A Way to Avoid the Fiscal Cliff without Creating Another One

So far the fiscal cliff debate has mainly been about whether tax revenues should be on or off the table with little mention of spending. But the economics of the debate—as distinct from the raw politics—make no sense without considering spending. And whenever spending is mentioned, it’s in terms of gargantuan ten-year totals like 2 or 3 trillion dollars, which are meaningless to most people and sweep under the rug key questions about the size of government and the speed of adjustment.

So consider an alternative way to present and discuss spending proposals. It involves the following chart, and while not everyone likes to use charts, this one is far more digestible than those multitrillion dollar sums thrown around. And it suggests away to avoid the fiscal cliff.

Starting on the lower left of the chart a history line shows the sharp rise in federal spending as a share of GDP from the year 2000 to the present. It then splits into four lines corresponding to different year-by year spending paths which were proposed in the months leading up to the budget deal of last year:

  • The top line is the Administration’s spending proposal made in February 2011.
  • The next line shows the result of the budget deal of the summer of 2011, but it does not include the additional sequestration reductions that were part of the deal.
  • The third line is the Simpson-Bowles spending proposal which was put forth in their December 2010 report.
  • The fourth line is a “pro-growth” proposal made by Gary Becker, George Shultz and me in the Wall Street Journal on April 4, 2011.
  • Two other proposals worth noting on the chart:
    • spending with sequester cuts from the 2011 deal; it’s close to Simpson-Bowles
    • the House Budget resolution of March 2012; it’s close to the pro-growth line.

Note that although federal spending as a share of GDP declines for the pro-growth and Simpson-Bowles paths, actual spending rises at 3.3 % per year and 4.8% per year respectively.

When looked at in this way, the logic of the pro-growth proposal jumps out at you:

  • First, the proposal simply reverses the recent spending surge by bringing spending to 2007 shares of GDP, still well above levels at the end of the Clinton Administration.
  • Second, the reversal is very gradual; substantially more gradual than the rapid run up in spending. This gives people a chance to adjust. In fact, macro model simulations show that this gradual spending reduction will increase economic growth even in the short run.
  • Third, the spending reduction will lead to a balanced budget without tax increases, because the budget was nearly in balance in 2007. This is why it’s called the pro-growth path, and it also allows for static revenue neutral tax reform which will raise growth further.

For those who want a bigger government than implied by the pro-growth path, the chart points to a good way to avoid the fiscal cliff without creating another:

(1) Agree now, during the lame duck session, to spending as in the Simpson-Bowles proposal. That is sequester spending levels without the damaging cliff-like sequester. Most members of Congress are familiar with the proposal making it easier to pass during the lame duck session.

(2) Postpone all scheduled income tax increases until a negotiation over tax reform is completed in the next Congress. There the key issue will be whether to increase taxes to pay for the higher spending levels in Simpson Bowles, or to keep spending at 2007 levels as a share of GDP without tax increases, or somewhere in between. Agreeing to the Simpson Bowles spending levels now in order to avoid the cliff shouldn’t give either side additional bargaining power after the cliff.

About John B. Taylor 117 Articles

Affiliation: Stanford University

John B. Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University and the Bowen H. and Janice Arthur McCoy Senior Fellow at the Hoover Institution. He formerly served as the director of the Stanford Institute for Economic Policy Research, where he is now a senior fellow, and he was founding director of Stanford's Introductory Economics Center.

Taylor’s academic fields of expertise are macroeconomics, monetary economics, and international economics. He is known for his research on the foundations of modern monetary theory and policy, which has been applied by central banks and financial market analysts around the world. He has an active interest in public policy. Taylor is currently a member of the California Governor's Council of Economic Advisors, where he also previously served from 1996 to 1998. In the past, he served as senior economist on the President's Council of Economic Advisers from 1976 to 1977, as a member of the President's Council of Economic Advisers from 1989 to 1991. He was also a member of the Congressional Budget Office's Panel of Economic Advisers from 1995 to 2001.

For four years from 2001 to 2005, Taylor served as Under Secretary of Treasury for International Affairs where he was responsible for U.S. policies in international finance, which includes currency markets, trade in financial services, foreign investment, international debt and development, and oversight of the International Monetary Fund and the World Bank. He was also responsible for coordinating financial policy with the G-7 countries, was chair of the working party on international macroeconomics at the OECD, and was a member of the Board of the Overseas Private Investment Corporation. His book Global Financial Warriors: The Untold Story of International Finance in the Post-9/11 World chronicles his years as head of the international division at Treasury.

Taylor was awarded the Alexander Hamilton Award for his overall leadership in international finance at the U.S. Treasury. He was also awarded the Treasury Distinguished Service Award for designing and implementing the currency reforms in Iraq, and the Medal of the Republic of Uruguay for his work in resolving the 2002 financial crisis. In 2005, he was awarded the George P. Shultz Distinguished Public Service Award. Taylor has also won many teaching awards; he was awarded the Hoagland Prize for excellence in undergraduate teaching and the Rhodes Prize for his high teaching ratings in Stanford's introductory economics course. He also received a Guggenheim Fellowship for his research, and he is a fellow of the American Academy of Arts and Sciences and the Econometric Society; he formerly served as vice president of the American Economic Association.

Before joining the Stanford faculty in 1984, Taylor held positions as professor of economics at Princeton University and Columbia University. Taylor received a B.A. in economics summa cum laude from Princeton University in 1968 and a Ph.D. in economics from Stanford University in 1973.

Visit: John Taylor's Page, Blog

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