December PFD "Con" Analysis

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December PFD "Con" Analysis

Postby lsabino » Wed Nov 14, 2012 10:55 am

On the “CON” side, there are a number of arguments for cutting spending as a better solution to the “fiscal cliff” and to foster long-term growth in the future. Much like yesterday, we’ll begin with a discussion of the offensive arguments (reasons why spending cuts are good for the economy and better than tax increases). We will then proceed to defensive arguments (reasons why spending cuts are not bad or why data to the contrary is flawed).

Offense:

1. Studies cite that many economists agree.
In the most general sense, it’s worth noting that many economists are in favor of spending cuts as an economic strategy more than tax increases. This is significant because they are, simply put, the experts in the field, having dedicated their lives to the study of these very phenomena. CNBC explains:

CNBC, “Spending Cuts, Not Tax Hikes, Best for Deficit,” August 22, 2011.
The majority of economists surveyed by the National Association for Business Economics believe that the federal deficit should be reduced only or primarily through spending cuts. The survey out Monday found that 56 percent of the NABE members surveyed felt that way, while 37 percent said they favor equal parts spending cuts and tax increases. The remaining 7 percent believe it should be done only or mostly through tax increases. As for how to reduce the deficit, nearly 40 percent said the best way would be to contain Medicare and Medicaid costs. Nearly a quarter recommended overhauling the tax system and simplifying tax rates and exemptions. About 15 percent said the government should enact tough spending caps and cut discretionary spending. The latest survey by the NABE was conducted in the two weeks ending Aug. 2, the day that the Senate passed and President Obama signed legislation to cut spending by more than $2 trillion and raise the nation's debt ceiling. The agreement managed to avert a potential default, but Standard & Poor's downgraded U.S. credit from AAA to AA+, citing the political wrangling over the deal as a reason.


2. Social spending distorts incentives for workforce participation.

Many scholars opposed to government spending (those who advocate spending cuts) discuss the role of incentives in motivating productive behavior. One of the government programs at issue in the “fiscal cliff” is unemployment insurance. Unemployment insurance is, basically, a social safety net that pays individuals a base amount while they are unemployed so they will not lose their homes, etc. while they look for work. Advocates of cutting this program believe it provides a perverse incentive to remain unemployed. Salim Furth explains (emphasis added):

Salim Furth, “Are Spending Cuts as Harmful as Tax Increases?” The Foundry, The Heritage Foundation, August 24, 2012.
Wednesday’s warning by the Congressional Budget Office (CBO) that the fiscal cliff is likely to push the economy back into recession should bring things sharply into focus for lawmakers. The CBO is correct that the fiscal cliff will lead to a recession, but its report contains faulty economic reasoning. The analysis contained in the CBO report treats tax increases and federal spending cuts as equally harmful to the economy. That contradicts a foundational principle of economics: People respond to incentives. Professor John Cochrane of the University of Chicago’s Booth School of Business points out that the CBO report misses badly on unemployment insurance, a topic exhaustively studied by economists, including The Heritage Foundation’s James Sherk. Cochrane writes: What will the effect on output and employment be of ending 99 weeks of unemployment insurance? That’s part of the fiscal cliff, and the CBO’s analysis says that reducing unemployment insurance will lower GDP. Really? A standard economic analysis comes to exactly the opposite conclusion. Generous unemployment and disability means that some people choose to stay unemployed rather than take lower-paying jobs, or jobs that require them to move. So long as you stay unemployed, you get a check from the government. Subsidizing anything produces more of it. So, a standard analysis says that cutting back unemployment insurance lowers unemployment, and raises output and this part of the fiscal cliff analysis should go the other way. Before you go all nuts on how heartless I am, keep the question in mind. I didn’t say what’s good or bad, I said what raises or lowers GDP and unemployment. The standard analysis of unemployment insurance says, yes, it raises unemployment and lowers GDP, but it provides important insurance for the truly needy and unfortunate. It’s something we do out of compassion even though it hurts us. What’s obviously true about unemployment insurance is usually true of other government spending. When the government taxes one person and provides for another, it reduces the incentives for both of them to work or to invest in education, a new business, or career mobility. For instance, if government provides health care to all citizens by taxing citizens who work, that twice reduces everyone’s incentive to work: earning an income is harder with higher taxes and is less important when someone else is paying for one’s health care. This does not mean that all transfer payments should be eliminated, but it does mean that they reduce GDP and employment. Government spending is good when it pays for valuable public goods. We tax ourselves to provide a fair justice system, education for all, and protection from violence—not to stimulate the economy. As Congress and the President consider how to address the fiscal cliff, they should understand that reducing the size of government through lower taxes and spending systematically raises private GDP, but increasing spending does not.


