Lessons for Europe\’s Debt Crisis from Early U.S. History

For much of the last decade, all European governments that borrowed using the euro were viewed as equal credit risks: that is, they paid essentially the same interest rate when borrowing. For an American, the obvious parallel involves borrowing by state and local governments, who all borrow in the same currency of U.S. dollars but have different credit ratings and borrow at different interest rates. Not coincidentally, the U.S. federal government has a long tradition of not bailing out state or local governments in financial trouble, while there is clearly a widespread expectation that the European Union will somehow act to bail out Greece and others.

At a first glance, pointing out that the U.S. federal government doesn\’t bail out the state or local governments might seems to make the case that Europe should also avoid such bailouts.  But C. Randall Henning and Martin Kessler point out that the historical patterns and potential lessons are more nuanced in \”Fiscal Federalism: US History for Architects of Europe\’s Fiscal Union.\” It\’s available here as Working Paper 12-1 from the Peterson Institute for International Economics and also here as part of the Bruegel Essay and Lecture Series. They point out that in some ways, the centrality of the federal level of the U.S. system was created by assuming the debts of the states after the Revolutionary War. But around 1840, the federal government then ended this practice. Here is Henning and Kessler (footnotes and citations omitted):

\”The first secretary of the Treasury, Alexander Hamilton, is by all accounts credited with creating a “modern” financial system for the new United States. The magnitude of his achievements emerges from considering the prior condition of the US economy. Before 1790, the United States was effectively bankrupt, in default on most of its debt incurred during the Revolutionary War, and had no banking system, regularly functioning securities markets, or national currency. Reliant on the 13 states to collect and share tax revenue, the federal government was unable to pay war veterans or service, let alone redeem, debts. Under the Articles of Confederation, the federal government had no executive branch, judicial branch, or tax authority….\”

\”The debt assumption plan involved the transfer of state debt to the federal government in the amount of $25 million. Added to existing federal debt incurred to foreign governments (France) and domestic investors in the amount of $11.7 million and $42.1 million, respectively, federal debt would then amount to $79.1 million —a very large sum compared with nominal GDP in 1790 estimated at $187 million.\”

Hamilton\’s plan was controversial at the time–so controversial that by around 1790, was a real chance that the new country might break up. Was the plan constitutional? How to deal with the fact that some states had borrowed far more than others, but after the federal government assumed the debt, all states would now need to repay it? Hamilton was also restructuring the debt at about the same time. However, as Hamilton and others perceived, making the federal government central in this way could help bind the states together into a union.  In the end, the federal government did assume the debts of the states, did restructure them, and did pay them off. But would this pattern continue?  Henning and Kessler: 

\”[T]he debt assumption of 1790 set a precedent that endured for several decades. The federal government assumed the debt of states again after the War of 1812 and then for the District of Columbia in 1836. During this period, the possibility of a federal bailout of states was a reasonable expectation; moral hazard was substantially present. This pattern was broken in the 1840s, when eight states plus Florida, then a territory, defaulted.  … The indebted states petitioned Congress to assume their debts, citing the multiple precedents. British and Dutch creditors, who held 70 percent of the debt on which states later defaulted, pressed the federal government to cover the obligations of the states. They argued that the federal government’s guarantee, while not explicit, had been implied. Prices of the bonds of even financially sound states fell and the federal government was cut off from European financiers in 1842. …John Quincy Adams evidently believed that another war with Britain was likely if state debts were not assumed by the federal government.\”

What were the underlying reasons that caused the U.S. Congress to break the assumption that it would take over the debts of the states as needed?

\”However, on this occasion Congress rejected the assumption petition and was able to do so for several reasons. First, debt had been issued primarily to finance locally beneficial projects, rather than national public goods. Second, domestically held bonds were not a large part of the US banking portfolio, and default had limited contagion effects at least through this particular channel. Third, the financially sound states were more numerous than the deeply indebted ones. And, finally, the US economy had matured to the point where it was less dependent on foreign capital. Foreign loans were critical to Hamilton’s plan in 1790, but they were a minority contribution when investments eventually resumed in the 1850s.\”

\”Eventually, most states repaid all or most of their debt as a condition for returning to the markets. …The rejection of debt assumption established a “no bailout” norm on the part of the federal government. The norm is neither a “clause” in the US Constitution nor a provision of federal law. Nevertheless, whereas no bailout request had been denied by the federal government prior to 1840 , no such request has been granted since, with one special exception discussed below [the District of Columbia in the 1970s].

