.

Moreover, the proposed 15 percent tax rate would cover not only public corporations but also all privately-held businesses whose profits are currently taxed at the personal tax rate of their owners. So, Trump’s plan would slash taxes not only for public corporations from Goldman Sachs to McDonald’s, but also for every partnership of doctors or lawyers, every hedge fund and private equity fund, and every huge family business from Koch Industries and Bechtel, to the Trump Organization..

There is no doubt that the President’s tax plan would provide enormous windfalls for the richest people in the country. Beyond that, it may or may not sustain growth through the next two elections, since even the best conservative economists commonly overstate the benefits of cutting tax rates. But the truth is, there aren’t many other options that a Republican Congress would accept.

 



The President’s Budget and the Case for Moving Beyond Austerity

April 10, 2013

The President released his FY 2014 budget today, and right off, it makes more economic sense than most of what passes for serious fiscal discussion in DC. In particular, it offers up new public investments, uses revenues and entitlement changes to restore long-term fiscal sanity, and phases in those changes down the road when the economy (hopefully) is stronger. Apart from Fed policy, the budget is government’s most powerful tool for affecting economic growth. So, the critical economic question is what budget approach would most effectively boost U.S. growth, for both the near-term and longer. The best answer for now is a plan built around an ambitious public investment agenda, serious measures to broaden the tax base and pare entitlement benefits for well-to-do retirees, and reform that finally resolve the festering issues left over from the 2008-2009 financial meltdown.

To appreciate why continued austerity would be economically reckless, just review the economic data from 2012. Yes, the United States grew faster than almost any other advanced economy. But that’s only because the Eurozone has been back in recession, France and Britain treaded water at 0.1 percent and 0.2 percent growth, and Germany grew less than 1 percent. Even in Northern Europe, Denmark contracted and Sweden expanded just 1.2 percent. So, the United States looked good with 2.2 percent growth — although only 0.4 percent in the final quarter of 2012 — in-between Canada’s 1.9 percent rate and Australia with 3.3 percent growth.

With such dismal growth, here and across the developed world, the budget’s first mission should be to strengthen it. There is no economic basis for any short-term spending cuts or tax increases, especially on top of the continuing, mindless sequester. To be sure, under very special conditions, austerity can stimulate economic activity in a weak economy — namely, when high inflationary expectations drive up interest rates, constraining investment and consumption. But those conditions have nothing to do with our current economy since interest rates here and across the advanced world are at or near record lows. The case for austerity, then, is simply politics, and the continuing calls from conservatives to slash federal programs merely mask their fervid preference for a small, weak government.

Economics matters more in this debate, and progressives should use our slow growth to promote an expanded agenda for public investment. They could call on Congress to dedicate an additional one percent of GDP to investments that will strengthen the factors that drive growth. That could mean, for example, more support for reforms to improve secondary education, reduce financial barriers to higher education, and provide retraining for any adult worker who wants it. It also could mean renewed public support to develop light rail systems across metropolitan areas and improve roads, ports and airports. This is also the right time economically for Washington to more actively promote the frontiers of technological innovation by expanding support for basic research. Finally, let’s review federal regulation with the aim of lowering barriers to new business formation. New and young businesses are reliable sources of new jobs and greater competition. Those elements, in turn, stimulate higher business investment, particularly in new technologies.

Progressives also would be well advised to accept long-term entitlement reforms that could accompany the new public investments. Since Social Security provides at least 90 percent of the income of more than one-third of retirees, pension reforms should focus on some form of means-testing. The best template to contain healthcare spending is more elusive. The Affordable Care Act includes a half-dozen measures calculated to slow rates of health spending. So, a bipartisan effort to strengthen those measures, perhaps with malpractice reforms to entice conservatives, would be a good place to start.

