04/30/2009 05:12 am ET Updated May 25, 2011

Nonsense Pronouncements About Budget Deficits

Last month the Congressional Budget Office projected that President Obama's recently proposed budget would add more than $9.3 trillion to the national debt over the next ten years. That's one third more than the administration's own projections. If the CBO is right, our national debt in 2019 will be roughly $20 trillion, almost double its current level.

On the heels of the CBO reports, cries of doom have been ringing out in the media and in Congress. The Washington Post's David Broder, for example, warned of the huge price that will fall on our children and grandchildren, "who will inherit a future-blighting mountain of debt." House minority leader John Boehner lambasted the president's fiscal irresponsibility and called for an immediate freeze in federal spending. Other doomsayers urge Congress to review the budget line by line, making draconian cuts on every page.

But although long-term budget deficits are indeed a serious concern, such hysteria is almost sure to make matters worse. The two critical steps for thinking more clearly about budget deficits are, first, to distinguish between the long run and the short run, and second, to examine how the borrowed money will be spent.

The consensus among economists is that the downturn may stretch well into next year and beyond. If they're right, the current short-run deficit is actually much smaller than it needs to be. Longer term, if failure to borrow meant forgoing productive investments in the post-recovery years, then bigger long-run deficits would again be better than smaller ones. But here the doomsayers have a stronger point. Long-run deficits rob us of money we could use to pay for things we value.

Spending cuts, however, are not the best way to eliminate long-run deficits. It would be far better, and not particularly difficult, to avoid them by using our own money to pay for those investments. And as I will explain, we could do that by simply changing the mix of things we tax.

Economists from both sides of the political aisle agree that the clear short-run imperative is to end the downturn. Herbert Hoover thought the best way to end the Great Depression was to balance the federal budget. And since falling incomes had caused tax receipts to decline precipitously, that meant deep cuts in federal spending. But as John Maynard Keynes explained in 1936, Hoover's strategy actually made matters worse.

We're in a deep downturn now because total spending is too low to purchase as much as our economy is capable of producing. Consumption spending, which was artificially propped up by home equity loans and credit card debt in recent years, will not reach its earlier levels any time soon. Nor are private investors likely to bridge the gap, since firms already have more than enough capacity to produce what people want to buy.

That leaves government. We need to increase government spending as quickly as possible. Much has already been written about how best to deploy the more than $2 trillion in stimulus spending that may be required. As even the most fiscally conservative economists concede, this effort will have to be financed largely with borrowed money, since higher taxes would simply delay recovery.

But even the Obama budget forecasts that deficits will persist well after the economy has recovered. That's because the president is reluctant to abandon his campaign pledge to revitalize the nation's infrastructure. He proposes to pay for some of that investment with higher income taxes on top earners and by selling carbon permits as part of his program to limit CO2 emissions. But because those revenues won't be enough, he proposes to bridge the gap with additional borrowing.

Perhaps the president chose that path because he believes the American public will not support additional taxes. If so, I believe he's wrong (more on this point in a moment). But surely no one who has studied voter reactions to proposed tax hikes in recent years could fault the president for holding such a belief.

Let's suppose, for the sake of argument, that the president rightly believes that additional tax revenue is unavailable. Should he then abandon his proposed revitalization program to bring the long-run budget into balance? If the investments he proposes will yield a high rate of return, the answer to that question is unequivocally no.

A simple numerical example illustrates why. At current interest rates, it will cost about $40,000 a year to service each additional $1 million we borrow. Suppose we use that $1 million to pay for a public investment that yields an annual return of 7 percent, or $70,000 a year in absolute terms. Compared to the alternative of not making this investment, we would be $30,000 a year better off by making it.

David Broder's dire pronouncements notwithstanding, making an investment like that with borrowed money would not impoverish our children and grandchildren. On the contrary, it would make them richer by exactly $30,000 a year.

Tax phobia in the United States has led to some three decades of profound neglect of our public sphere. As a result, there's a huge inventory of public investments that would yield rates of return larger than the interest rate we pay on borrowed money.

For example, because of bottlenecks that currently prevent freight trains from transporting double-decker cargo containers along the Northeast rail corridor, thousands of such containers must instead be transported by truck each day along Interstate I-95. According to one estimate, eliminating these bottlenecks would cost cost $6.2 billion and would return more than twice that amount in benefits, without even counting the value of reduced greenhouse gas emissions. It's sheer folly not to make this investment.

Delayed road maintenance provides another compelling example. Blown tires, damaged wheels and axles, bent frames, misaligned front ends, destroyed mufflers, twisted suspension systems and other problems caused by potholes on U.S. roads generate an average of $120 worth of damage per vehicle each year. Adding to those costs is that when road surfaces are not maintained on schedule, the work ends up costing two to four times as much when we are finally forced to do it. If the only way to fix our roads on time were with borrowed money, our children and grandchildren would be much poorer if we refused to borrow.

