There are a couple of fundamental questions at the bottom of Washington's ongoing battles over deficits and debt: (1) How big should the U.S. government to be? and (2) How should we pay for it? The answers to both will ultimately have to be political ones — messy calculations based on who pays, who benefits, who votes, and who makes the campaign contributions. But it would be nice to know what the economics are, wouldn't it?
It turns out economists have lots of theories of optimal government spending and optimal taxation. This isn't the same as saying they have reliable or consistent answers. As one critic wrote of Robert Lucas's American Economic Association presidential address on economic growth in 2003, in which the Nobel laureate cited several studies showing dramatic welfare gains from hypothetical tax cuts in France and the U.S.:
Such findings have two distinctive features. First, they show big numbers. Second, they are not really findings. Contrary to the words offered so traditionally and casually by economists, none of these authors actually 'found' or 'showed' their results. Rather, they chose to imagine the results they announced. In every study Lucas cited here the crucial ingredient was a theoretical model laden with assumptions.
The author of these words is University of California, Davis economic historian Peter Lindert, who hid them among the data appendices in volume two of his epic 2004 empirical study, Growing Public: Social Spending and Economic Growth Since the Eighteenth Century. The books have developed something of a cult following among econowonks across the political spectrum. People on the left love Lindert's conclusion, contained in this shorter working paper, that the rise in spending (and accompanying taxation) has not carried with it the costs predicted by neoclassical economic theories such as the ones wielded by Lucas. But those on the right love his explanation that this is mostly because countries with high social spending have tax systems that appear to have been designed by a neoclassical economist: with low progressivity, low taxes on capital, and big value-added taxes on consumption.
Lindert found essentially no correlation between levels of social spending (expressed as a percentage of GDP) and economic growth in wealthy nations in the post-World War II era. During the first big rise in social spending, from 1880 to 1930, there was actually a positive correlation — probably because early poor-relief measures improved workers' health and productivity. Lindert thinks social spending on health-care and education can still have positive growth effects — and of course government infrastructure and R&D spending, which weren't a focus of his study, can boost growth as well. But his main takeaway was that the Swedens and Germanys of the world have a "more pro-growth and regressive mix of taxes" (italics LIndert's) than lower-spending nations such as the U.S.
So basically, the frequent Republican contention that high government spending is choking economic growth in the U.S. isn't really backed up the evidence — at about 42.5% in 2010, government spending's share of GDP in the U.S. (that includes state and local spending) is on the low side among the world's wealthy nations. But at the same time, if spending is to go higher, or if we simply want to be able to pay for the spending we're already doing, the Democratic focus on raising taxes on the wealthy isn't going to get us there.
Which brings us back to the political discussion in Washington. Republicans have for the past couple of years been going with the mantra that federal spending should be brought down to a "historical average" of 18% of GDP. Since World War II, federal spending has actually been closer to 20% of GDP, but tax revenue has averaged just under 18%, so that is a reasonable starting point (if you go back farther in history, you can of course get it much lower, but it's not clear what that proves). It's also possible to run ongoing deficits of 1% or 2% of GDP without major ill effects — as long as the economy grows fast enough and interest rates are low enough that the federal debt shrinks as a percentage of GDP.
The question is whether it's realistic to think federal spending can be kept to 20% of GDP (or wise to think it should). Right now it's at 24%, and while that will decline as the economy continues to recover, the retirement of the Baby Boom generation is going to put upward pressure on spending for decades to come. We're also going through an era of economic and technological upheaval that probably calls for increased investment in education and research, and may even justify increased social spending. So it's perfectly reasonable to argue that spending, and taxes, will have to be higher going forward.
As Peter Lindert's research shows, this wouldn't have to hurt economic growth. But as his research also shows, it really can't be done just by raising income tax rates on the wealthy. The U.S. already has about the most progressive income tax system around. European social democracies tend to have flatter income taxes, plus value-added taxes that hit all consumers. They tax capital gains and dividends at lower rates than regular income, just as the U.S. does, but they also all have lower corporate tax rates than the U.S. This lack of progressivity extends to the spending side: Lindert says social programs are less likely to be means-tested in the big-spending social democracies than in the U.S. or Great Britain.
The economic logic behind all this is that progressive tax systems and means-tested social programs can carry with them big disincentives to work, particularly near the bottom of the income scale. As for the low taxes on capital and corporate income, that's partly neoclassical theory (by encouraging investment, you get more growth) but also just realism about enforcement (global corporations and investors can easily get around such taxes).
This lesson has sunk through to budget experts like Alice Rivlin, whose original deficit-reduction plan with Republican former Senator Pete Domenici included a value-added tax. But it has so far been political poison: Republicans hate any talk of new taxes, and Democrats hate any talk of regressive new taxes. If the U.S. is going to make it safely through the budget challenges of the next few decades, though, both parties are going to have to get over their phobias.