These initiatives, by themselves, still won’t be enough. Economic history teaches us — if only we’d listen — that the recovery that follows a financial crisis is always slow and bumpy, unless policymakers directly resolve the distortions that brought about the crisis. Many of those distortions in finance and housing linger on. In finance, the challenge is to get financial institutions to divest themselves of their remaining toxic assets and, equally important, further limit the impulse of these institutions to speculate in exotic financial instruments that remain only lightly regulated, like a hedge fund. The political resistance will be daunting, of course. But the economics is clear: Until such changes occur, Wall Street will not focus sufficient resources towards supporting home-grown business investment.

The challenge in housing is as difficult politically, though technically less complicated. Across the nation’s five largest mortgage holders, almost 12 percent of all mortgages were in serious trouble at the close of last year. Some 6.5 percent of all mortgages were delinquent, another 1.6 percent of them were in bankruptcy proceedings, and 3.6 percent were in foreclosure. So long as these rates are abnormally high, especially foreclosures, housing values will be weak — and the primary asset of most U.S. households will languish. Even worse, a weak housing market consigns most homeowners to stagnate economically or even grow steadily poorer; and that means they will consume less and the recovery will continue to be stunted. One sensible approach would be a new federal program to help people avoid home foreclosures through government bridge loans — like student loans — made available until the job market recovers.

This year’s budget debate will probably follow a now-familiar and sterile course, in which the President offers his plan, which is promptly met with partisan invective, followed by personal attacks from all sides. For average Americans to see their economic prospects really improve, progressives will have to forgo the partisan fights and instead use the Obama proposal to start a new public conversation, one focused on the challenges and changes necessary to get this economy back on track.



The Quiet Role of Class in the Coming Budget Battle

December 2, 2010

The political struggle over how the federal budget will shape American government is now in full swing and likely to dominate Washington for the next two years. This week, the President joined the battle by proposing a two-year freeze on federal pay, his symbolic version of Bill Clinton’s maxim that “the era of big government is over.” In doing so, he aligns himself with growing public skepticism about the value of much of what Washington does. Yet, the anger driving the public debate isn’t really about federal spending much less federal pay. It’s about continuing high unemployment and stagnating incomes, because if Washington can’t get that right, what credibility does it have to manage everything else the public pays for? 

There’s another, more subliminal factor feeding the public’s anger about taxes and spending, and the only accurate term for it is economic class. Most Americans are fine with rich people getting richer, even when they get richer faster than everyone else — as long as the rest of us make progress too. But that’s clearly and painfully not the case today — the stock market and corporate profits are way up and multi-million-dollar Wall Street bonuses are back; while high unemployment won’t budge, wages are down, and the value of most people’s homes keep falling. On top of that, it was middle-class Americans who financed a recovery, through taxpayer bailouts and emergency spending, which so far seems to benefit only the wealthy. These factors alone should give Republicans pause as they prepare to block the extension of unemployment benefits and hold tax cuts for the middle-class hostage to preserving the tax cuts for the well-to-do.

The bigger political question is how most Americans would feel about the GOP’s hard-line positions, if they realized how much the economy in recent years has tilted to favor the wealthy. Recent data from the Federal Reserve document this tilt. In 2007, for example, the top one percent of Americans owned about 35 percent of all of this country’s assets or wealth — including houses, stocks, bonds, businesses, and so on — and the top 10 percent owned 70 percent of those assets.

The distribution of financial assets is even more skewed: In 2007, the top one percent owned 43 percent of the total value of all bank accounts, stocks and bonds, business equity, mutual funds, pensions, and retirement savings; and the top 20 percent of Americans owned an astonishing 93 percent. Ownership of only one type of asset is still spread around fairly broadly: With 70 percent of Americans being homeowners, the bottom 90 percent owned 40 percent of the total value of all residential real estate in 2007. But that fact is no longer evidence for the conservative trope that good times for the wealthy presage good news for everyone else: Since 2007, the housing bust has destroyed about 30 percent of the value of American homes, and it was triggered by Wall Street geniuses who took the taxpayer bailouts and now are pocketing multi-million dollar bonuses.

The tilt towards the wealthy is also much less steep in most other societies. While the top 10 percent of Americans own 70 percent of this country’s wealth and assets, the top 10 percent of Britons own only 56 percent of the wealth of their nation, the top 10 percent of Canadians own just 53 percent of their country’s assets, and the top 10 percent of Germans hold but 44 percent of the assets of their nation.  

