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July 20, 2010

Latest Posts from Economist's View

Latest Posts from Economist's View

"The 'Tax Expenditure' Solution for Our National Debt"

Posted: 20 Jul 2010 01:17 AM PDT

The economy is still fragile, and now is not the time to begin solving our long-run debt problem. That would make things worse. But once the economy is on firmer footing, we will need to begin addressing this problem. Martin Feldstein argues that the elimination of special tax rules is a good way to reduce the long-run debt load:

The 'Tax Expenditure' Solution for Our National Debt, by Martin Feldstein, Commentary, WSJ: When it comes to spending cuts, Congress is looking in the wrong place. Most federal nondefense spending, other than Social Security and Medicare, is now done through special tax rules rather than by direct cash outlays. ...
These tax rules—because they result in the loss of revenue that would otherwise be collected by the government—are equivalent to direct government expenditures. That's why tax and budget experts refer to them as "tax expenditures." This year tax expenditures will raise the federal deficit by about $1 trillion... If Congress is serious about cutting government spending, it has to go after many of them. ...
Neither party has focused on controlling this kind of spending. Democrats are reluctant to cut such programs... Republicans also are reluctant to cut these tax perks, because they regard the additional revenue collected by the federal government as a "tax increase"—even though the increased revenue is really the effect of a de facto spending cut. ...
But eliminating tax expenditures does not increase marginal tax rates or reduce the reward for saving, investment or risk-taking. It would also increase overall economic efficiency by removing incentives that distort private spending decisions. And eliminating or consolidating the large number of overlapping tax-based subsidies would also greatly simplify tax filing. ...
If tax expenditures are not cut, taxes on households and businesses will have to rise to prevent an explosion of the national debt... When benefits for Social Security and Medicare are set aside, the rest of the outlay side of the budget is too small—7.5% of GDP—to provide much scope for reducing annual budget deficits that are now projected to average 5% of GDP for the rest of this decade. In contrast, total tax expenditures are now 6.4% of GDP.
Not every type of tax expenditure should be cut. Some provide good incentives while others increase the fairness of the tax system. But they can be reduced by one-third or more. ... Cutting them ... 2% of GDP would reduce the national debt in 2020 by some $4 trillion, bringing the projected debt down to 72% of GDP from 90%. ...
Cutting tax expenditures is really the best way to reduce government spending. And to be politically acceptable, the cuts in tax expenditures must be widespread... While some of the dozens of small tax perks should be eliminated all at once, others should be reduced gradually in order to avoid economic disruptions. Some of the biggest ones, like the deduction on federal tax returns for local property taxes (projected to cost the federal government $25 billion in the coming fiscal year) might be reduced but not completely eliminated. ...
The American public wants to reduce ... deficits... A major reduction of the spending that is built into our tax code is the best way to achieve that.

There aren't any easy solutions to the long-run debt problem. There are special interests attached to each of these tax breaks, so it won't be easy to eliminate enough of them to make a difference. A bill eliminating a substantial number of breaks could be portrayed as a vote against all sorts of popular and/or powerful groups and scare legislators away from supporting such legislation. I know my first thought was that care would need to be taken to ensure that we don't eliminate provisions that help to attain equity or that promote other worthy societal goals, and every group facing the elimination of their tax break will argue that it is needed for these reasons. But these arguments will be made no matter what we do, and to the extent that we can eliminate these tax provisions without harming our ability to pursue these goals, we ought to do so.

However, with that said I should also note that the main driving force behind the long run debt problem is health care costs -- if we solve the health care cost problem then we also solve the debt problem, and if we don't, we don't. Since eliminating these "tax expenditures" does not help with the health care cost problem at all, there's no reason compromise our ability to promote equity or other goals by being overly aggressive in eliminating these tax breaks. Not all of these tax provisions serve a worthy purpose, but many do and those should be preserved.

links for 2010-07-19

Posted: 19 Jul 2010 11:02 PM PDT

Deficit Neutral Stimulus

Posted: 19 Jul 2010 07:29 PM PDT

I certainly can't disagree with this -- I posted a similar recommendation a few days ago in response to the question of whether the Bush tax cuts should be allowed to expire:

Obama's Fiscal Priorities Are Right, by Alan Blinder, Commentary, WSJ: ...Let the upper-income tax cuts expire on schedule at year end. That would save the government an estimated $75 billion over the next two years. However, it would also diminish aggregate demand a bit. So, instead of using the $75 billion to reduce the deficit, spend it on unemployment benefits, food stamps and the like for two years. That would surely put more spending into the economy than the tax hike takes out, thus creating jobs.

How much more? Getting a numerical estimate requires the use of a quantitative model of the U.S. economy. In recent testimony before the House Budget Committee, Mark Zandi of Moody's Analytics used his model to estimate that extending unemployment insurance benefits has almost five times as much "bang for the buck" as making the Bush tax cuts permanent.

Based on his estimates, the budgetary trade I just recommended would add almost $100 billion to aggregate demand over the next two years—without adding a dime to the deficit. That translates to about 500,000 more jobs each year. Maybe Mr. Zandi's numbers are high. But the direction is clear: Redirecting money from the Bush tax cuts to unemployment benefits would be a net job creator. ...

Will Geoengineering Make Things Better or Worse?