Two arguments here:

1. Causes unemployment which harms the economy. Furth argues that this specific instance of federal spending increases unemployment because individuals don’t have an incentive to take certain jobs. If unemployment insurance pays a base wage, it’s unlikely that an individual will settle for “just any job” or will take a job that would require significant lifestyle changes (moving across the country or even a longer commute).

2. Destroys incentive for the taxed to invest. In a more general sense, government spending also causes other problems. The money that goes to programs like unemployment insurance must come out of taxes. Those who are taxed to subsidize others’ inability to find work (or, arguably, unwillingness to find work) are potentially less likely to invest in education, infrastructure, or other privately funded public goods because they have less money to do so.


3. Past data supports that spending to stimulate the economy doesn’t work.

Although data exists to support both sides, there’s relatively solid data to suggest that administrations that taxed the least and spent the least yielded higher economic returns than those that did the opposite. Taylor and Vedder explain in a Cato Policy Report (I really recommend you read the whole thing; it’s very detailed):

Jason E. Taylor and Richard K. Vedder, “Stimulus by Spending Cuts: Lessons from 1946,” Cato Institute, Cato Policy Report May/June 2010.
The conversation has begun regarding the nation's exit strategy from the unsustainable fiscal and monetary stimulus of the last two years. Our soaring national debt will not only punish future generations but is also causing concern that our creditors may bring about a day of reckoning much sooner (the Chinese have recently become a net seller of U.S. government securities). There are fears that the Fed's policy of ultra-low interest rates may bring new asset bubbles and begin the cycle of boom and bust all over again. And unless the Fed acts to withdraw some of the monetary stimulus, many fear a return of 1970s era double-digit inflation. On the other hand, there are widespread fears that if we remove the stimulus crutch, the feeble recovery may turn back toward that "precipice" from which President Obama has said the stimulus policies rescued us. History and economic theory tell us those fears are unfounded. More than six decades ago, policymakers and, for the most part, the economic profession as a whole, erroneously concluded that Keynes was right — fiscal stimulus works to reduce unemployment. Keynesian- style stimulus policies became a staple of the government's response to economic downturns, particularly in the 1960s and 1970s. While Keynesianism fell out of style during the 1980s and 1990s — recall that Bill Clinton's secretary of treasury Robert Rubin turned Keynesian economics completely on its head when he claimed that surpluses, not deficits, stimulate the economy — during the recessions of 2001 and 2007-09 Keynesianism has come back with a vengeance. Both Presidents Bush and Obama, along with the Greenspan/Bernanke Federal Reserve, have instituted Keynesian-style stimulus policies — enhanced government spending (Obama's $787 billion package), tax cuts to put money in people's hands to increase consumption (the Bush tax "rebate" checks of 2001 and 2008), and loose monetary policy (the Federal Reserve's leaving its target interest rate below 2 percent for an extended period from 2001 to 2004 and cutting to near zero during the Great Recession of 2007-09 and its aftermath). What did all of this get us? A decade far less successful economically than the two non- Keynesian ones that preceded it, with declining output growth and falling real capital valuations. History clearly shows the government that stimulates the best, taxes, spends, and intrudes the least. In particular, the lesson from 1945-47 is that a sharp reduction in government spending frees up assets for productive use and leads to renewed growth.


4. Trade off with the private sector.

As you would expect, many advocates of spending cuts argue the inverse of the PRO argument that more government spending encourages private investment in public works that benefit everyone. Government spending, con authors argue, crowds out private investment in beneficial projects (roads, schools, technology, etc.) This, they argue, is particularly disastrous because the government, lacking a profit incentive to be efficient and innovative, is bad at all of these things. Christopher Preble explains:

Christopher Preble, “Are Military Spending Cuts Good for the Economy?” August 8, 2012, Cato At Liberty, Cato Institute.
After all, every dollar spent by the government — federal, state or local — is extracted from the private sector. Advocates for higher taxes and more government spending claim that individuals in Congress, state capitols and city halls are wise enough to know where these resources should be spent. Conservatives and libertarians point out that this attempt to pick winners and losers will fail more often than it succeeds, and the net result is a less productive economy. The principle applies equally when the money is spent by government agency A (e.g. the Department of Agriculture) vs. government agency B (e.g. the Department of Defense). In fact, it costs more than a dollar to send a dollar to the government because of the excess burden of taxation, a process documented by a number of economists, including Harvard’s Martin Feldstein. The tax system imposes costs on the economy by discouraging economic activity, including both work and investment, that would otherwise occur in the absence of those taxes. Feldstein finds that higher marginal tax rates generate an excess burden on the economy of $0.76 for every additional dollar of revenue. Because “the taxes needed to fund existing spending impose an excess burden smaller than the taxes needed to fund increased spending,” Zycher conservatively estimates an excess burden of 35 percent for current military expenditures. Accordingly, he concludes, “a reduction in annual defense outlays of $100 billion can be predicted with high confidence to increase the size of the private sector by at least $135 billion per year.”