The gap in incomes also has grown substantially over the last generation, and that suggests that the wealth disparities will only continue to increase. From 1982 to 2006, for example, the share of all annual income claimed by the top one percent of Americans increased from 13 percent to more than 21 percent; and the top 20 percent of us took home more than 61 percent of all the income earned here in 2006. Put another way, 80 percent of Americans have to divvy up about 38 percent of all the income generated in our economy. To be sure, a modestly progressive tax system ensures that the top one percent and the top 20 percent both contribute slightly larger shares of all federal revenues than they collect as income. But their share of federal revenues is also much smaller than their fast-growing share of the nation’s wealth.

These disparities have grown not from our politics, but from the way the economy is evolving. For example, our economy is increasingly capital-intensive — just consider, for example, how much more technology-dense most offices and workplaces are today, compared to just 20 years ago. Since capital is the source of more wealth creation than before, the wealth of those who own most of it has been growing faster. Incomes also are linked closely to the ability to work with all of that capital, increasing the income share of the top 20 percent of Americans with the most advanced skills and education. It is certainly not the burden or responsibility of government to alter the economy’s natural course. But when that course precludes meaningful economic progress for most people and creates profoundly undemocratic disparities in wealth and incomes, it surely becomes the government’s responsibility to ensure that the majority can genuinely thrive in that economy.

That’s a budget battle that President Obama could champion with confidence. For example, a good handful of subsidies for various industries would pay for low-cost access to college and graduate training for any young American with the drive and ability to see it through — as Britain, Germany and other countries, all with much smaller disparities of wealth and incomes, do. A small tax on financial transactions could float a new program of low-cost loans for homeowners with troubled mortgages, and so help stabilize the housing values that comprise the only asset of most Americans. Even a modest reform of the “carried interest” tax preference for hedge funds and private equity funds could more than pay for grants to community colleges to provide free computer training for any working person who wants it. And surely it’s time for the new realities of wealth and incomes in the United States to provide part of the framework for reforming our taxes and entitlements.



Lesson in Economics for the National Deficit Commission

October 27, 2010

The French statesman Georges Clemenceau famously called war “too serious a matter to entrust to military men”; and in the same spirit, national budgets in a democracy are too important to leave to economists.  But no sensible government would wage war without listening to generals and admirals, and the National Commission on Fiscal Responsibility and Reform — aka the National Deficit Commission — would be equally well served to consider basic economics more carefully.  This week’s leaks from the Commission include reports that its members are leaning towards cutting back the deductions for mortgage interest and employer health insurance payments.  This approach could certainly raise a lot of money in the short run.  But for an economy suffering as ours is from weak demand, a fragile housing market, and a decade of slow hiring and income gains, these proposals are economically illiterate.

Listen up, National Deficit Commission.  This is the wrong time — maybe the worst time — to target the mortgage deduction.  Falling housing values have been the single largest force holding down consumer demand, and with it investment and growth, because their decline leaves the 70 percent of Americans who own their homes poorer.  That has created a classical, negative wealth effect which dampens spending.  On top of that, these falling housing values sharply raise the ratio of most people’s debts to their assets, moving most people to reduce their debt.  And that has meant fewer large purchases and less credit-card buying.

Cutting the mortgage interest deduction would only intensify these dynamics, because the value of that deduction is incorporated or “capitalized” in housing prices.  When prospective home buyers try to figure out whether they can afford the monthly payments on a particular house, they naturally factor in the value of the deduction.  Buyers are willing to pay more than they would without the deduction — and sellers demand more than they could without it.  Reduce the deduction, and buyers will be able to afford less, sellers will have to accept less, and housing values will fall further.

There are reasonable arguments for paring back this deduction, since it channels so much investment into housing.  Of course, that’s its explicit intention, so home ownership can be part of the American dream.  And yes, a smaller deduction would raise considerable revenues.  But doing it would inescapably further drive down housing values, and doing it now could lock in years more of slow economic growth.