\”The fiscal sovereignty of states, the other side of the no-bailout coin, was thereby established. During the 1840s and 1850s, states adopted balanced budget amendments to their constitutions or other provisions in state law requiring balanced budgets. This was true even of financially sound states that had not defaulted and their adoption continued over the course of subsequent decades, so that eventually three-fourths of the states had adopted such restrictions.\”

Henning and Kessler suggest three lessons from U.S. history that Europeans should consider as they look at whether or how to assume some of the debts of countries like Greece.

\”First, debt brakes are likely to be more durable and effective when “owned” locally rather than mandated centrally.\”

The U.S. states didn\’t have a no-deficits rule imposed on them. They volunteered for such rules as part of wanting to borrow for infrastructure projects. U.S. states could drop their no-deficits rules at any time if they wanted. This is fundamentally a different situation than having the European Union or the European Central Bank try to imposed debt limits on recalcitrant countries.

\”\’Second, maintaining a capacity for countercyclical macroeconomic stabilization is essential. Balanced budget rules have been viable in the US states because the federal government has a broad set of fiscal powers, including countercyclical fiscal action.

When a recession  hits, U.S. states and their citizens often get some help from the federal government. With a common central bank and a common currency, many countries in the EU have already given up the paper to react to a recession within their borders by cutting interest rates or by depreciating their currency. If they also have debt limits imposed on them, they may be unable to react to a recession with fiscal policy, either. In the modern economy, arrangements that have the effect of preventing governments from reacting at all when their countries are in a recession are not likely to work well.

\”Finally, because debt brakes threaten to collide with bank rescues, the euro area should unify bank regulation and create a common fiscal pool for restructuring the banking system.\”

 The interaction between bank failures and government debt needs to be addressed. In some cases, like Ireland, bank failures were the main cause of government debt–when government offered guarantees that the banks would not go under. In other cases, like Greece, excessive government debt risks bringing a wave of bank failures, because Greek debt is so widely held by many large European banks. A unified and funded system of bank regulation across Europe would reduce both of these risks.

I don\’t have a trail map for how Europe should tiptoe through its current debt and financial crises. The middle of an economic crisis can be a poor time to try to implement the long-term arrangements, that if only they had been in place, would have reduced the risk of the crisis in the first place. But the U.S. model of not bailing out states does depend, in part, on the fact that states adopted their no-borrowing rules themselves, on a powerful federal fiscal authority, and on a unified and funded system of banking regulation. Without these conditions in place, Europe may have set itself up for a situation where intermittent bank bailouts and government debt bailouts are better than the even less-palatable alternatives.

Will Federal Debt Lead to High Inflation?

In the Fall 2011 issue of the National Interest, John H. Cochrane explores the \”Inflation and Debt\” connection. He points out that most economists don\’t see it as very likely that government debt will be the proximate cause of inflation. They point to the sluggish economic recovery, which tends to hold down price and wage levels. They believe that if inflation gets started, the Federal Reserve can act to nip it in the bud.

Cochrane takes the other side of this argument. He writes: \”As a result of the federal government\’s enormous debt and deficits, substantial inflation could break out in America in the next few years. … The key reason serious inflation often accompanies serious economic difficulties is straightforward: Inflation is a form of sovereign default. Paying off bonds with currency that is worth half as much as it used to be is like defaulting on half of the debt. And sovereign default happens not in boom times but when economies and governments are in trouble.\”

Can the Federal Reserve stop inflation? Cochrane argues that much of the conventional economic thinking about anti-inflation policy assumes a background of a reasonably sound fiscal policy. \”[R]easonably sound fiscal policy .. is the central precondition for stable inflation. Major explosions of inflation around the world have ultimately resulted from fiscal problems, and it is hard to think of a fiscally sound country that has ever experienced a major inflation. So long as the government\’s fiscal house is in order, people will naturally assume that the central bank should be able to stop a small uptick in inflation. Conversely, when the government\’s finances are in disarray, expectations can become \”unanchored\” very quickly. … But what if our huge debt and looming deficits mean that the fiscal backing for monetary policy is about to become unglued?\”