Posted: 19 Jul 2010 01:53 PM PDT

Is geoengineering the answer to our global warming problems?:

Is the cure (geoengineering) worse than the disease (global warming)?, by David Biello: If there's one thing more potentially contentious than the international politics of global warming..., it's the politics of the most radical suggestion to solve it: geoengineering. ...
Geophysicist Kate Ricke of Carnegie Mellon University and her colleagues show that one of the more feasible geoengineering methods—injecting reflective particles into the atmosphere to mimic the world-cooling effects of a volcanic eruption—will have effects that vary from place to place. So, for example, India might be rendered too cold (and wet) by a level of particle injection that's just right for its neighbor China while setting the levels to India's liking would toast the Middle Kingdom.
What's worse, the computer models that show that such injections might work in the short term also show that they will change global weather patterns by making part of the atmosphere more stable—and therefore less likely to promote storms. That means less rainfall to go around—and these side effects become worse with time. ...

Engineers used to show up in comments and tell me that, unlike economists, they know how to build systems in ways that prevent the chance of catastrophic collapse like we had in the financial system. Then the oil spill in the gulf happened and they've become much more scarce. Even if the models said this will work without any worrisome side effects or geographic differences, the stakes are too high to use that result as an excuse to delay action on the global warming problem. We need to start solving this problem now and if we are lucky, we won't have to depend upon the geoengineers to prevent catastrophic effects from global warming.

What Should be Done with Fannie Mae and Freddie Mac?

Posted: 19 Jul 2010 08:55 AM PDT

The Economist asks:

What should be done with Fannie Mae and Freddie Mac?

Here's my response (additional responses from Laurence Kotlikoff, Phillip Swagel, Tom Gallagher, and John Makin, with others to follow, all responses):

There are two potential justifications for the existence of institutions like Fannie and Freddie. One is to solve a significant market failure in the private sector mortgage market. If there is some reason why the mortgage market does not function properly on its own, perhaps due to lack of information on one side of transactions, inefficient risk management, adverse selection, the presence of moral hazard, etc., then government can step in and fix the problem.

The second justification is the role these institutions can play in stabilizing the macroeconomy. Contrary to what you may have heard from people who want you to believe that government is always the problem and never the solution -- the people who try to blame Fannie and Freddie for the crisis despite evidence they weren't the primary cause -- having such institutions in place may allow a better response to a financial crisis than would otherwise be possible.

With respect to the market failure justification, no market is perfect, and the mortgage market is certainly no exception. Even so, I think it's hard to justify the existence of Fannie and Freddie based upon their ability to solve private sector market failures. To the extent that market failures do exist, there are better ways to overcome them. For example, there may be externalities from home ownership that accrue to the local community, but these benefits are not captured in the price of homes. If this is the case and the external benefits are large, then there may be a role for government to subsidize home ownership. However, simple mechanisms such as tax rebates can be used to solve this problem, we wouldn't need Fannie and Freddie. Since the same is true for most other examples of mortgage market failure I can think of, it's hard to justify the existence of Fannie and Freddie based upon their ability to effectively overcome imperfections in the mortgage market.

I think a better case can be made for Fannie and Freddie based upon the role that they can (and did) play in helping to stabilize a financial system that is in crisis. Fannie and Freddie concentrate risk that is dispersed across many different banks and other financial institutions. If a systemic shock hits, instead of having all the difficult problems that come with the nearly simultaneous failure of such a large number of banks, only one or two institutions get into trouble. This allows regulators to focus their efforts on these institutions as they attempt to stabilize the financial system.

The politics of the recent bailout of Fannie and Freddie are lousy, and the distribution of benefits to large banks through the backdoor bailouts Fannie and Freddie provide could certainly be improved, but mortgage markets may have failed entirely were it not for Fannie and Freddie. In addition, they have helped to keep long-term interest rates low through their purchase and guarantee of mortgage contracts. Things are bad, but a completely dysfunctional mortgage market coupled with much higher long-term interest rates would have been much, much worse.

However, it's important to note that it's not certain that the effect of institutions like Fannie and Freddie will, on net, be positive. The benefit of these institutions is that they allow us to more effectively stabilize mortgage markets -- which are prone to bubbles -- when they get into trouble. However, there is also a cost. The implicit government guarantee that stands behind Fannie and Freddie increases risk taking behavior overall making crises both more likely and more severe.

This means that effective regulation of risk taking behavior will improve the chances that Fannie and Freddie are beneficial on net. As explained at the link given above, regulation of Fannie and Freddie was relatively successful in this regard, but far from perfect. It was the private sector, not Fannie and Freddie, that took the lead in exploiting the short-run profit potential of risky mortgage products. Initially, regulation kept Fannie and Freddie out of these highly risky markets. It wasn't until Fannie and Freddie began losing market share that they began to find ways around the restrictions that prevented them from pursuing the same risky strategies. They were followers, not leaders, into subprime markets.

However, the fact that they could follow at all indicates that regulation was less than perfect. The loss of market share should have been a signal that the private sector markets needed closer scrutiny, and Fannie and Freddie should not have been allowed to follow the private sector down the sinkhole. The fact that Fannie and Freddie were allowed to follow private sector into risky markets when they began losing market share to private sector firms, and the failure to adequately regulate the risk that private sector institutions could take undermines faith in regulators and makes the case for Fannie and Freddie murky.

I still think that, overall, having Fannie and Freddie was beneficial, and I'll give lukewarm support for these institutions. But that support is conditional upon the expectation that regulators will do a better job of monitoring and regulating the amount of risk that is present in financial markets. The presence of institutions like Fannie and Freddie encourages banks to take on additional risk, and the additional risk generates costs that can more than offset the benefits Fannie and Freddie provide in terms of helping to stabilize the financial system when it gets into trouble. We need to do a better job than we have in the recent past of regulating the amount of risk that banks can take in response to the insurance that they get from the implicit government support of Fannie and Freddie. If we can't, then the case for the existence of Fannie and Freddie is much harder to make.

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