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Financial Planning > Tax Planning > Tax Reform

Conservative Economist: Deficit Cutting Has Gone ‘Far Enough’

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In a shot across the bow aimed at deficit hawks in the conservative camp, an economist at the right-leaning American Enterprise Institute (AEI) argues that deficit reduction “has proceeded far enough for now.”

In an economic outlook titled “Austerity Undone,” AEI resident scholar and federal budget expert John Makin wades into the debate over post-crisis economic policy with criticism directed at both austerity advocates on the right and spending proponents on the left.

His conclusion is that the U.S., despite the rancorous political debate over the past several years, is now—thanks to the sequester—on a sustainable fiscal path, with the deficit set to fall below its 30-year average by 2017. We should therefore declare victory and move on to tax and entitlement reforms, he says.

Makin begins his argument by noting the discovery last week that a spreadsheet error caused economists Carmen Reinhart and Kenneth Rogoff to overstate the danger of a high debt-to-GDP ratio. The duo had argued that growth in high-debt countries falls to a negative 0.1%, but a critique of that study found that the correct figure should actually be positive growth of 2.2%.

Reinhart and Rogoff’s study had been used to bolster the case for austerity, but Makin points out that adding a (new) category (not included in their study) for countries even deeper in debt shows no less growth than moderate-debt countries.

Adding further to doubts about austerity, Makin cites inflation hawks at the Federal Reserve who each year seem to clamor for the Fed to begin raising interest rates.

And yet each passing year has exhibited slower than expected growth along with slowing inflation and falling bond yields, thus making a hike in interest rates unnecessary and potentially dangerous.

Makin also cites an IMF warning to the U.S. that the sequester’s deficit cutting policies are “too strong,” though he criticizes the IMF for muddling its message through contradictory and overwrought statements.

Makin, however, argues that it is precisely the sequester—together with Congress’ January tax hikes aimed at averting the fiscal cliff—that has finally placed the U.S. on track to solving its fiscal problems.

“Perhaps by accident, Congress has in fact reduced the U.S. budget deficit by enough to enable working at long-term fiscal reform,” he writes.

The combination of increased taxes and reduced spending yields $300 billion in annual deficit reductions beginning this year, which will reduce the deficit from last year’s 7% of GDP to 5% of GDP this year and further down to 3.7% next year, below the G7 average.

What’s more, if these policies continue undisturbed, the deficit should fall to just 2.5% of GDP by 2017, below America’s 30-year average of 3.4% and the G10 average of 3.5%.

That’s where Makin turns his fire on President Barack Obama and congressional Democrats who want to undo the sequester. The President’s budget seeks to replace the sequester’s $1.1 trillion in spending cuts with $1.4 trillion in savings expected to come from winding down the war in Afghanistan.

“The actual net deficit reduction proposed is more like zero,” he writes, adding that “without the proposed $563 billion in additional taxes on the wealthy, which Republicans have already rejected, the deficit actually rises under the president’s budget.”

He also criticizes shameless scare tactics that discredit the sequester, such as House Minority Leader Steny Hoyer’s laying blame for the Boston Marathon bombing on the sequester.

Rather, Makin says it is the fiscal compact America has hazarded into through tax hikes and the sequester that is currently reducing the U.S. debt-to-GDP ratio. That ratio, already below Reinhart and Rogoff’s feared and now questioned 90%, is set to fall from 77% next year to 73.1% in 2018.

Makin notes with alarm, however, that our debt-to-GDP ratio is set to start rising again after 2023, according to Congressional Budget Office projections based on assumptions of rising interest rates. To avert that unhappy trend, it will be necessary to begin addressing structural problems caused by high marginal tax rates and unsustainable entitlement spending.

Makin concludes: “Reforms of tax and entitlement programs should be legislated over the next two years to place those programs on a truly sustainable path over the coming decades. Then, we can get back to concentrating on growing the economy.”


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