This is an equally ill-timed moment to cut back the deduction for employer-provided healthcare insurance.  Once again, there are reasonable arguments for rethinking this deduction, but shrinking the deficit under current conditions isn’t one of them.  Limit this deduction for employers, and hiring costs will go up at a time when job creation is already historically weak.  Worse, the change would raise the cost of retaining people working today, creating new pressures for more layoffs.  The Commission may be talking about taxing workers, not businesses, on some share of the value of their employer-provided health insurance.  That seems no more sensible economically at this time, since it would reduce most people’s after-tax incomes at a time when their consumer spending is historically weak. 

The truth is, this is not the time for any short-term deficit reduction.  We tried fiscal tightening in 1937, at the early signs of recovery from the Great Depression, and it bought us four more years of slow or negative growth.  Japan tried it too in the mid-1990s, during the early stages of their recovery from a financial meltdown, and it set off another half-decade of economic stagnation.  Now Britain’s new conservative-coalition government is trying budget austerity, and the results almost certainly will be similar. 

Yet, it also would be foolish for the Commission to squander this rare public support for deficit reduction, so long as its members focus on the long term and consider the economic fallout from their various brainstorms.  The place to begin is with the two forces driving the long-term deficits — prospective, fast-rising entitlement spending, and taxes that raise sufficient revenues only when the economy booms.  On the spending side, Social Security could be the relatively easy part, because its budget gap remains comparatively small for many years — if Americans are prepared to accept smaller benefits down the line.  Experts figure, for example, that we could close one-third of that gap by using the CPI for the elderly, rather than the higher overall CPI, to calculate future cost-of-living adjustments.  And much of the rest of the problem would fade away if we tied the annual increase in people’s initial benefit to a combination of wage gains and inflation, rather than just wage gains.   

The harder part involves Medicare and Medicaid costs.  As with Social Security, the main difficulty lies not in figuring out how one could slow annual cost increases in health care, but rather in marshalling majority support for such measures.  In fact, the President’s health care reform already included a catalogue of approaches to slow the growth of medical costs, albeit on a limited scale or in weak form.  The Commission could urge Congress to scale up and strengthen those measures.  If those reforms work, they not only would generate large budget savings down the line.  The same approaches also would support jobs and incomes, since fast-rising health care costs have significantly slowed job creation and wage progress.

The Commission purportedly has agreed to use additional revenues to close one-third of the long-term deficit.  Assuming that additional taxes would go into effect only once the economy fully recovers, higher taxes for wealthy Americans would raise revenues without severely damaging demand, since they don’t spend nearly all that they earn.  The same idea could even be applied to industries which, by economy-wide standards, earn abnormally high profits.  By this measure, the leading candidate is finance.  A small tax on financial transactions, for example, would raise substantial revenues for the deficit with little adverse effect on the overall economy if other advanced countries follow suit — and Germany, France and the United Kingdom all have indicated interest.

And if the Commission wants to tackle broader tax reform, the top candidate should be a carbon-based fee on energy.  A tax on greenhouse gas emissions not only would restore U.S. leadership on climate change.  It also could turbo-charge the development and deployment of green fuels and technologies, a potential source of exports; and reduce our dependence on foreign oil and the consequent distortions in our foreign policy.  And if Congress set a carbon tax high enough to sharply reduce CO2 emissions, a good share of the revenues could go to reduce payroll taxes, spurring job creation and income gains. 

These approaches may not satisfy the balance-the-budget-at-all-costs crowd.  But sound deficit reduction requires a larger economic frame.  At a time of serious economic stress and frustration, the National Deficit Commission should embrace real economic thinking.



Why the Value of Your House Moved Global Markets This Week

August 26, 2010

This week’s housing news was a primer on globalization. U.S. existing home sales fell 27 percent in July, twice as sharp a drop as Wall Street analysts said to expect. (Of course, they’re the same geniuses who didn’t see their own meltdown coming; didn’t expect the long, deep recession that followed; and couldn’t figure out that the recovery would be slow and halting.) Right away, our stock markets sunk by one to two percent — no surprise there — but we weren’t alone. On Wednesday morning, the financial news led with “European Stocks Drop on Dismal U.S. Home Sales Data” and “Most (Asian) Stocks Fall Amid Speculation on U.S. Home Sales Report.”