Cochrane cites familiar evidence that federal indebtedness  is on an unsustainable path. He suggests that a process of \”fiscal inflation\” will unfold in this way:

 \”[O]ur government is now funded mostly by rolling over relatively short-term debt, not by selling long-term bonds that will come due in some future time of projected budget surpluses. Half of all currently outstanding debt will mature in less than two and a half years, and a third will mature in under a year. Roughly speaking, the federal government each year must take on $6.5 trillion in new borrowing to pay off $5 trillion of maturing debt and $1.5 trillion or so in current deficits.\”

\”As the government pays off maturing debt, the holders of that debt receive a lot of money. Normally, that money would be used to buy new debt. But if investors start to fear inflation, which will erode the returns from government bonds, they won\’t buy the new debt. Instead, they will try to buy stocks, real estate, commodities, or other assets that are less sensitive to inflation. But there are only so many real assets around, and someone has to hold the stock of money and government debt. So the prices of real assets will rise. Then, with \”paper\” wealth high and prospective returns on these investments declining, people will start spending more on goods and services. But there are only so many of those around, too, so the overall price level must rise. Thus, when short-term debt must be rolled over, fears of future inflation give us inflation today — and potentially quite a lot of inflation.\”

Cochrane argues that investors are already worrying about even the current low rates rates inflation, given the prevailing ultra-low interest rates, and that the result could be a slow-motion financial run:

\”Just how low are today\’s rates? The one-year rate is now 0.2%; the ten-year rate is about 2%, and the 30-year rate is only 4%. We have not seen rates this low in the post-war era. Furthermore, inflation is still running at around 2-3%, depending on exactly what measure of inflation we choose. If an investor lends money at 0.2% and inflation is 2%, he loses 1.8% of the value of his money every year. Such low rates are therefore unlikely to last. … But both the Fed\’s desire to keep rates this low and its ability to do so are surely temporary. …

\”A \”normal\” real interest rate on government debt is at least 1-2%, meaning a 4-5% one-year rate even if inflation stays at 2-3%. A loss of the special safety and liquidity discount that American debt now enjoys could add two to three percentage points. A rising risk premium would imply higher rates still. And of course, if markets started to expect inflation or actual default, rates could rise even more. …

\”These dynamics essentially add up to a \”run\” on the dollar — just like a bank run — away from American government debt. Unlike a bank run, however, it would play out in slow motion. … The United States rolls over its debt on a scale of a few years, not every day. So the \”run on the dollar\” would play out over a year or two rather than overnight…. Like all runs, this one would be unpredictable…. For that reason, I do not claim to predict that inflation will happen, or when. This scenario is a warning, not a forecast. Extraordinarily low interest rates on long-term U.S. government bonds suggest that the overall market still has faith that the United States will figure out how to solve its problems…. But we are primed for this sort of run. All sides in the current political debate describe our long-term fiscal trajectory as \”unsustainable.\”… As with all runs, once a run on the dollar began, it would be too late to stop it…. Neither the cause of nor the solution to a run on the dollar, and its consequent inflation, would therefore be a matter of monetary policy that the Fed could do much about. Our problem is a fiscal problem — the challenge of out-of-control deficits and ballooning debt. Today\’s debate about inflation largely misses that problem, and therefore fails to contend with the greatest inflation danger we face.\”

As Cochrane readily states, his analysis of the threat of a fiscal inflation is unconventional, and I\’m not yet a  convert. But I do think that his analysis hits a number of key points that deserve serious consideration.

The current path of federal borrowing is unsustainable–not this year or next year, but probably in the middle-term and certainly in the long term. Investors are not going to be eager to hold these burgeoning levels of debt. If the very low nominal interest rates and negative real rates that such debt is currently paying continue, investors will start looking for other assets. (Gold, anyone?)  If the interest rates on federal debt start rising, the federal debt problem will become much more severe in a hurry–and investors will continue to be less interested in investing. In this setting, the Federal Reserve is likely to be in an unpleasant pickle. The Fed has already taken up, at least in part, the task that it had during and after World War II of making it cheaper for the government to borrow–if necessary, by having the Fed buy Treasury debt directly. There will be heavy political pressure on the Fed to keep doing this–in effect, protecting the U.S. government from the costs of heavy borrowing by printing money. This scenario could play out as inflation, although I\’m less confident of that prediction than Cochrane. It might result in a heavy shock to the U.S. financial system, which is still struggling to recover from the problems of 2008 and 2009.

