Commentary Magazine


Obama's Big Experiment

FDR had the New Deal, LBJ the Great Society. But the economic adventurism of Barack Obama lacks a catchy nickname, and it deserves one, because it is more innovative and path-breaking than most conservatives and many on the left think. While Obama’s policies appear on the surface to derive from standard liberal orthodoxy—regulate more, spend more, tax more—Obama and the White House economic team have, in fact, plucked cutting-edge economic theories from the graduate-school classroom, scaled them up to national size, and beta-tested them on the $15 trillion American economy.

Call it the Big Experiment.

In 2009, White House economists turned to a novel and flashy new field, behavioral economics, when it designed its Making Work Pay tax credit as part of the $800 billion stimulus. The money was parceled out in dribs and drabs instead of doled out in one lump sum. Delivering the credit in that manner was supposed to make consumers more likely to spend—the whole point of the stimulus—rather than save. But a follow-up analysis by economists from the Federal Reserve and the University of Michigan found the tax credit’s clever design actually encouraged the opposite behavior. Taxpayers saved rather than spent.

Dartmouth University’s Atlas Project produced data that suggested rising medical costs were the result of insecure, incompetent, or overcautious doctors ordering unnecessary tests and failing to recommend proper preventive treatment—all of which suggested to the project’s designers that doctors needed more direct government supervision. Obama health-care czar Peter Orszag used the research to argue that Washington could dramatically cut future Medicare spending without sacrificing quality. Thus was born the Independent Payment Advisory Board, a collection of 15 bureaucrats making decisions about treatment protocols that Sarah Palin famously dubbed a “death panel.”

A few months after Obama signed the Patient Protection and Affordable Care Act, the New York Times published a powerful front-page story that shredded the Atlas Project. Its researchers “acknowledged in interviews that in fact it mainly shows the varying costs of care in the government’s Medicare program,” the Times noted. “Measures of the quality of care are not part of the formula.” But the legislation had already passed.

Now Obama seems ready to attempt his greatest experiment of all, again based on a novel economic theory. On January 1, the American economy is scheduled to launch itself right over a fiscal cliff and hurtle down a deadly, black-diamond ski slope of $400 billion in tax hikes (mostly from the expiration of the 2001 and 2003 Bush tax cuts and the 2011 payroll tax-cut extension) and $100 billion in spending reductions (including $65 billion in the Budget Control Act, half from defense and half from payment cuts to Medicare providers). All in just one year. One glance at how Old Europe is doing these days with similar policy moves suggests that this tax-heavy version of fiscal austerity will put the sickly U.S. recovery out of its misery—from double-diamond run to double-dip recession.

Traditional Keynesian demand-siders and Reaganite supply-siders would agree it would be policymaking malpractice to raise taxes in a stagnant economy that is slowly recovering from the worst financial crisis since the 1930s. But Obama is under the sway of a new post-Keynesian liberal academic theory that says tax rates don’t matter much—not until they reach 70 percent or higher. If Obama indeed believes this, and there are signs he does, the president might well let the tax hikes happen right on schedule, assuming he wins reelection. While Obama has committed to avoiding the spending cuts and letting only upper-income tax hikes take place, other Democrats—including Senator Patty Murray of Oregon, who also heads the Democratic Senatorial Campaign Committee, and former Democratic presidential candidate Howard Dean—say they are willing to take the risk and take the plunge. As Dean recently tweeted: “We should go over the fiscal cliff. Only way we cut defense, go to Clinton era taxes and fix the deficit. It will hurt but resolve the deficit.”

A Big Experiment, indeed. A recent research note from Citigroup suggests all that fiscal retrenchment would knock off four percentage points from next year’s gross domestic product. If you assume the economy will grow only about 2 percent next year under current conditions (the consensus at the moment), the result of such sudden austerity could be a recession of a magnitude similar to the one of 1990–91. The little economic progress that has been made since the end of the 2007–2009 downturn would be erased.

Or not—if you believe the findings of the Nobel Prize–winning economist Peter Diamond and his student Emmanuel Saez, of Berkeley. In a recent study, widely cited and praised by other thinkers and across the liberal blogosphere, Diamond and Saez argue for sharply higher income tax rates. They conclude “that raising the top tax rate is very likely to result in revenue increases at least until we reach the 50 percent rate that held during the first Reagan administration, and possibly until the 70 percent rate of the 1970s.”

