Respond to this Article September 2004

The Deficit Conquers All

By Sebastian Mallaby

Ronald Reagan promised tax cuts in his 1980 campaign, and delivered in his first year in the White House. After that, however, Reagan turned around, raising taxes three times during his term in office. For those who now contemplate a second Bush term, the Reagan story holds out hope. Won't the budget deficit, compounded by the approach of baby boomer retirement, compel Bush to reconsider his love affair with tax cuts?

It's possible. But most of what we've seen from Bush thus far suggests it isn't likely. The president has elevated consistency above most other governing virtues: His attack on Kerry as a flip-flopper reflects his own peculiar brand of unapologetic policy rigidity. Bush shows no signs of dropping any member of the foreign policy team that led him to alienate allies, botch the postwar planning in Iraq, misconstrue intelligence on weapons of mass destruction, and permit the abuses of Abu Ghraib. Likewise, he shows no sign of rethinking his ambition to make his first-term tax cuts permanent, especially since his father paid a political price for reneging on his tax commitment.

To the contrary, indeed, the best guess is that Bush won't merely seek to make his tax cuts permanent. He will actually want new ones. His has already proposed new tax breaks for retirement savings, and he favors tax-sheltered health savings accounts. It seems inevitable that a president from either party will want to "fix" the Alternative Minimum Tax, a device that prevents high earners from claiming too many deductions. Perish the thought that the well-off should raise their kids without the help of tax deductions from the government.

If this is the likely shape of tax policy in a second term, how will history judge the Bush presidency? Some early reviews are already available: "Past administrations from the time of Alexander Hamilton have on the average run responsible budgetary policies," says the Nobel laureate George Akerlof. "What we have here is a form of looting." Is that judgment going to stand? The more you consider the country's options, the more Akerlof appears to be on target.

To see why this is so, consider the following thought experiment. Assume that a second-term Bush will stick to his tax cuts, and then ask: Is there something, anything, that can possibly be done to stop future deficits from exploding?

The Bush administration's stock answer to this question can be dispensed with quickly. Officials declare their solemn intent to restrain government spending, but their record suggests the opposite. President Bush has presided over an explosion of spending not just on defense and homeland security, but in other areas, too. He has signed into law an enormous subsidy program for farmers; he has increased foreign aid by 50 percent; he has participated in the creation of a Medicare drug entitlement. Some of these programs are deserving, to be sure. But the Bush promise to restrain spending simply isn't credible, especially since the president has never once wielded his veto pen to block Congressional pork-barreling.

The next way the Bush administration claims to be able to address the deficit is to reform Social Security. Let's be generous, now: We'll set aside the fact that Bush ignored the various reform proposals put forward by his own Social Security advisory commission, judging the topic too politically hot to handle. Let's assume that, in a second term, Bush acquires a burst of reformist courage on Social Security. What impact is that likely to have on the nation's budget outlook?

There are two answers. In the short term and even the medium term, a shift to private retirement accounts would increase the budget deficit, since the government would have to carry on paying existing retirees while forgoing the Social Security contributions of younger workers, who will have opted out of the system. In the longer term, meaning after 2048, by the administration's own calculations, real savings are possible, because the money in private retirement accounts can be invested in equities, which tend to earn decent returns over the long term. That investment income represents money to finance retirement that isn't available now. Whatever the disadvantages of private accounts--notably, that they transfer investment risk onto individuals--the Bush administration can fairly claim that privatization would improve the long-term budget outlook.

How big is this effect, though? Surprisingly small, is the answer. According to a study by Alan Auerbach of Berkeley and Peter Orszag and William Gale of the Brookings Institution, the budget deficit is likely to grow from about 4 percent of GDP at the moment to around 20 percent in 2040. But the cost of social security will expand from just 4.3 percent of GDP to 6.5 percent. In other words, only a small fraction of the nation's looming fiscal disaster is due to Social Security.

If Social-Security reform is insufficient, what else could Bush do? The president's team makes much of his determination to boost economic growth, and (as the 1990s demonstrated) growth can certainly have a big impact on the budget. To give a rough measure of growth's fiscal potential, an extra 1 percentage point on the annual growth rate would cut the projected deficit in 2014 from around 3.5 percent of GDP to a far less alarming 0.5 percent, according to the Berkeley-Brookings calculations.

Generating that extra growth--which means boosting the economy's cruising speed from just under 3 percent growth a year to just under 4 percent--is going to be a tall order. The tax cuts, by themselves, are not going to do it. Although certain kinds of tax cuts do boost incentives to work hard, save more, and take entrepreneurial risks, all of which theoretically boost growth, tax cuts also tend to lower the government's savings rate, reducing the pool of capital available for investment and nudging up interest rates. A range of econometric studies suggest that these opposing effects--stronger work incentives on the one hand, higher interest rates on the other--roughly cancel each other out. A second-term Bush administration would therefore need to broaden its agenda to get the growth that might make the tax cuts seem retrospectively defensible.