The bottom line is that the government needs to enact actual policies–not vague promises about policies that could be enacted in the future–that will reduce the path of future budget deficits. I\’d start with some steps that should be relatively (if not actually) easy, like phasing in a later retirement age a month per year over the next few decades. This step would make a substantial difference to Social Security and a modest difference to Medicare (because  such a large share of Medicare expenses happen later in life, not in the year or two right around retirement). A next step might be to resurrect many of the recommendations of the National Commission on Fiscal Responsibility and Reform–the so-called Bowles-Simpson commission–that  President Obama first appointed, but then ignored. I don\’t know whether Cochrane is correct that the federal debt problems will cause an inflation problem in the next few years, but on the present path, federal borrowing is going to bring a highly unpleasant crunch of some sort.

Using Financial Repression to Reduce Government Debt

The usual ways of reducing a government debt burden over time are fairly well-known: cut spending or raise taxes; have the economy grow faster than the debt burden, so the ratio of debt/GDP declines over time; a burst of inflation, which reduces the real value of past debt; and in some cases an outright default or restructuring of the debt. To this list, Carmen Reinhart, Jacob F. Kirkegaard, and M. Belen Sbrancia offer \”Financial Repression Redux.\”Here are some main themes (references omitted for readability):

Here\’s their definition of financial repression:
\”Financial repression occurs when governments implement policies to channel to themselves funds that in a deregulated market environment would go elsewhere. Policies include directed lending to the government by captive domestic audiences (such as pension funds or domestic banks), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks, either explicitly through public ownership of some of the banks or through heavy “moral suasion.” Financial repression is also sometimes associated with relatively high reserve requirements (or liquidity requirements), securities transaction taxes, prohibition of gold purchases, or the placement of significant amounts of government debt that is nonmarketable…. \”

How financial repression works like a tax
\”One of the main goals of financial repression is to keep nominal interest rates lower than they would be in more competitive markets. Other things equal, this reduces the government’s interest expenses for a given stock of debt and contributes to deficit reduction. However, when financial repression produces negative real interest rates (nominal rates below the inflation rate), it reduces or liquidates existing debts and becomes the equivalent of a tax—a transfer from creditors (savers) to borrowers, including the government. But this financial repression tax is unlike income, consumption, or sales taxes. The rate is determined by financial regulations and inflation performance, which are opaque compared with more visible and often highly politicized fiscal measures. Given that deficit reduction usually involves highly unpopular expenditure reductions and/or tax increases, authorities seeking to reduce outstanding debts may find the stealthier financial repression tax more politically palatable.\”

How is financial repression currently operating in the U.S.?
One potential example of how financial repression is operating in the U.S. is the super-low interest rates. In part, of course, these are an attempt to stimulate the economy, but it also seems plausible to me that they are intended to help the U.S. government in financing its debt. But a more straightforward example is that when the Federal Reserve and other central banks buy U.S. Treasury debt directlydebt that might very well need to pay a higher interest rate if it was sold to outsiders. Back in 1990, outsiders owned about 75% of U.S. Treasury debt; now they own about half.

How is financial repression happening in other countries? 
Central banks in many other countries–for example, the UK, Ireland, Portugal, and Greece–have sharply increased their holdings of government debt. In France and Ireland, major pension funds have been required to invest in government debt.

How much can financial repression reduce government debt?
These authors cite research that financial repression can have a major effect in reducing government debt, through what they call \”the liquidation effect.\” Many of their calculations focus on how government debt burdens were reduced after WWII. They write: \”For the United States and the United Kingdom, the annual liquidation effect [between 1945 and 1980] amounted on average to between 3 and 4 percent of GDP a year. … For Australia and Italy, which recorded higher inflation rates, the liquidation effect was larger (about 5 percent a year).\”

My point here isn\’t to argue for or against what they call financial repression. But if their calculations are roughly right, it\’s an option for reducing government debt that could end up playing a major role, and needs to be better understood.


Herbert Hoover, Deficit-Spender: Correcting John Judis in The New Republic

In the October 6 cover story for The New Republic, titled \”Doom!\”, John B. Judis admonishes readers to beware the economic lessons of the 1930s–and then proceeds to make a number of incorrect statements about what happened in the 1930s.