Diamond and Saez argue that high tax rates tend to “go with higher economic growth.” As evidence, they noted in an April Wall Street Journal op-ed that per capita GDP growth in the United States averaged 1.7 percent between 1980 and 2010 when top tax rates were “relatively low.” By contrast, growth averaged 2.2 percent between 1950 and 1980 when rates were at or above 70 percent. In addition, Diamond and Saez find “no clear correlation between economic growth since the 1970s and top tax-rate cuts across Organization for Economic Cooperation and Development countries.”

Just what liberal politicians want to hear—not that Obama needs any convincing at this point. His criticism of America’s 30-year decline in marginal tax rates started long before his class-warfare reelection campaign and his support of the Buffett Rule to create a new minimum tax on wealthy Americans. His tax talk in his 2006 book, The Audacity of Hope, should have been a red flag. In it, Obama wrote that the “high marginal tax rates that existed when Reagan took office may not have curbed incentives to work or invest but they did lead to a wasteful industry of setting up tax shelters.” That was ahistorical and false. The primary rationale for reducing tax rates by 30 percent across the board in 1981 (when Reagan took office the top rate was 70 percent) was that they penalized working, saving, and investing. Judging from his own writing, had Obama been sitting in the Oval Office in 1981 instead of Reagan, he would have advocated leaving tax rates where they were but cracking down on tax loopholes. A technocratic fix in the name of efficiency—but in pursuit of the ever-always liberal goal of boosting tax revenues.

More recently, Obama has offered a broader and more explicit critique of the pro-market turn U.S. economic policy has taken over the past generation. As he said in his December 2011 speech in Osawatomie, Kansas: “There is a certain crowd in Washington who, for the last few decades, have said, let’s respond to this economic challenge with the same old tune. ‘The market will take care of everything,’ they tell us. If we just cut more regulations and cut more taxes—especially for the wealthy—our economy will grow stronger….But here’s the problem: It doesn’t work. It has never worked.”

Never worked? The U.S. economy created 50 million net new jobs between 1982 and 2007, with GDP growing at an average annual pace of 3.3 percent.

If Obama seems willing to let tax rates return to where they were in the 1970s, then reversing the 2001 and 2003 tax cuts and returning to 1990s levels isn’t a stretch. In fact, Obama may have been close to embracing such a plan back in 2009. At least that’s the story told by liberal journalist Noam Scheiber in his recent book, The Escape Artists.

In the fall of 2009, according to Scheiber, Obama’s chief congressional lobbyist hatched a plan to extend the middle-class Bush tax cuts for two years at the end of 2010, when the entire Bush package was set to expire. The upper-income tax cuts were to expire on schedule. And if Congress couldn’t devise a way to fully pay for the $2.3 trillion extension of the middle-class cuts, they would expire, too, in 2015. White House budget director Orszag was an easy sell on the idea; he “believed the only practical way to balance the budget was to repeal all the Bush tax cuts, not just the upper-income variety.”

Orszag then presented the plan to his boss. The administration’s chief wonk, Barack Obama, was intrigued. He asked a series of encouraging questions about how the proposal would work. According to two sources in the room, he was taken with both the political merits—that is, putting Republicans on the defensive—and the policy rationale of lopping trillions off the deficit. He gave no indication that he was troubled by the plan’s most explosive feature: that it would likely break his central campaign promise to not raise taxes on the middle class—one which Republicans would surely wrap around his neck with populist glee.

The White House political team eventually quashed the idea. But Scheiber believes that if Obama is reelected, letting all the Bush tax cuts expire—a $3 trillion tax hike over 10 years—“may simply be too tempting to pass up.”

Expiration of the Bush tax cuts would advance the leftist dream of transforming the United States into a high-tax nation similar to Europe. Indeed, when liberal think tanks produce long-term budget plans, they assume both taxes and spending will soar hand-in-hand in coming years. Last year, three liberal think tanks devised budgets to put the federal budget on a sustainable fiscal path through 2035. Their plans, on average, called for Washington to collect 24 percent of GDP in revenue—as opposed to the post–World War II average of around 18 percent.1 The highest level of tax revenue Uncle Sam has ever taken was 20.9 percent in 1944.

To reach such a stratospheric level of taxation, the think tanks called for unprecedented tax hikes via millionaire surtaxes, higher taxes on alcohol and tobacco, securities transaction taxes, higher taxes on capital gains, higher taxes on corporations, higher death taxes, carbon taxes, and gasoline taxes.

