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Silver Linings Playbook

Article by Ike Brannon March 13, 2013 //   5 minute read

People who hope that the business cycle will eventually boost economic growth and slow the depletion of the government’s empty coffers got some sobering news the other day. Doug Elmendorf, director of the Congressional Budget Office, told a U.S. Senate committee that government spending will increase as a proportion of GDP indefinitely, thanks to the growing cost of health care and the increasing proportion of citizens receiving entitlements of some sort. With longevity for those who reach age 65 increasing at a historic pace and the baby-boom retirees entering their golden years, Elmendorf’s sober statement — while revealing nothing new — managed to depress anew a wide swath of conservative politicians.

Is there any way to put some lipstick on this mess of a situation? Let me give it a try — while using some of these slim silver linings as a suggestion for action.

The first thing to consider is that revenue can grow faster than GDP, and faster than government spending. After all, it has done so regularly during upticks in the business cycle. Indeed, from 2004 to 2007 revenue grew over 40%, a post-war record. Three things happen when the economy grows: More people get jobs and begin paying income taxes, more people start getting raises bumping them up into higher income tax brackets, and businesses see profits rise, boosting their tax obligations. Unfortunately, revenue as a proportion of GDP doesn’t rise indefinitely because the business cycle eventually rears its head and recessions decrease profits, employment, and wage growth.

However, it’s wrong to think (as many have suggested) that there is some internal thermostat within the economy that slows it when revenue is high and speeds it up when it is low. The historical observation that revenues have been between (roughly) 18% and 20% in the three decades before the Great Recession does not imply that this range is somehow binding. Higher tax rates invariably bring lower growth, and now that Congressman Pete Stark has retired, there is no serious tax increase proposal afoot that would slow growth so much as to decrease tax revenue as a result. But higher tax revenue that results from a period of sustained economic growth does not necessarily imply anything about future economic growth — i.e., there’s no reason to think that increased revenue constrains growth.

The second point to consider is that the real problem facing our federal budget becomes evident in the long run, and forecasting long-run revenues is well-nigh impossible. We can get a rough guide as to our long-run obligations by guessing at future longevity gains, health-care inflation, and retirement ages, but these are very imprecise, to say the least. Forecasting long-run revenue is even more problematic. Since revenue is so highly dependent upon economic growth, it requires CBO to place a bet on growth 10 or 20 years into the future. But the sad reality is that CBO (and everyone else who attempts this) has no ability to do more than guess at GDP growth even a few quarters into the future.

What revenue estimators agree upon is that economic growth simply cannot be counted on to get us out of this mess, in part because our entitlement obligations are tied to economic growth. The formula that computes the initial Social Security benefits for new retirees ties benefits to the growth of wages, which has historically grown about one percentage point faster than the rate of inflation, meaning that strong growth actually increases benefits apace.

Our budget situation is painful to contemplate for anyone being realistic about the future. The fact that none of our manufactured budget emergencies have even begun to address the soaring entitlement issue does not give me confidence that this will end well. But it is clear that one essential ingredient to solve our long-run shortfall is stronger economic growth. Here’s hoping it doesn’t evaporate before we get the political will to tackle it.