Why does a bad report on American home sales rattle investors a half-world away? To be sure, housing is an important piece of every U.S. recovery. And the world pays close attention to ours, since we remain by far both the world’s largest market for imports and the place where most foreign multinationals maintain their subsidiaries. This time, however, there’s more at stake. Housing is both a lynchpin for a full recovery from the financial crisis that pushed most of the world to the brink of depression; and the key to something better than our current stumbling expansion.

The link to finance is straightforward. Everybody remembers how Wall Street’s largest institutions swooned or crashed when the end of the housing bubble brought down hundreds of billions of dollars in mortgage-backed securities and the credit default swaps that backed them up. But when Washington stepped in to rescue most of them, it took out its own risky bet that a housing recovery would quickly stop the bleeding. So we never seriously considered what Sweden did so successfully in the early 1990s — and what we did ourselves to resolve the S&L crisis: Take over an insolvent Bear Stearns, AIG or Merrill Lynch, pull out the weak and failed assets, and sell the still-healthy stuff to new investors who would promptly reopen the institution under a new name. And the bailouts didn’t even require that these institutions put their books back in order by getting rid of the most risky housing-based assets which they still held.

The catch is that if the housing market continued to deteriorate — as it did — more of those assets would decline in value or fail outright. Those losses, current and prospective, leave finance much less willing to lend to most other companies. And that means that strong business investment, which is a critical part of all healthy expansions, this time will follow a housing recovery, not lead it.

There’s more at stake in the current housing market than the pace of business investment. Some 70 percent of U.S. households are homeowners, which makes housing values the most important piece, by far, of most Americans’ wealth and economic security. So, the sharp drop in those values has made most of Americans poorer than they had been; and, unsurprisingly, people who feel poorer tend to spend much less. The health of the housing market, in short, now directly affects both business investment and consumer spending, and with them the outlook for the entire U.S. recovery.

It’s little wonder that world markets reacted badly to this week’s dismal U.S. housing report. Beyond the 27 percent drop in existing home sales — and one day later, sales of new homes also fell sharply — nearly one-third of the houses that did sell were “distressed” properties. That means they were either in foreclosure or sold for less than their outstanding mortgages. Average home prices did inch up a little bit, but the only reason was that the end of the temporary tax credit for first-time homebuyers led to a particularly sharp fall in their purchases, which normally involve lower-priced homes.

Nor are there signs of a real housing recovery anytime soon. Foreclosures are still running at four times their normal levels — and nothing drives down a neighborhood’s housing prices and slows down sales more than nearby homes in foreclosure. On top of that, supply continues to way outpace demand: At current rates of home sales, it would take over a year to clear all of the homes already on the market today.

If we don’t take serious steps to finally turn around these conditions, the United States and much of the rest of the world will be looking at a weak expansion, or worse, for several more years. One measure that could have a powerful effect would be steps to bring foreclosure rates down to normal levels. For example, congressional Democrats could advance a new program modeled on student loans for homeowners with mortgages in trouble. Homeowners who qualify could borrow the funds they need to stay in their homes, at a low interest rate, with no interest due the first year so long as they stay in the homes for at least two more years.

Most Republicans will denounce it as just another “big government program.” Yet, without a housing recovery, the alternative is not only smaller government but also a smaller economy, because businesses can’t find loans, people can’t find jobs, and most consumers can’t spend like they used to.



The Economy is Slowing Down – Alas, Much as We Expected

July 15, 2010

Recent polls have left most Democrats discouraged, even if the loss of public confidence reflects economic weaknesses largely beyond their control. Americans these days seem to both blame President Obama for economic developments that were not his doing and discount his real accomplishments in other areas. It’s hardly a surprise that life in politics is unfair. The real misstep here has been the President’s persistent optimism about the economy, since the basic shape and force of the current economic undertow were entirely predictable — and actually predicted by a number of us.