There is a real-world test of this approach right now—in the Eurozone. A recent report from the European Commission2 shows pretty clearly what has gone wrong there. Its most debt-troubled nations—Greece, Italy, Spain—have relied too heavily on tax hikes to get their balance sheets back in order. A massive 40 percent of total EU fiscal adjustment has been from the tax. Spain now has a 52 percent top marginal tax rate plus a 21 percent value-added tax. Four years ago those rates were 43 and 16 percent, respectively. The taxes are too onerous and the spending cuts too niggardly.

Not only does Europe’s experience with tax-hike austerity argue against America following a similar path; so does a closer analysis of the basic theory of Diamond and Saez. Recall that the two economists point out how the U.S. economy performed better in the higher tax 1950s, 60s, and 70s than in the lower tax 80s, 90s, and 2000s. But a straight comparison is highly misleading. The postwar decades were affected by a host of unique factors, not the least of which was that they came right after a devastating global war that left America’s competitors in ruins. A National Bureau of Economic Research study described the situation this way: “At the end of World War II, the United States was the dominant industrial producer in the world….This was obviously a transitory situation.”

And as former Bain Capital executive Edward Conard notes in his new book, Unintended Consequences: “The United States was prosperous for a unique set of reasons that are impossible to duplicate today, including a decade-long depression, the destruction of the rest of the world’s infrastructure, a failure of potential foreign competitors to educate their people, and a highly restricted supply of labor. For the sake of mankind, let’s hope those conditions aren’t repeated. It seems to me anyone who makes comparisons between today’s economy and that of the 1950s and 1960s without fully disclosing their differences is deceiving their readers.”

Also, economic growth slowed almost everywhere after 1973. Thus, as the economist Scott Sumner points out during an interview on the podcast, EconTalk, we need to look at relative economic performance in order to identify the effect of pro-market policy reforms such as deregulation, privatization, and the lowering of marginal tax rates. Sumner’s research found nations pursuing such pro-market policies slowed less and outperformed those that didn’t, such as France and Italy. The growth rates of “countries that didn’t reform very much, like Italy and Greece…slowed from 7 percent to 2 percent in recent decades,” Sumner explains. “The United States and Great Britain have actually slowed much less than the more statist economies.”

Almost as bad as going over the fiscal cliff is claiming you want to avoid it—but waiting until January 2013 to do anything about it. Some Democrats have suggested just such a strategy to squeeze Republicans into accepting a plan that extends only the middle-class tax cuts—while getting some Republicans to accept higher taxes in exchange for eliminating the defense cuts. But it would be a terribly risky idea for both Democrats and Republicans to wait until 2013 and then try to reverse the tax hikes and spending cuts retroactively.

Not only would it create tremendous uncertainty with financial markets already worried about Europe’s downturn and America’s stagnation, but it will also take time to move legislation. When President George W. Bush came into office in January 2001, Republicans made a decision to cut taxes using the budget reconciliation process, requiring just 51 Senate votes. Simple in theory, but it didn’t happen quickly.

“Both the House and the Senate needed to pass a budget,” as analyst Dan Clifton of Strategas Research points out. “That budget had to be identical and report instructions to the Committees of jurisdiction that would write the tax legislation. The House and Senate then needed to pass legislation, which were often different in their details. Then a final conference agreement was reached. When the process was over, President Bush signed the tax cuts into law the first week of June. In 2003 when they moved on a new tax bill, the process was consolidated by one week and the bill was signed the last week of May.”

If the fiscal cliff isn’t dealt with during the lame-duck period after this November’s elections, it will be a drag on the U.S. economy well into 2013.

The best solution here isn’t the status quo—which would be to extend all the Bush tax cuts and kill the defense and Medicare cuts. Ideally, Congress would postpone reckoning with the fiscal cliff for a year while they work on tax and entitlement reform to boost economic growth and put the budget on a long-term fiscal trajectory toward solvency. And at the same time, they could begin slowly cutting current spending.

Of course, that can happen only if American voters shut down the Big Experiment in November. If they don’t, the Big Experiment will continue and the American guinea pig will suffer parlous consequences yet untold.


Footnotes

1 2011 Fiscal Summit: The Solutions Initiative (May 2011). Sponsored by the Peter G. Peterson Foundation.  Retrieved from http://pgpf.org/solutionsinitiative.

2 European Economic Forecast (Spring 2012). Retrieved from http://ec.europa.eu/economy_finance/publications/european_economy/2012/pdf/ee-2012-1_en.pdf.

About the Author

James Pethokoukis is an editor and blogger at the American Enterprise Institute. His articles on economics for Commentary include “Paul Ryan’s Hope” (June) and “Let There Be Growth and/or Inflation” (January).

 

 




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