"Avoiding Fiscal Meltdown
May 12, 2010 - 3:41 pm
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Jeffrey MironBio | Email
Jeffrey Miron is Senior Lecturer and Director of Undergraduate Studies in the Department of Economics at Harvard University.
As countries around the world attempt to rein in their current and future fiscal nightmares, four approaches merit discussion.
The first is rules, such as balanced budget amendments or limits on spending, that "mandate" lower deficits without adopting specific tax increases or spending cuts.
This approach is feel-good silliness designed to con voters into thinking politicians have done something, without actually imposing any pain. Little evidence suggests this approach has much impact, mainly because politicians have myriad ways to honor the letter of the rules but not the spirit. Moving entities like Fannie Mae "off-budget" by "privatizing" them is one example.
The second approach to fiscal salvation is policy changes that make an economy more productive. Such changes are always a good idea, regardless of debt, and many such changes are available (e.g., eliminating agricultural subsidies, removing barriers to free trade). But even in the best case scenario, higher economic growth will not be sufficient to avoid the impending fiscal disasters.
A third approach to restoring fiscal balance is higher taxes. This reduces deficits to some degree, but the magnitude is limited. Higher taxes cause slower economic growth and greater tax evasion, so they bring in less revenue than standard projections. Indeed, given the level of taxation in many economies, higher rates might reduce revenue by pushing economies to the wrong side of the Laffer curve.
That leaves only one path for real deficit reduction: substantial cuts in government expenditure, especially lower government retirement and health benefits. Fortuitously, these cuts can enhance economic efficiency and promote growth. Reduced retirement benefits, for example, encourage people to work until their productivity has declined, not just until they reach a specific age. Higher co-pays and deductibles in government health insurance push consumers to balance costs and benefits in deciding how much health care to consume, improving the allocation of resources in the health sector.
Thus cutting expenditure has both a direct benefit and an indirect benefit on fiscal balance. It is the only approach, moreover, that can significantly reduce the fiscal time-bombs on the horizon."
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