In a wide-ranging interview in the Wall Street Journal published on March 27, 2010 I indicated that the American people were unhappy with the state of the economy, wanted greater economic growth and more limited government, and that they would vote that way in November. Indeed, voters did give President Obama a real “shellacking” (to use his words), as Republicans gained control of the House of Representatives and the governorships of most states, and made large gains in the Senate. The common expectation is that this division will produce a political stalemate, as both parties position themselves for the presidential election in 2012. Yet, the American people need an agenda to raise the growth rate of the American economy, and cut sharply actual and future fiscal deficits. If these happen, not only would unemployment and other short-term problems would be taken care of, but also optimism would return about the longer-term prospects of the United States.
What follows is a partial agenda to raise economic growth and reduce the long run fiscal deficit. The most important step in raising the growth rate is not to increase but rather to lower taxes on capital and entrepreneurship. This implies maintaining essentially all the Bush tax cuts, including those on capital gains and dividends, and those on incomes at all levels, including quite high incomes. The estate tax on very high levels of wealth could be reinstated if politically necessary, but it will only bring in a very small amount of tax revenue, and will be more costly than it is worth. Tax reform also implies a reduction in the corporate income tax, and especially reductions in taxes on incomes of small businesses. Successful small businesses that grow to become large companies, such as Wal-Mart, Starbucks, Microsoft, and Apple, form the foundation of the American economy. They should be strongly encouraged.
One goal of such tax reform is to eliminate as much as possible taxes on capital since economic theory basically implies that economic efficiency requires that capital not be taxed in the long run. For the supply of capital in the long run is highly responsive to after-tax rates of return on capital.
Modern economies are based on the command of knowledge and information. Since knowledge is created by basic and applied research, the United States should increase the share of its GDP that is spent on R&D, a share that has been stable at a little more than 2.5%. The patent system encourages applied research, but basic research, in medicine and other fields, is not patentable, so it needs, and has received, an extra push through subsidies. While most basic research projects fail, the successes often bring enormous benefits to society. Neither bureaucrats nor scientists can predict in advance which projects will succeed and which will fail, so it is important to encourage a broad peer-reviewed approach to basic research topics and investigators.
I do not have space in this brief comment to discuss many other policies beyond taxation that are needed to speed up significantly the growth rate of an advanced country like the United States. These include a quite free approach to international trade, encouragement of immigration, especially skilled and ambitious immigrants, flexible labor and product markets, and limited regulation of most economic activities.
Since the tax cuts and subsidies I advocate will tend to reduce tax revenue, it is especially important to control government spending and the fiscal deficit. I will concentrate on the two main entitlement programs, old age retirement support and medical spending. Together they take about 45% of the total federal budget, and unless reformed, will be even more important in the future.
The drain of social security benefits on the federal budget can be reduced relatively easily. The best approach is to change from a pay as you go system to a defined contribution system. Barring such a drastic change, it would help a lot to continue to extend the retirement age for healthy men and women until it reaches age 70. Older persons live longer and in better health than their predecessors, yet social security systems have been slow in all countries in adapting retirement ages to these health improvements of the elderly.
Controlling spending on medical care is much more challenging, and requires radical changes in the present health care delivery system. The health care law passed this spring (so-called Obama Care) made matters worse rather than better, for reasons partly discussed in my post “The Health Care Bill: Progress or Retrogression?” (3/28/10). I will not repeat all the arguments in that post, and concentrate on only two major defects of both the old and new laws. Out of pocket expenses by individuals receiving care should be much higher in the United States than its average level of about 12% of medical spending. If the American system can move even half way towards the Swiss level of an out of pocket share of over 30%, substantial savings in medical spending would occur in ways that would reflect patients’ evaluations of how much the care is worth to them. In addition, the American system should be weaned from being mainly tax-deductible employer based health insurance to a more desirable system, where individuals and families can buy insurance in other ways on the same after tax terms as from employers.
Significantly reforming entitlements would greatly slow down the rate of growth in federal government spending. Despite what some elected Republican officials are saying, politically it will be impossible to actually cut government spending. However, overall cuts in federal spending are not necessary to get the main fiscal problems under control, and to reduce the effective relative size of government, as long as the economy grows significantly faster than government spending does. Speeding up the growth rate of the economy, and slowing down significantly the growth rate of federal spending, would accomplish these goals.
Are these changes likely during the next few years? I am optimistic about the tax cuts, and about extending the age of eligibility on access to social security benefits. Medical care will continue to be a tough nut to crack, but the recently expressed opposition by American voters to the new health care law might help push health reforms in the right direction.