This is not a case of the hooey bandied about by know-nothing partisans that the President’s stimulus “failed.” Regardless of what he might have done in early 2009, the U.S. economy could not have avoided a long, bad recession — nor, without heroic action could we have escaped the slow recovery now disappointing many Americans. What we got is the basic shape of recessions that are triggered by financial meltdowns and the recoveries that eventually follow them. Yes, the crisis grew out of years of regulatory and economic-policy negligence, mainly by the Bush crew. But once it arrived, there was never a realistic prospect that $800 billion of new spending and tax cuts over two years would produce a big, V-shaped bounce back, as it might have if this were just part of a normal business cycle. In fact, all of that fiscal stimulus, on top of even more powerful easy Fed policies, did stop the slide into a Depression and finally pushed us into a slow recovery.

We also know why the stimulus couldn’t do more than that — or, more precisely, why it’s in the nature of a financial crisis to take years for an economy to recover fully. To begin, financial meltdowns leave most households markedly poorer in ways that ordinary business cycles don’t — what’s your house worth today? — and that makes most people a lot less eager to spend. So, as the stimulus has wound down, retail sales have stumbled for both of the last two months — in fact, the only people spending like most Americans used to, are the very wealthy, who still have more money than they know what to do with. And most others, even if they’re inclined to spend, have a hard time getting credit because a financial meltdown also leaves lenders much weaker. It also shouldn’t have surprised anyone that this reluctance to lend has extended to most businesses, keeping investment weak.

Moreover, these developments unfold in an economy that had serious problems before the meltdown and everything that has followed. The recession has drawn people’s attention to a decade-long problem: American business’ capacity to create new jobs, even when growth is strong, has weakened markedly. In the Bush expansion of 2001-2007, we produced less than half as many new jobs as we did during comparable periods of the 1982-1989 expansion and the 1992-2000 expansion. And when the economy turns down these days, it also sheds jobs at extraordinary rates. More than 3 million jobs were lost in the 2001 recession and its aftermath, which was six times the job losses, relative to the decline in the GDP, seen in previous recessions. Much of the same happened this time, as the recent recession cost nearly 8 million jobs. In fact, the jobs losses have been so large and so persistent that they’re putting independent downward pressure on the economy, eating away further at investment and consumer spending.

On top of all this, the potential for a second financial crisis, or a second round, is out there. The problem this time begins in Europe, where governments struggling with unproductive economies and large and fast-mounting deficits are having trouble finding global investors to finance their new bonds. It started in Greece and is spreading to Portugal, Spain and perhaps beyond; and while the EU says it will bail them out if the worst comes, the markets continue to bid down the value of their debt. The rub here is that nearly all of that debt is held by financial institutions still weakened from the last crisis, especially French and German banks which, for example, hold $630 billion just in Spanish government bonds. Even if those bonds, along with Greece’s and Portugal’s, skirt a formal default, their declining value is driving some major European banks to the edge — much as the plummeting value of mortgage-backed securities two years ago destroyed Lehman Brothers, Bear Stearns, Merrill Lynch and AIG. And if large European institutions fall, their counterparties on Wall Street will be left holding tens of billions of dollars in obligations no longer worth much. This scenario is still far from likely, but it remains quite possible that we could find ourselves back where we were in late 2008.

The good news is that if another crisis comes, the administration will have more tools to deal with it, as Congress is on the verge of passing some decent financial reforms. They might need those new powers, because congressional Republicans seem committed to blocking anything the President proposes, whatever the cost to the American economy. And whether or not the administration finds itself facing another economic crisis, or merely has to deal with a stagnant job market and meager wage gains, the luxury of large Democratic margins will soon be gone. In either case, President Obama will have to reclaim center stage and mobilize American opinion in ways that force his opponents to concede to sensible measures — much as Bill Clinton did after the Democrats’ 1994 setback and Ronald Reagan did after the big GOP losses in 1982. If the President can pull that off, he can still build a serious and successful economic legacy.



