When and what kind of deficit reduction matters most: The danger of aggressive 10-year deficit targets in the current budget debate

In the aftermath of the American Taxpayer Relief Act of 2012 (i.e., the lame-duck budget deal, ATRA for short), many in Washington have urged 10-year deficit reduction targets that are trillions more than the $600 billion reduction already locked in by ATRA. While many of these calls for increased deficit reductions have been inchoate (as noted here), others have been more reasonably grounded. Yet, we think that nearly all demands for specific, ambitious 10-year deficit reduction targets are likely to be terribly counterproductive in the current debate

The primary reason for this is simple: Without a sharp focus on when and what kind of deficit reduction should happen, these calls can easily lead policymakers to embrace measures that will surely hamper economic recovery. And this recovery should be the primary focus of these policymakers. The output gap in 2012—essentially the difference between actual economic output and output that would have been produced had all productive resources in the economy been put to work—will likely register just shy of $1 trillion, or 5.6 percent of the economy. This is $1 trillion in national income that the country is forfeiting each year simply due to the continued weakness in aggregate demand—weakness that would likely be exacerbated by any aggressive deficit reduction in the next few years. This depressed state of the economy makes the timing and composition of any proposed deficit reduction crucial. And yet these crucial details are generally not a primary focus in 10-year deficit reduction targets that are dominating the debate.

In regards to timing, deficit reduction that imposes a drag on growth really should not begin at all until the economy moves much closer to full employment. In 2010, we proposed that no deficit reduction should be imposed before we had achieved 6 percent unemployment for six months (six-for-six). This still seems like a useful guidepost to us. Given that the last Congressional Budget Office (CBO) forecast is that the economy will not meet this guidepost until the middle of 2017, this necessarily restricts the amount of deficit reduction that can be feasibly achieved over 10 years. So, one danger of focusing too much attention on the entire 10-year deficit reduction target is that some policymakers may decide to take a 10-year target of $1.5 trillion to simply mean we should impose deficit reduction of $150 billion each year for 10 years, starting in 2013 (or even 2014).

However, if policymakers are determined to begin deficit reduction before full-employment is reached (as has actually already commenced, with the federal fiscal drag for 2013 probably on the order of at least 1.5 percentage points or higher, depending on the ultimate fate of the sequester), then textbook macroeconomics suggests a way that it can be composed so as to neutralize any drag on growth: increase taxes on high-income households and corporations and pair this with some increases in near-term spending.

Ensuring that deficit reduction doesn’t drag on overall growth isn’t just important to the economy—it also matters greatly to medium-term fiscal balances. The combination of an economy with a large output gap and a Federal Reserve committed to keeping policy interest rates near zero for years to come means that effective fiscal expansion (i.e., targeting larger deficits using any stimulus with a multiplier of 1 or greater) can actually reduce the debt ratio. Conversely, fiscal contraction has the potential to increase the debt ratio.

It should go without saying that any policy that reduces both unemployment and the debt ratio in the near-term should be seized as a pure win-win. This simple fact might be obscured by specifying overall deficit reductions that need to be achieved over an entire 10-year period, with little reference to the timing of these reductions.

Besides not being specific enough on timing, even the more reasonably grounded 10-year deficit reduction targets have been too vague about the composition of future deficit reductions. But given the fragility of the current recovery, and given the very large difference between various policies’ impact on economic recovery, this composition of any proposed deficit savings will matter a lot. So, a package composed of 90 percent tax increases and 10 percent spending cuts will drag much less on economic growth in coming years than one that sees the split as 50/50. Given that there has been substantial 10-year deficit reduction already achieved in the past two years, and given that even post-ATRA the large majority of this deficit reduction is set to come through damaging spending cuts, future targets for deficit reduction must rely overwhelmingly on tax increases to minimize drag on economic recovery.

A financial transactions tax, for example, could achieve substantial deficit reduction over the next decade while providing only the most minimal drag on economic recovery. The same argument applies generally to any tax increase aimed at very high-income households or corporations. The reason is simple: The problem with today’s economy is that it is demand-constrained, yet because high-income households have relatively low propensities to consume, tax increases aimed at them do not lead to large reductions in spending. In the “fiscal cliff” debate, we highlighted the very large divergence between budgetary cost and economic cost in various components making up the “cliff.”

 In short, there is very little reason to believe that aggressive 10-year deficit reduction targets should be guiding policymakers right now. Indeed, we have probably already cut far too much spending if the goal was a rapid return to economic health. Further, if rapid deficit reduction over the next decade is deemed necessary by policymakers, the principles of textbook macroeconomics argues that it should come almost entirely out of progressive tax increases, and should be accompanied by actual increases in spending—as detailed in our proposal for how to navigate the fiscal obstacle course. Ten-year deficit targets presented with insufficient emphasis on these timing or composition issues could well be seized on by less sophisticated policymakers to do real damage to economic recovery.