Dear Prudence, Can We Have Good Fiscal Policy?

(For the sake of my argument, I will assume two things- (1) Democrats are willing to go to the mat for good policy; (2) Republicans are actually willing to govern and not just obstruct. Neither of these assumptions are true.)

The United States currently faces two major crises- (1) a stagnating economic recovery, and (2) a staggeringly large, and growing, budget deficit. Not only do both portend continued and future trouble for the US economy, but they generally run in opposite directions. Injecting additional dollars into the economy, via some type of stimulus, will grow the deficit. And, cutting spending, in order to shrink the deficit, will only further strangle what is a weak recovery.

Given what seems an impossible situation (addressing both problems simultaneously), there are limited fiscal policy options available. Of course, one could go full Keynesian and simply prime the pump with additional stimulus, regardless of whether or not it is financed by debt. Given the extremely low rates on Treasuries, such an option ought not be entirely ruled out of order. In fact, this is the argument made by Krugman and others. And while it is true that the cost of borrowing is near zero, our addiction to debt (going on close to ten years now, thanks to the Bush administration) needs to be checked at some point. One might argue that now is not the right time to do so, and it is a valid point.

What I would suggest is something that finds a compromise between the deficit hawks and the Keynesians. Allow the Bush tax cuts for the wealthy to expire, as they are scheduled, and use this revenue to finance other stimulative activity. It is important to note that it is only the tax cuts for the wealthy that would be allowed to expire. Those targeted at the middle class should be extended another two years.  What exactly would this revenue finance?

1. Off the top, some of the additional revenue must be used to finance the middle class tax cuts and a fix to the AMT.

2. Payroll tax holiday. I’m open as to the exact length of such a holiday, but feel that it needs to be long enough that people will not just smooth their consumption. Too short of a holiday will not provide much stimulus because people will either smooth consumption or use this short term increase in income to pay off debt. My best guess is that a holiday needs to be longer than 6 months.

3. Infrastructure investment. The President has called for a $50 billion investment in roads, rails and runways. While this is a good start, it is inadequate to really bring our transportation system into the 21st century. Decades of neglect cannot be remedied in a year or two. We must make a long-term commitment to modernizing our infrastructure, including transportation but also our power grid.

4. Backstop state revenues. One of the major shortcomings of the original stimulus bill was that it did not provide enough revenue to states. Unlike the federal government, states must maintain a balanced budget. Certainly, some creative accounting can be done, and personnel is sometimes moved over to the capital budget in order to avoid cuts, but it’s no secret that state budgets have been wracked by this recession. The original stimulus also structured aid to states the wrong way. Instead of providing a temporary increase in FMAP and money for education (and other minor support), the package should have been an open-ended commitment to close state budget gaps, for at least two fiscal years. (Obviously, there would need to be a maintenance of effort requirement so that federal funds were supplementing, not supplanting, state revenues.)

A key feature of all these proposals is their fixed term duration, with the exception of a permanent AMT fix. This ensures that any increase in the deficit will be temporary and not baked into out years. In addition, the final three recommendations all have a stimulative effect, which means more people working, less people collecting unemployment, and more income and sales tax revenues for state and federal governments.

It is clear that we should not simply spend our way out of the recession, but we must not cut our way out of the deficit. A prudent fiscal policy attempts to address both of these concerns, or is at least mindful of both. What I have offered here is such a plan. It’s not my ideal, nor is it perfect. But it is a reasonable attempt to jump start our economy while narrowing our deficit.


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