In the third paragraph, Judis pats himself on the back for asking Mitt Romney a tough question. Judis asked: \”I want to ask you something about history.You know, when Herbert Hoover had to face a financial crisis and then unemployment, his strategy was to balance the budget and cut spending, and that made things worse. When Roosevelt came in, unemployment was twenty-five and went to fourteen percent by 1937. With deficits. Aren\’t you repeating the Hoover mistake?\”

Before listing the various mistakes here, the actual spending, debt, and deficit numbers starting in 1930, both in nominal terms and as a share of GDP, are readily available in the Historical Tables volume that is published each year with the president\’s proposed federal budget. All numbers I quote here are from the \”Historical Tables\” volume in the 2012 budget. From that source, you can easily confirm the following facts:

1) Hoover\’s budget strategy over his term of office was not to balance the budget. The budget ran a small deficit of -.6% of GDP in 1931, followed by a much larger deficits of 4.0% of GDP in 1932 and 4.5% of GDP in fiscal year 1933 (which, as Judis points out at a different point in his discussion, started in June 1932 and was thus mostly completed before Roosevelt took office in 1933).

2) Hoover did not cut spending. In nominal terms, federal spending went from $3.3 billion (!) in 1930 to $4.6 billion in 1933.  Given price deflation during that time, the real increase in government spending would have been larger. With the economy declining in size, federal outlays more than doubled from 3.4% of GDP in 1930 to 8.0% of GDP in fiscal year 1933.

3) Because of this pattern, it would be hard to find an economic historian to argue that fiscal tightness was a significant factor in worsening the Great Depression from 1929 to 1932. The economic literature has for half a century focused on how overly tight monetary policy deepened the Depression, and has noted at length how the dysfunction of monetary policy at that time worked through banks and the financial system and through the exchange rate to hinder the economy. It would also be hard to find an economic historian to argue that the primary reason for the drop in  unemployment rates from 1933 to 1937 was a surge of expansionary fiscal policy.

4) During the 1932 presidential campaign, Franklin Roosevelt promised to wipe out the Hoover budget deficits and instead to run a balanced budget. In his first few months after taking office, FDR tried to put this policy into effect–before soon abandoning it. For a source, here is a description from the quick history at the Franklin D. Roosevelt American Heritage Center Museum: \”Roosevelt promised in his 1932 campaign that he would end the deficits that had plagued the Hoover administration and restore a balanced budget. This he never did, and eventually he would come to consider deficit spending a useful and necessary response to recession. In 1933, however, he remained committed to fiscal orthodoxy, and on 10 March he asked Congress to pass legislation cutting government salaries and veterans\’ benefits. Both Houses passed the Economy Act within days, despite protests from some progressives who argued correctly that the measure would add to the deflationary pressures on the economy… The New Deal soon departed from these conservative beginnings.\”

It gets worse. Judis writes (a bit smugly) how Romney evaded his question, and then writes: \”But he [Romney] seemed to be suggesting that the premise of my question was flawed because deficits are much larger today and will probably continue unabated. And they are larger–but that is because our GDP and government are also larger.\”

But deficits as a share of GDP are much larger now than than they were in the Great Depression. The two biggest deficits in the 1930s were 5.5% of GDP in 1936 and 5.9% of GDP in 1934. The budget deficit was 10.0% of GDP in 2009, 8.9% of GDP in 2010, and (estimated) 10.9% of GDP in 2011.

Judis believes that additional fiscal stimulus is warranted. I supported both the Bush fiscal stimulus package in 2008 and the Obama stimulus package in 2009, although I had some disagreements with their design and targetting. While I do think it\’s tremendously important to get the U.S. deficits under control in the middle term, I wouldn\’t try to slash the deficit in the short run with unemployment still  up around 9%.

But the notion that the Great Depression was an example of highly active fiscal stimulus and the Great Recession was not is upside-down. Recent years have seen a far larger fiscal stimulus in response to a lower unemployment rate than in the 1930s. During the Great Depression, Franklin Roosevelt faced unemployment rates of 25% and continued the Hoover policy of budget deficits, running deficits no larger than 5.9% of GDP and more usually in the range of 3-4% of GDP through the 1930s. During the Great Recession, the U.S. economy experienced unemployment of nearly 10%, and has responded with fiscal stimulus on the order of 10% of GDP.

