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Politicians Can't Agree on Debt? Well, Neither Can Economists

The politicians grappling over how to pay the nation’s debts have been contributing to the heat of summer with back-and-forth charges that their opponents are disregarding the laws of economics.

Boehner, Cantor
CNBC
Boehner, Cantor

Such laws, unfortunately, do not exist. Economists agree that federal borrowing must be reduced, but they do not agree about the proper mix of tax increases and spending cuts. Basic considerations, like the impact of higher taxes on saving and investment, remain the subjects of wide-ranging disagreements despite decades of intensive research.

The absence of a clear mainstream is one underappreciated reason for the standoff between the Obama administration and Congressional Republicans over raising the federal debt limit before Aug. 2, when the Treasury Department says it will run out of borrowing authority.

Washington no longer suffers from a dearth of “one-handed” economists, as Harry S. Truman famously lamented. The problem now is that experts are lined up behind every political position, in part because the decisions are not purely economic. The value of defense or education or justice extends beyond dollars and cents.

“I just don’t think economists have any comparative advantage” in answering these questions, said Joel Slemrod, a University of Michigan professor and a leading expert on taxation. “There are a lot of reasons why sensible people might disagree about the answers to the fiscal questions that we face. It’s a value judgment that the citizens of the country have to make.”

President Obama and Congressional leaders did not meet over the weekend as Mr. Obama had said they might. Instead, with talks on a long-term debt-reduction deal at an impasse, action this week shifts to Congress, where Republican leaders intend to press for votes on a balanced budget amendment and other economic measures that have almost no chance of success, given Democrats’ opposition.

Last week, after lawmakers pressed for guidance from the Federal Reserve chairman, Ben S. Bernanke, he responded that Congress needed to make the decision.

“I want to see the numbers add up,” he said. “I want to see the revenues and expenditures balanced. As for how to do it — that’s your job.”

The key point of contention is whether the government should pay any part of its debts by raising revenue, or solely by spending less.

Industrialized nations have almost always adopted a combination of the two to cut debt, according to an International Monetary Fund survey last year. The fund, which examined 30 instances dating to the 1980s, found that nations on average closed half the gap with tax increases and half with spending cuts.

Both approaches cause immediate economic pain, but the dominant school of economic theory predicts that tax increases should be somewhat less painful to the nation’s economy. A $100 spending cut reduces economic activity by $100, while an equivalent tax hike will be paid partly from savings, so that spending is reduced by a smaller amount.

Recent studies, however, have found the opposite: Countries that rely primarily on spending cuts tend to experience less economic pain in the short term. Moreover, in some cases, the cuts seem to spur faster growth.

The monetary fund study reported that a 1 percent fiscal consolidation achieved primarily through tax increases reduced economic activity by 1.3 percent over two years, while an identical consolidation driven primarily by spending cuts reduced activity by 0.3 percent.

“It’s coming to be accepted wisdom that it’s better to have spending cuts than tax increases,” said Alan Auerbach, an economics professor at the University of California, Berkeley.

As with most economic questions, however, there are no certain answers. Economists do not understand why rebounds happen. They are also not sure whether the economy of the United States, the world’s largest, would respond in the same way as the economies of smaller countries. One of the studies that found in favor of spending cuts says in its preface, “It is fair to say that we know relatively little about the effect of fiscal policy on growth.”

Republicans have embraced the study’s conclusion without the caveats, extending the logic to argue that any revenue increase would do more harm than good. “A tax hike would wreak havoc not only on our economy’s ability to create private-sector jobs, but also on our ability to tackle the national debt,” the House speaker, John A. Boehner, said recently.

Republicans also cite a paper published last year by Christina Romer, a former chairwoman of President Obama’s Council of Economic Advisers, and her husband, David Romer, which studied tax hikes in the United States since World War II. The couple, professors at Berkeley, reported that a 1 percent tax increase reduced economic activity on average by 3 percent over three years.

Dr. Romer has said she believes that a similar study of the impact of spending cuts would find even greater damage.

Not a 'hard science'

The Obama administration has accepted the idea that most of the gap should be closed through spending cuts. It argues, however, that fairness demands a significant increase in federal revenues to preserve some of the programs that it considers important.

“The problem is that if you don’t do the revenues, then to get the same amount of savings you’ve got to have more cuts, which means that it’s seniors, or it’s poor kids, or it’s medical researchers, or it’s our infrastructure that suffers,” Mr. Obama said last week.

There is broad agreement among economists that the pain of tax increases can be minimized if, instead of raising taxes, the money is raised by eliminating subsides like tax credits for ethanol and interest deductions for homeowners, so that a greater share of income is subject to taxation.

“If you get rid of those preferences it makes the tax system more fair and more efficient,” said Leonard E. Burman, a professor of public affairs at Syracuse University who specializes in tax policy. “It makes the economy work better.”

The lack of definitive answers reflects the reality that economics is not a hard science.

“Reasonable people can sit down and, apart from any political or policy motivations, come up with different answers,” said Robert S. Chirinko, a finance professor at the University of Illinois at Chicago who studies corporate taxation.

Dr. Chirinko said his own studies had found that tax increases caused real but modest reductions in corporate investment. Studies by the Harvard economist Martin Feldstein, a noted conservative, find larger reductions.

“The problem is that economists really can’t run experiments like in science class,” Dr. Chirinko said. “I keep coming up with the same answer, so I have some confidence. On the other hand, Martin Feldstein is a great economist.”

— Jackie Calmes contributed reporting.