President Obama could invest as rapidly as available materials and manpower would permit during his entire time in office and still not exhaust the list of projects whose rate of return substantially exceeds the interest rate on borrowed money. That making such investments is the right thing to do is not a difficult or controversial point. The pundits and congressional leaders who are urging us to abandon them need to rethink. And if they refuse, we must demand an explanation.

That said, we'd still end up much richer in the long run if we paid for the investments with our own money. As I argue in this month's issue of The American Prospect, there's actually a relatively simple and painless way to do that. Once the economy has again reached full employment, we should adopt a new tax system focused on behaviors that cause injury to others. Such behaviors are often profoundly wasteful. Because taxing them leads people to adapt in ways that curtail waste, it's a relatively painless way to generate additional revenue.

Taxes on pollution and congestion are familiar cases in point. When Congress attacked the problem of acid rain in the 1990 Clean Air Act by effectively taxing SO2 emissions, firms were able to reduce those emissions at a small fraction of the cost associated with traditional regulatory remedies. The president's proposal for a carbon cap and trade system is a further step along this path.

But there are many other promising steps he could take. Although gasoline taxes in Europe, for example, are more than $2 a gallon higher than in the U.S., motorists there have adapted in a variety of ways and actually spend less on fuel than Americans do, including taxes. And they seem no less satisfied with their driving experience than we are.

The centerpiece of my proposal is to scrap the income tax in favor of a more steeply progressive tax on consumption. Each family would report its income to the IRS and also its annual savings, much as many now document their annual contributions to tax-exempt retirement accounts. A family's annual consumption is then calculated as the difference between its income and its annual savings. That amount less a large standard deduction--say, $30,000 for a family of four--is its taxable consumption. Rates would start low, perhaps 10 percent, then rise gradually with taxable consumption, topping out at significantly higher levels than current top marginal rates on income. For instance, a family that earned $50,000 and saved $10,000 would have taxable consumption of $10,000 and owe $1,000 a year in tax.

The beauty of the progressive consumption tax is that it would essentially create new resources out of thin air. Contrary to the assumption of standard economic models, individual purchase decisions are heavily dependent on the spending of others. As the economist Richard Layard has written, for example, "in a poor society a man proves to his wife that he loves her by giving her a rose, but in a rich society he must give a dozen roses."

Similarly, the size of house CEOs feel they need depends on the houses that executives in similar circumstances have. Because salaries of top earners have risen so sharply in recent decades, they have been building bigger houses. This has shifted the frame of reference that defines what the near rich consider necessary or desirable, so they too have built bigger, and so on, all the way down the income ladder. The median new house built in the U.S. in 2007 was half again as large as its counterpart from 1970, despite the fact that median hourly earnings had scarcely risen during the interim.

To keep up, middle-income families have had to work longer hours, save less, and commute longer distances. They could escape some of this pressure by simply buying less expensive houses. But because of the link between house prices and neighborhood school quality, most families appear unwilling to take that step.

To see how a progressive consumption tax would slow this expenditure cascade and free up resources for more productive purposes, it's instructive to examine how the tax would affect top earners' decisions about how big a house to build. Suppose the top marginal tax rate on consumption is 100 percent and that top earners currently live in 20,000-square-foot-houses. A substantial increase in their income has led them to consider building additions onto those houses.

Each faces a choice between two designs, one at 5,000 square feet, the other at 10,000. If the pre-tax cost of the latter design is higher by $5 million, its post-tax cost will be higher by $10 million. Now suppose, plausibly, that this price penalty induces everyone to choose the smaller addition. Because it's relative house size that matters, people will be just as happy as if they'd all chosen the bigger one. (If we account for the hassle of recruiting and supervising additional help to maintain larger houses, they might even be happier!) The government gets $5 million in additional tax revenue, which it can use to hire the contractors who would have built pointless mansion additions to instead construct new overpasses on the Northeast rail corridor.

Before the current downturn, the United States was the richest country on the planet. We'll still be the richest country once the downturn's over. We can easily afford to pay for worthwhile public investments with our own money. The current tax system makes it difficult to do this, because higher tax rates on income discourage private savings, the lack of which helped provoke the current downturn.

The solution is to tax consumption instead of income. Higher tax rates on consumption not only do not discourage thrift, they strongly encourage it. Phased in gradually after the downturn ends, a progressive consumption tax would slowly shift the composition of spending away from consumption toward investment. Full employment would be maintained, and productivity would grow faster.

President Obama was elected in large part because of his ability to persuade people to share his vision of a better future. If I am right that painless ways exist for raising the tax revenue needed to finance his ambitious program, he ought to be able to persuade the American people to embrace them. But if he can't or won't, let's hope he'll at least resist calls by Broder and Boehner to abandon the worthwhile investments he has proposed.