A New Plan to Create Jobs—and Address Climate Change

May 20, 2010

The long-awaited climate proposal from John Kerry and Joe Lieberman (minus Lindsay Graham) is now on the table; and it’s clear already that it has no better chance of being enacted than other failed proposals before it. One informal count this past week finds 26 Senators likely to vote yes and another 11 probable supporters — a total of 37, against nearly as many “no” votes and probably no’s (32) and nearly again as many fence-sitters (31). Despite the lessons of Katrina, the global importuning of Al Gore, and the President’s pledge to solve the problem, support for steps to stabilize greenhouse gas emissions at safe levels hasn’t changed much in the last half-decade. The hard truth is, a serious climate program is unlikely to happen unless its advocates shift their legislative approach and retool their political strategy.

You don’t have to be David Axelrod (or Karl Rove) to appreciate why. In a period of widespread economic anxiety and populist anger, congressional sponsors of climate legislation have persisted in pushing a big, new Washington fix that would raise most people’s energy costs in the near term, on the strength of promises by scientists that doing so will lessen the chances of dangerous climatic changes several decades from now — changes which scientists cannot yet specify in any detail.

The cap-and-trade model long pushed by a handful of national environmental groups and adopted by Kerry-Lieberman and by Waxman-Markey in the House has other features bound to repel most Americans, especially the creation of a new, trillion-dollar financial market in federal permits to emit greenhouse gases, all to be managed and potentially manipulated by Wall Street. How many Senators are prepared to explain today, or any time for the foreseeable future, why the only climate plan they can come up with would raise everyone’s energy bills and enrich energy traders and executives at Goldman Sachs and JP Morgan Chase?

The planet needs a different approach. The answer is to marry a plan to create jobs with a funding mechanism to reduce greenhouse emissions. Earlier this year, the CBO reported that the single, most powerful policy tool available to spur job creation is a sharp reduction in the employer’s side of the payroll tax, targeted to new hires who increase a firm’s entire workforce and total payroll. The catch is that since payroll tax revenues are dedicated to fund Social Security and Medicare, we have to replace the foregone revenues. We can finance this job-creating cut in payroll taxes by enacting a new, carbon-based fee which also would address climate change.

To be sure, the new carbon fee — like cap-and-trade or, for that matter, EPA regulation — would drive up most people’s energy bills. But the cuts in the payroll tax would offset the higher energy costs, and the new jobs and higher wages spurred by those payroll tax cuts would leave most of us better off, along with the planet. While the emphasis on jobs would be new, this general approach is not. Most economists and many environmentalists have long held that a fee on energy based on its carbon content is the most economically-efficient and environmentally-effective way to accelerate the development of new, climate-friendly fuels and technologies, and spur businesses and households to adopt them. Such a “tax shift” is also the long-time position not only of Al Gore, but also such groups as Greenpeace, Friends of the Earth, and the U.S. Climate Task Force (which, in full disclosure, I chair with Harvard professor and former Gore aide Elaine Kamarck).

It’s time for climate activists to respect the priorities of most Americans. Congress should enact broad reforms to create new jobs, boost incomes, and strengthen the economy — and pay for these reforms with a new, carbon-based energy fee that would steadily drive down our use of fossil fuels and their dangerous greenhouse gas emissions.



Deciphering the Crisis in Greece and Its Significance for America

May 12, 2010

With the world’s stock and bond markets thoroughly roiled by Greece’s sovereign debt problems, it’s only natural to ask the perennial question, how does it affect us? The outlines of the crisis are certainly familiar. As I’ve been warning in this space for more than a year, governments around the world would inevitably face serious fiscal problems, dealing with the daunting debts accumulated from the huge bailouts for the financial meltdown and the large stimulus programs for the subsequent deep recession. In countries that began with large deficits and national debts, such as Greece, Portugal, Spain and Italy, those fiscal stresses have become very serious. Here, in the United States, we’re just beginning to hear calls for deficit reductions. If recent history is any guide, we will ignore the problem for several more years, until voters finally demand that Washington take real action.

