Toward a Different Fiscal Future

Wall Street Journal | Moody’s Investors Service’s warning last week that the AAA credit rating of the United States is in jeopardy raises fresh concern about the nation’s fiscal health. The question to ask about the president’s eye-popping budget, also rolled out last week, is whether it prepares the country for its future—or shackles it to past decisions that our leaders would rather not confront.

President Obama’s blueprint gave us a federal budget deficit for fiscal year 2010 of $1.6 trillion, about 10.6% of GDP. While one expects bigger budget deficits in a downturn, the administration expects the deficit and debt buildup to persist. By 2013, it forecasts that deficits will bring about a debt-to-GDP ratio of 72%, unprecedented in our experience except during a major war.

The problem is spending. Despite Mr. Obama’s words about restraint, the new budget proposes more spending—1.8% of GDP for 2011 to be precise—and a higher level, roughly one percentage point of GDP higher, in subsequent years.

Debates about the budget traditionally revolve around these numbers. There is another way to look at the federal budget, however, and that is to focus on its effect on our economic health, not just the government’s fiscal health. Focusing on economic health means setting our sights on productivity growth—our future living standards.

To understand what this means, consider the famous “kitchen debates” between Soviet President Nikita Khruschev and Vice President Richard Nixon in 1959 about the merits of capitalism and socialism. Nixon famously pointed to color television as a milestone in American innovation. The Soviet leader replied by trumpeting his nation’s lead in rocket thrust. The issue resurfaced in the televised 1960 presidential debates, when Sen. John F. Kennedy attacked Nixon for wanting to lead a nation No. 1 in color TV, but not in rockets.

Nixon’s response was essentially nothing. But the correct response was obvious: The nation with the higher present and future productivity growth—the U.S.—could lead in both color TV and rockets.

Today our productivity growth is imperiled by the anti-investment tilt of the president’s budget plan for escalating federal debt. Even conservative estimates of effects of federal debt on interest rates (by Eric Engen of the Federal Reserve and me in the 2004 National Bureau of Economic Research Macroeconomics Annual) suggest that the last Obama budget blueprint would lead to a one-percentage-point rise in Treasury interest rates as the economic recovery takes hold. The consequence—lower business investment and real GDP 4% lower than it would otherwise be by the next presidential election—compromises our future.

But there is more bad news. The Congressional Budget Office (CBO) estimates that, without policy changes, by 2050 spending on Social Security, Medicare and Medicaid alone would be 10 percentage points of GDP more than today. Total federal spending would exceed 30% of GDP. ObamaCare would only exacerbate the problem. This means government spending for national defense, education, research and other priorities would be dramatically constrained.

This brings us to the reason we need a real budget debate today: Tax increases cannot plausibly make these problems go away. If taxes were increased sufficiently to accommodate the CBO’s projected increase in entitlement spending, long-term U.S. GDP growth rates would be reduced between a half and a full percentage point (an estimate derived from widely cited research by Mr. Engen and Jonathan Skinner of Dartmouth), unacceptably lowering our future living standards. This would be equivalent to erasing all the “growth dividend” gains of the great productivity boom of the 1990s.

There is a better way forward. In the present economic situation, attempting to reduce the deficit drastically could spell another economic contraction. One can even make cogent arguments for cutting taxes on business investment and corporate profits, given the importance of an improved investment climate for the recovery.

Rather, the president and the Congress need to present a credible path toward lower deficits and more effective government. Such a plan should have three elements.

First, introduce specific targets for reducing discretionary spending. The administration has set too easy a goal for a putative President’s Fiscal Commission, likely requiring deficit reduction of only 1% of GDP by 2015, to stabilize the debt-to-GDP ratio at more than 70%. But this level is even higher than in 1950, when we were paying off debt from World War II.

The discretionary spending binge in both the Bush and Obama years offer many opportunities for further cuts. Indeed, holding growth in the nondefense discretionary spending to 2% per year, well under present levels, is achievable and would free up funds for our future priorities.

Second, slow the growth of entitlement spending on Social Security and Medicare. A good way would be to shave 1% per year from projected entitlement growth.

It is possible to do so progressively, lowering the growth in benefits for middle- and upper-income households, while strengthening support for lower-income households. Expanded saving incentives and health saving accounts can be used to help more affluent households prepare for retirement. Taken together, these changes offer the greatest chance for reducing long-term spending while holding fast to government’s legitimate social insurance role.

Third, if the administration wants to maintain the spending path on which its budget blueprint places us, it must confront and propose significant, broad-based tax increases. Let’s be clear what this means.

Our present income tax already relies very heavily on revenue from high earners; the top 1% pay well over one-third of federal income taxes. Mr. Obama’s budget increases the reliance. But we cannot count “taxes on the rich” for deficit reduction, health-care expansion and funding entitlements while ignoring the effect of those tax increases on investment, innovation and growth.

To raise the revenue for the president’s welfare-state ambitions, the tax increases must necessarily be broad-based, as, for example, with a broad-based consumption tax. A useful start would be to calculate—and present to the public each year—the broad-based consumption tax required to pay for higher spending.

In the end, the reason to get the nation’s fiscal house in order is less about deficits or debt as percentage points of GDP than about our future. We need a healthy, dynamic and innovative economy. We need a safety net for those buffeted by change. And we need the flexibility to increase support for national defense and other new domestic priorities.

Mr. Hubbard, dean of Columbia Business School, was chairman of the Council of Economic Advisers under President George W. Bush.