There are, in principle at least, several policies that could boost growth. Fully liberalized global trade would create a boost to GDP of 2 percent, according to Harvard's Jeff Frankel, an alumnus of Clinton's Council of Economic Advisers. But this would be a one-time boost to the size of the economy, not a shift in the growth rate, so it would be too small to close more than a small part of the deficit forecast for 2014, and would make barely any impact in the years thereafter. In any case, free trade is not something that an American president can will into existence unilaterally. Even success in the current Doha round of trade talks would fall short of freeing trade completely.

Tort reform is another growth-promoting option. America's outrageous system, which transfers more than $100 billion into lawyers' pockets annually, slows growth in two ways: The expense of dealing with litigation consumes corporate funds that might otherwise go to innovation and research; and the fear of litigation causes companies to withhold products from the market, order safety tests that generate little useful information, and generally to dissipate their energies in defensive strategies that are more about reducing legal exposure than about genuine safety improvements. But how much extra growth might you get from tort reform, setting aside the problem that it would be unlikely to get through Congress? Robert Litan of Brookings Institution puts the answer at just 0.1 percent of GDP per year.

A similar verdict holds for regulatory reform, another policy that the administration has pushed quietly. Regulatory reform need not be an assault on air quality or safety or anything else of value; it can consist of weeding out expensive regulations that buy little benefit in terms of health and safety, and replacing these with others that are less burdensome and more effective. A smart benefit-cost review of the regulatory state could reduce the drag on businesses without harming citizens. But though this yields some effect on the growth rate, it isn't dramatic.

What of boosting government investment in education and research spending? More education is certainly a good idea. As the journalist Daniel Altman writes in Neoconomy, his book on the Bush economics philosophy, the verdict of the economics profession is that an extra year in a four-year college can raise a worker's future wages by 5 to 10 percent, more than paying for the cost of the tuition. But the fiscal pay-off from this strategy is limited, because the government will only capture a third of the worker's extra earnings in taxes. Equally, government-funded research can generate growth-enhancing breakthroughs from biotechnology to the Internet, and more might be a good idea. But the link between extra spending and extra breakthroughs is unpredictable. It seems unwise to bet the nation's fiscal future on it.

The bottom line is that higher growth is possible, and would have a real fiscal pay-off; but government has no certain way of boosting the growth rate enough to make its tax cuts look retrospectively defensible. As information technology revolutionized American business during the 1990s, economists did revise their view of the economy's potential growth substantially upward: Whereas productivity increased at 1.5 percent a year in the first half of the 1990s, it increased at 2.5 percent in the second half. But the Internet revolution probably won't be matched any time soon, and policies such as tort reform or regulatory reform come nowhere close to it. Moreover, it would take a further jump of more than 1 percent to fix the vast deficits that loom in 2040 and onward.

If neither Social-Security reform nor pro-growth government policy are likely to rescue the Bush budget policy, what is there left? The answer is health care. Between now and 2040, on the Berkeley-Brookings projections, federal spending on Medicare and Medicaid will grow by over 6 percent of GDP, nearly three times the size of jump as Social Security faces.

A large chunk of this projected health care spending reflects inefficiencies in the U.S. system. The nation spends 15 percent of GDP on health, 6 percentage points more than the average rich economy; and yet Americans do not live any longer. Within this country, some states manage to spend twice as much per Medicare patient as other states spend--again, without any improvement in health outcomes. Elliott Fisher of Dartmouth University reckons that, if the efficiency of the best-run fifth of the nation could be matched by every region, Medicare spending would drop by 30 percent. Similar savings might be achievable in the private health system, which would help the government's finances as well. Medical insurance is provided by companies to employees on a tax-free basis, so efficiencies that squeeze money out of health into other parts of the economy increase the tax take.

Health care clearly offers bigger deficit-closing opportunities than Social-Security reform or pro-growth policies. But are these opportunities enough to rescue Bush's fiscal legacy? If the Medicare spending projected in 2040 were cut by 30 percent, the savings would come to just over 2 percent of GDP; the tax flow-through from new private-sector health efficiency might bring that up to a total of 3 percent. But that is the equivalent of just under a fifth of the total deficit projected in 2040, and it assumes that the political system showed more grit in tackling the medical-industrial complex than it has hitherto exhibited. Moreover, squeezing inefficiencies out of health care would likely not prevent the tendency of health costs to rise faster than GDP. The steep rise in health care spending is driven overwhelmingly by new technologies. We are not going to stop wanting the benefits of new kinds of care, so health spending will carry on rising rapidly.

In short, the thought experiment points to some pretty stark conclusions. Even if you assume improbable amounts of political courage in a second Bush term, the chances that the administration could come up with something dramatic enough to forestall fiscal disaster are between modest and zero.

The basic premise of the tax cuts--that the size of government can and should be contained--is ahistorical and wrong. Ahistorical, because government's share of GDP has in fact grown steadily as societies have grown richer over the past century. Wrong, because government in the age of the baby bust is going inevitably to grow. Bush has failed to understand where history is headed, and history will judge him harshly for it.

Sebastian Mallaby is a member of The Washington Post editorial board and author of forthcoming The Worlds Banker: A Story of Failed States, Financial Crises, and the Wealth and Poverty of Nations.


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