Greece can’t wait, despite the recent violent protests there against budget austerity. Greece is also burdened with a relatively weak and uncompetitive economy, so it cannot generate strong growth to help ease the problem. Moreover, the organization of the Eurozone denies Greece, along with other member-nations with high and fast-rising public debts, two standards measures to boost competitiveness and help countries grow out of their mess. Greece can’t depreciate its currency to make its exports cheaper in foreign markets, since it shares the Euro with many other countries uninterested in a sharp depreciation that would leave them poorer. Greece also can’t cut its interest rates to spur domestic investment and attract capital from other EU countries, since the European Central Bank (ECB) sets the interest rates for everyone in the Euro Area.

That’s why Greece has been headed for a default on its government bonds. The hitch is that a Greek default would shatter the EU’s grand myth, that their (partial) economic union enhances the efficiency and competitiveness of its members enough to protect them from such crises. Moreover, if the EU stood by as Greece sank, international investors would dump the public bonds of other debt-burdened EU countries, starting with Portugal, Spain and Ireland. All of this would drive down the value of the Euro, especially relative to the currencies of the EU’s two major trading partners, the United States and China. By the way, that would be both bad and good news for us. A stronger dollar would make our exports more expensive in Europe, undermining the President’s hopes of relying on exports to help drive growth at home. But a stronger dollar, along with the threat of a sudden crisis for the Euro, also draws more foreign capital to the United States, which helps keep our interest rates low.

So far, the EU and the IMF (prodded by us with promises of a larger U.S. financial contribution) have headed off a Greek default, by unveiling a $1 trillion bailout plan consisting mainly of loans and a pledge by the European Central Bank to accept Greek bonds as collateral for loans to the European banks that buy those bonds from the Greek government. The fund is big enough to rescue Portugal and Spain as well, a smart move since serial debt defaults pose the greatest danger of all.

The announcement of the plan strongly recalls the original TARP bailout. Both plans were pulled together hastily to signal government’s determination to head off a collapse. In both cases, the signal is more important than the actual plan, since neither makes much economic sense. The EU plan depends, first, on taxpayers across northern Europe agreeing to shoulder much of the costs to rescue Greece and, second, on Athens following through with deep spending cuts and sharp tax increases that are bitterly opposed by most Greeks. Even if all of that came to pass, the plan has more fundamental flaws. It purports to respond to Greece’s public debt crisis by expanding the debts of Greek and other European banks as well as other EU governments — as if international investors will generously overlook Europe piling up even more debt than today. And if Greece does follow through on the draconian austerity measures contemplated in the plan, its economy will sink further, requiring even more public debt. In short, the bailout plan is a fantasy; and Greece and Europe will face another round of this debt crisis not long from now.

The improbable shape of the EU bailout does recall our own, original TARP plan. Just as the EU bailout does nothing to address Greece’s lack of competitiveness, the TARP in its various versions has never addressed the forces and factors that drove our financial crisis. So, 20 months later, our large banks are still not strong enough to resume normal lending to American businesses. Their continuing vulnerability also makes Europe’s current debt problems even more serious for us. Greek bonds — along with the bonds of Spain, Portugal, Ireland and Italy — are held mainly by financial institutions. German and French banks are the most exposed, but ours are well in the mix, too. Those bonds have been declining in value for weeks, taking their toll on bank balance sheets. A formal default by Greece would hit all of them; and serial defaults by Greece, Portugal and then Spain — and possibly Italy — would trigger another worldwide financial crisis.

This time, we would have few policy tools left to stop a downward spiral — and Congress almost certainly would fiercely oppose another huge taxpayer bailout, especially Republicans in the midst of a populist purification process that already has purged Bob Bennett in Utah and Charlie Crist in Florida. This is all speculative — thank goodness — but we could find ourselves with very few options to address a crisis that ultimately could lead to another Depression. Our best hope for now is that Greece and the Eurozone will somehow muddle through, much as we did in 2009.