And the elephant in the room, which Judis doesn\’t discuss, is the accumulation of debt. After all of the deficits of the 1930s, the total ratio of federal debt held by the public still totaled only 44.2% of GDP in 1940. Throughout the 1930s, the federal government had a lot of capacity to borrow–and could then still ramp borrowing much higher to finance the fighting of World War II. But in 2011, total federal debt held by the public is an estimated 72% of GDP. Looking ahead over the next decade, the federal government has a lot less capacity to borrow.

ADDED: For a follow-up on the post on October 4, see my post on  More Herbert Hoover: Father of the New Deal.

How Much Revenue from Limiting Deductibility?

One unattractive aspect of having certain expenditures be deductible in the U.S. tax code is that any deduction is worth more to someone in a higher tax bracket. Thus, when it comes to typical deductions like the mortgage interest deduction, the deduction for state and local taxes, the deduction for charitable contributions, or the deduction for large out-of-pocket health care expenditures, someone in a 35% tax bracket saves 35 cents off their tax bill for each $1 of deductible expense, while someone in a 15% tax bracket saves only 15 cents off their tax bill for each $1 of deductible expense. Of course, the two-third of taxpayers who don\’t have enough of these specific expenses to make it worthwhile to itemize their deductions just take the standard deduction, and get nothing extra off their tax bill for these expenses.

Proposals are always kicking around to reduce deductibility, by limiting the tax savings from a deductible expense to say, 28% or even 15%. How much revenue might such proposals raise?

What about limiting deductibility to 28%?
Daniel Baneman, Jim Nunns, Jeffrey Rohaly, Eric Toder, Roberton Williams estimate the revenue to be raised from a proposal to limit deductibility to 28% in a recent paper for the Tax Policy Center. They write (footnotes omitted):

\”To measure the revenue and distributional implications of these proposals, the analysis considers two baselines: current law and current policy. “Current law” is the standard baseline that official revenue estimators at the Joint Committee on Taxation use to score tax proposals. It assumes that tax law plays out as it is currently written. Most important, that means that the 2001–2010 income and estate tax cuts expire at the end of 2012 and that temporary relief from the alternative minimum tax (AMT) expires at the end of 2011. The “current policy” baseline assumes that Congress permanently extends all provisions in the 2011 tax code (except the 2 percent reduction in Social Security payroll tax) as well as AMT relief, indexed for inflation after 2011. …

[A] proposal from the Obama Administration … would limit the benefit of itemized deductions to 28 percent. ..  Thus, for example, an additional $100 of itemized deductions would save a taxpayer in the 35 percent bracket only $28 rather than $35. The 28 percent limitation on itemized deductions would raise an estimated $288 billion over the next ten years compared with current law …  Relative to current policy, the proposal would raise $164 billion.

The 5.3 million affected households in the top quintile would see their taxes go up by an average of about $2,900. The average tax increase for the 697,000 affected households in the top 1 percent would be about $13,300. Almost all of the tax increase—99.8 percent—would fall on households in the top quintile of the income distribution—those with cash incomes greater than $111,000. …  The top 1 percent would bear 61 percent and the top 0.1 percent would pay a little more than one-third.\”

What about limiting deductibility to 15%?
The Congressional Budget Office does a regular report called \”Reducing the Deficit: Spending and Revenue Options.\” In the March 2011 report, Revenues–Option 7 is \”\”Limit the Tax Benefit of Itemized Deductions to 15 Percent.\” CBO estimates that this change could raise $1,180 billion over the next 10 years relative to current law, which is roughly four times as much as the 28% limitation would raise. The CBO doesn\’t do a distributional analysis, but this change would only affect those who already itemize deductions, and would have by far its largest effect on those with higher incomes.

Of course, there are justifications for the existing tax deductions, and reasons and history behind the justifications, and interest groups behind it all. But in a situation where all the meaningful options for long-term deficit reduction are going to be painful in one way or another, limiting deductibility has some advantages. It would raise revenue from those with higher incomes without increasing the marginal income tax rates, or part of the revenue could even be used to reduce the top marginal rates. Limiting deductibility also reduces the role of the federal government in certain aspects of the economy like providing incentives for greater mortgage borrowing. It should be in the mix of possibilities.

For a related post several weeks ago, see \”Tax Expenditures: One Way Out of the Budget Morass.\”

Tax Expenditures: One Way Out of the Budget Morass?