The picking winners and losers argument in this evidence is important. Government spending by nature subsidizes an industry or business by giving it money it wasn’t earning in exchange for a service. Conservative authors argue that this is bad because the government may not select the company that’s best for the job. By giving money to a particular company, industry, or individual, they’re “picking a winner” instead of forcing those entities to compete in an open market. Without competition (which awards companies, individuals, etc. for being good at something), inefficient use of money abounds because there’s no incentive to be the best. There’s no urgent need to make money. John Taylor elaborates on this point:

John B. Taylor, “Goldman Sachs Wrong About Impact of House Budget Proposal,” February 28, 2011, Economics One.
Some claim that House budget proposal H.R. 1 to reduce the growth of federal government spending will cause a slowdown in the economy and even increase unemployment. Consider, for example, a recent report by Alec Phillips of Goldman Sachs which claims that the House proposal would reduce economic growth in the second and third quarters of this year by 1.5 to 2 percent if enacted into law next month. … There are several things wrong with the analysis used in Goldman Sachs report. First, it does not take account of the beneficial effects of starting now on a credible plan to reduce the deficit. Basic economic models in which incentives and expectations of future policy matter show that a credible plan to reduce gradually the deficit will increase economic growth and reduce unemployment by removing uncertainty and lowering the chances of large tax increases in the future. The high unemployment we are experiencing now is due to low private investment rather than low government spending. By reducing some uncertainty and the threats of exploding debt, the House spending proposal will encourage private investment. The analysis in this Goldman-Sachs report is based on the same type of “large multiplier” theory that predicted that the stimulus package of 2009 would stimulate economic growth. Research by me and my colleague John Cogan finds that more up-to-date theories, which bring important incentive and expectations effects into account, show far smaller multipliers. In these models a reduction in the growth of spending will immediately crowd in private investment. Moreover, by following the stimulus money, we found that in actuality the stimulus package of 2009 had no material positive effect on economic growth or employment. The same economic theory which said the stimulus would increase economic growth in the past two years, says that reversing that spending will reduce growth now. It was wrong in the past and it is highly likely to be wrong again.


Another argument to highlight here: If this tradeoff argument is accurate, private companies will also do nothing to address unemployment. With government spending crowding out private money, private companies are less likely to hire more workers. Since the vast majority of workers are employed by private companies, the effects on overall unemployment could potentially be very large.

Defense:

1. Multiplier effect predictions are wrong.
A defensive argument to consider is that “pro” authors vastly overestimate the “multiplier effect” of funding cuts. That is, they assume that a withdrawal of government funding would ripple through the economy much more aggressively than likely. Many pro authors argue that defense spending cuts, for example, would be disastrous because they would withdraw funds from not only the defense industry but also all of the other industries and jobs that depend on defense (steel production, for example). Con authors argue that the withdrawal of these funds is necessary to allow industries we have less of a need for to contract and those industries that depend on it to find more profitable niches. To extend the example, this means that if there were defense cuts, those individuals that lost jobs or money would seek out other, more useful, avenues for their skills or products. If we don’t need as many steel workers for military contracts, for example, they could focus their skills on something we do need – for example, building mass transit. Jobs and industries that cycle out of the economy, then, aren’t gone forever and don’t spell the economic disaster pro authors believe they will. Christopher Preble explains:

Christopher Preble, “Are Military Spending Cuts Good for the Economy?” August 8, 2012, Cato At Liberty, Cato Institute.
In a new paper released today, economist Benjamin Zycher outlines some of the economic rationales for such cuts. … There are at least two major problems with Fuller’s research (and others like it), one methodological, the other conceptual. Zycher scrutinizes them both. The primary methodological flaw is Fuller’s grossly inflated assumptions about the multiplier effects of defense spending, in particular, and government spending generally. The supposed economic effects above imply a multiplier of 1.92%, whereas the recent peer-reviewed economics literature shows multipliers of between 0.6% and 0.8%. Zycher observes: a multiplier effect of less than 1% “suggests strongly that increases in defense spending (and government spending more generally) have effects on GDP that are offset by reductions in other economic activity.” The conceptual problem of proclaiming that defense spending is good for the economy, and cuts are bad, flows logically from the different assumptions about the multiplier. Fuller and others focus narrowly on the particular industries affected by cuts. But these cuts should free up resources elsewhere. To be sure, there are likely to be temporary dislocations for some workers and businesses. These will be difficult for the individuals and firms affected, but the economy as a whole will benefit as skills and resources are redirected to more productive activities.


Further reading:
Andrew Balls, “How Government Spending Slows Growth,” January, 2000, The National Bureau of Economic Research.

This wraps up our December con analysis! Good luck – and, as always, feel free to send your cases to lauren.sabino@ncpa.org for a free critique! Have other questions? Use this thread for clarification! We can’t wait to help you with your hard work!
lsabino
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