Sunday, September 18, 2011

Framing the Budget Debate

By Lewis Sage

The federal budget is mind-numbingly complex; I get that.  I’ve written about some of that complexity – as has Dr. Strong – a lot over the past couple of months.  [No Magic Wand (7/14), Spending Cuts and Tax Increases (7/18), Rationality and Freedom (8/8).]  But how someone answers just two fundamental questions may tame the complexity, prune the logical tangle, and frame the debate over short- and long-term fiscal policy.
Question One: Does fiscal policy work?  Do spending increases and tax cuts boost private sector spending and ignite the output multiplier?  If your answer is, “No,” then you see no role for public policy in the economic recovery and you can proceed directly to Question Two.  If, on the other hand, you believe that fiscal stimulus works in the short run, then, logically, you must also believe that its inverse works as well: less spending and more taxes run the multiplier in reverse.  Bottom line: if fiscal policy works, then even a budget-neutral reduction of federal spending would create a second dip in the economy, while some form of fiscal stimulus would prevent that dip and, if large enough, reduce unemployment.
Question Two: Is the federal government too big?  This is an essentially philosophical issue on which reasonable folks can disagree, reasonably.  If you think it is too big, then it’s a problem that’s been around for at least the past thirty years [More on Spending Cuts and Tax Increases (7/24)].  At the beginning of the Reagan administration, total federal spending was 21.2% of GDP; it’s been as much as 22.4% (1985) and as little as 18% (2000), but it was back to 20.8% at the start of the Obama administration.  If you believe that federal spending is too big a fraction of our economy, note that the last time it was less than 18% was in the middle of the Johnson administration (1966) and that to get below 15%, we have to run the clock back to Truman (1951).
So, assuming that 1) we would prefer low unemployment to high unemployment; and that 2) huge federal budget deficits can’t persist indefinitely, here’s how the answers to our questions parse the political rhetoric.

Fiscal policy works
Doesn’t work
Government is too big
Cut taxes immediately;
cut spending later
Cut taxes immediately;
cut spending more
Not too big
Fiscal stimulus immediately;
fiscal contraction later
Raise taxes immediately;
leave spending at 20% of GDP

If fiscal policy doesn’t work, the only issue is the size of government: balance the budget by shrinking spending more than taxation if government is too big for your tastes or close the gap with increased taxes if the scale of government is ok.
If fiscal policy does work, then the belief that government is too big guides us to stimulative tax cuts now and to large, budget balancing, spending cuts when the economy has recovered.  If a federal share around 20% is acceptable, then temporary tax cuts and spending increases are indicated and, post-recovery, permanent tax increases will be required to close the gap.
If you can’t find your favorite politician’s position on the menu, it’s worth asking why not.

Dr. Lewis C. Sage likes intersections. Since 1991, he has taught Law and Economics, Mathematical Economics, and the Economics of Healthcare. A former Fulbright Fellow (Bulgaria 1995-6), he teaches an interdisciplinary Honors seminar, Enduring Questions, and is studying strategy in the NFL draft with faculty and students in Sports Management and Psychology. E-mail:

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This blog lives under the auspices of the Department of Economics whose mission has been to hold high the lantern beaming an "economic way of thinking" onto the world. Selfishness, rationality and equilibrium have been central to the teaching of an economic way of thinking rooted in the Renaissance. And, in this regard, the department has faithfully stayed the course. The intent of this blog, thinking out loud..., however, is to entertain exchanges which may challenge the centrality of economics as we teach it.