When seeking to reduce budget deficits, the usual choices are lower spending or higher taxes. But there is a third option, a category-scrambler called \”tax expenditures.\” Basically, this category includes all the ways in which government tax revenues are reduced by deductions, credits, deferrals, exclusions, exemptions, and special preferential tax rates.

Tax expenditures scramble how one thinks about spending and taxes because if they were repealed, they would presumably lead to higher taxes, which seems like a tax increase, but they also would mean that the government is ending a decision to direct resources and intervene in a particular direction, which sounds like a spending cut. Earlier this year, there was a political dogfight over ending the tax breaks for ethanol production: some viewed this as a cut in government \”spending\” for ethanol; others viewed it as a covert tax increase. Because tax expenditures scramble categories, they may offer a politically savvy way to address some of our budget woes. Reducing tax expenditures might offer some revenue to reduce budget deficits, finance lower marginal tax rates, and raise funds for some more important government spending priorities. 

Donald Marron has written a nice overview of these issues in the Summer 2011 issue of National Affairs in \”Spending in Disguise.\” Richard Epstein also takes up this topic in an article in Defining Ideas called \”The Tax Expenditures Muddle.\”

The dollar numbers here are enormous. Each year, the Analytical Perspectives volume of the federal budget presents tables showing the dollar cost of tax expenditures. Here\’s the list from the 2012 budget volume, cropped to include only those provisions which cost the Treasury more than $4 billion in the 2012 fiscal year

There are two obvious problems with using tax expenditures as a policy tool. The first is that the many of the biggest tax breaks are wildly popular. Just look at some of the big ticket items on the list: Exclusion of employer contributions for medical insurance premiums and medical care; Deductibility of mortgage interest on owner-occupied homes; Step-up basis of capital gains at death; Deductibility of charitable contributions, other than education and health; Exclusion of interest on public purpose State and local bonds; Capital gains exclusion on home sales; Deductibility of State and local property tax on owner-occupied homes; Exclusion of interest on life insurance savings; Social Security benefits for retired workers; and so on.

The second issues is that many of these tax expenditures have at least some economic justification. For example, money given to charity can be viewed as not devoted to one\’s own consumption, and thus appropriately outside the scope of taxation. Epstein offers an interesting potential justification for the interest deduction on home mortgages: \”One clear case of a tax expenditure is the interest deduction on a home mortgage. There is no question that interest payments count as expenditures, and thus a reduction to gross revenues. But that expenditure is offset, not quite perfectly, by the consumption value of the home purchased with a home mortgage. A precise economic test would first allow the interest deduction but bring the imputed income attributable from home use into the system, even though it is not a receipt of any kind. But since calculating that imputed income is too costly, the law should follow the simpler rule that treats the consumption enjoyed as a perfect income offset to the interest deduction. In fact in most cases, the consumption value of the home is probably greater than the interest payments on the loan, especially toward the end of the life of the mortgage. Nonetheless, that excess imputed income goes untaxed, because of the insoluble difficulties of its direct measure.\”

Moreover, many tax expenditures are a kind of gamesmanship that can easily go astray. Marron offers a nice hypothetical example: \”Princeton economist David Bradford once offered a simple thought experiment to illustrate how far such games could go. Suppose that policymakers wanted to slash defense procurement and reduce taxes, but did not want to undermine America’s national security. They could square that circle by offering defense firms a refundable “weapons-supply tax credit” for producing desired weapons systems. The military would still get the weapons deemed essential to national security, defense contractors would get a tax cut, and politicians would get to boast about cutting both taxes and spending. But nothing would have changed meaningfully.\”

Despite the political and practical issues, tax expenditures need a close look. They add up to something like $1 trillion each year, which is just too large a total to ignore. Certainly one can make an argument that tax expenditures have contributed to the rapid rise in health care costs over time, because health insurance is for so many people a form of untaxed compensation. One can also argue that tax expenditures have contributed to the roller coaster of housing prices that helped bring on the Great Recession. One can also point out that if the goal is to help people afford health insurance or housing, there are surely more effective and equitable methods than these tax breaks. Granted,  lot of tax expenditures aren\’t attractive political targets, but it\’s not clear to me that they are tougher than Medicare, or defense spending, or tax increases, or any of the other ways of addressing the U.S. budget deficits.