Where Will the U.S. Economic Recovery Come From?

People who complain that things were better in the old days are sometimes urged to consider that despite the economy’s recent setbacks, (inflation-adjusted) per capita income is now twice what it was in the mid-1960s. But that’s a crude measure of economic well-being, and by many other yardsticks, the 1960s actually look pretty good.

We had an economically vibrant middle class. Roads and bridges were well maintained, and impressive new infrastructure was being built each year. We cheered when President Kennedy urged, “Ask not what your country can do for you, ask what you can do for your country.” We were sure we could win the race to put a man on the moon. We were optimistic.

No longer. Proposals to build desperately needed new infrastructure consistently fail in Congress, and existing infrastructure has been steadily falling into disrepair. Rich and poor alike now endure crumbling roads and unsafe bridges. Water-supply and sewage systems fail regularly, as does electricity at the slightest hint of a storm. Countless schools are in shambles. Many Americans live in the shadow of poorly maintained dams that could collapse at any moment. Funding has been cut for programs to lock down poorly guarded nuclear materials in the former Soviet Union—a global problem, no doubt, but one in which the stakes are so high that it would be in America’s interests to take on the problem by itself, if necessary.

There have also been unwelcome changes in the rate and pattern of income growth. Between 1945 and 1970, incomes were rising at almost 3 percent a year for families up and down the income ladder. Since then, however, incomes have been growing much more slowly and unevenly, with only top earners enjoying significant gains. CEOs of large U.S. corporations, for instance, saw their pay increase tenfold over this period, while the inflation-adjusted hourly wages of their workers actually fell. Families in the 1960s were able to meet their financial obligations on a single paycheck. Today, even two-earner households are awash in debt.

Our most pressing concern, however, is that we’re now in the fourth year of the deepest downturn since the Great Depression. The consensus forecast of economists is that we’re likely to remain there because of a strange unwillingness to adopt the time-tested remedies for economic downturns.

The basic problem is that there’s too little spending to require the services of those who want jobs. That’s what almost always happens in the wake of severe financial crises like the ones in 1929 and 2008. As John Maynard Keynes wrote in 1936, downturns like these tend to be stubborn. Consumers won’t lead a recovery because they’re busy paying down debt and fearful they’ll lose their jobs, if they haven’t already lost them. Nor will businesses lead the way. They’re currently sitting on cash, but see no reason to invest it because they already have enough capacity to produce more than people want to buy.

The only actor with both the ability and motive to produce the required increase in spending is government. Many recoil at the prospect of make-work projects, but there’s no shortage of genuinely urgent work to be done in the public sector. The American Society of Civil Engineers’ recent Report Card for American Infrastructure identified $2.2 trillion worth of long-overdue infrastructure repairs. Yet Senate Republicans were unwilling to approve even the modest infrastructure and other spending increases proposed in the president’s jobs bill, explaining that further increases in government spending would not only crowd out private spending, leaving no net stimulus, but also bankrupt our grandchildren. So we’re destined to remain in the doldrums for the time being.

The Republican prescription for fiscal austerity is unpersuasive, not to say strange. It’s true that in the long run, government can’t continue to spend more than it takes in, any more than a business or family can. But the short run is a different matter. When a family or business confronts an attractive investment opportunity, borrowing is often the only way to exploit it. The same is true of government.

The right way to think about government stimulus spending under current conditions is to view it as an investment. By getting the economy back on its feet as quickly as possible, that investment would stimulate permanent increases in the nation’s capital stock, in productivity and income, and in tax revenue, as well as substantial reductions in transfer payments. Austerity, in contrast, will exacerbate the existing spending shortfall, making the recession, and deficits, even worse.

There may be people who would respond to a current increase in government debt by increasing their own savings by exactly the amount necessary to cover their share of the implied future tax liability. But you’ve probably never met any of them. Most people already save too little to maintain their pre-retirement standard of living after they stop working, and most have no idea how big the federal debt is, much less how it might affect their future tax liabilities. The notion that current increases in government spending would be exactly offset by current reductions in private spending is simply not to be taken seriously.

Notwithstanding what most economists view as a compelling case for current stimulus, Republicans in the House and Senate have repeatedly rejected that case. What’s clear is that arguing about this issue in the abstract has become a dead end. We must change the conversation, and the easiest way to do that is to focus on why infrastructure investment makes sense quite apart from its role as economic stimulus. No one denies that the jobs need to be done, after all, and no one denies that they’ll be much cheaper the sooner we do them.

One vivid example is a 10-mile stretch of Interstate 80 in Nevada that badly needs resurfacing. The state’s Department of Transportation estimates that if the job were done now, it would cost about $6 million. But because heavy truck traffic and winter weather will cause deeper fissures in the roadbed over time, the same job will cost $30 million if we wait just two years. Since no one would be willing to say publicly that we should let I-80 deteriorate indefinitely, our choice is simple: fix it now for $6 million, or fix it later for a vastly larger amount.

Reinforcing the case for immediate action is that the people and machines required for the job are currently largely idle. If we wait, we’ll have to bid them away from other useful jobs. The required materials are now cheap in world markets, and the interest rates on the money required for the job are at record lows. Those costs will rise. Doing this job now is a no-brainer. Again, the American Society of Civil Engineers has identified a huge backlog of similar projects. Doing these projects as quickly as possible will not impoverish our grandchildren. If we really want to impoverish them, we should continue to postpone.

The downturn will end, eventually. But even with the economy back at full employment, we’ll still face serious long-run budget issues. Some insist that we should balance budgets by cutting wasteful government spending. But every president in my lifetime has pledged to do that, and although some made more progress than others, total spending rose during each of their administrations. Government programs exist because constituents want them. They’re always hard to cut. We should continue to try to eliminate waste, of course. But no one who’s familiar with the numbers thinks we can balance the budget with spending cuts alone. Tens of millions of baby boomers will retire during the next decades. Spending will increase no matter how energetically we try to curb waste.

In short, the budget cannot be balanced without additional revenue. Yet each of the Republicans on the congressional supercommittee charged with that task has pledged never to approve any new taxes under any circumstances. And at one of the early debates, the Republican presidential candidates unanimously rejected a proposal that called for only $1 of new revenue for every $10 in spending cuts. An economic train wreck looms.

Fortunately, there’s a painless way to avoid it. The simplest step would be to scrap the current progressive income tax in favor of a much more steeply progressive tax on each household’s consumption expenditure. Each family would report its taxable income to the IRS (ideally, under a tax code that greatly simplifies the calculation of taxable income), and also its annual savings, as many now do for IRAs and other tax-exempt retirement accounts. The difference between those two numbers—income minus savings—is the family’s annual consumption expenditure. That amount less a large standard deduction—say, $30,000 for a family of four—is the family’s taxable consumption. Rates would start low and would then rise much more steeply than those under the current income tax.

The tax bill for families in the bottom half of the spending distribution would be lower than under the current system. But high marginal rates on top spenders would not only generate more revenue than the current system, it would also reshape spending patterns in ways that would benefit people up and down the income ladder.

If top marginal income-tax rates are set too high, they discourage productive economic activity. A top marginal income-tax rate of 100 percent would mean that taxpayers would gain nothing from working harder or investing more. In contrast, a higher top marginal rate on consumption would actually encourage savings and investment. A top marginal consumption-tax rate of 100 percent would simply mean that if a wealthy family spent an extra dollar, it would also owe an additional dollar of tax.

That feature of the tax gives rise to what can be described, without exaggeration, as fiscal alchemy. Consider, for example, how the tax would affect a wealthy family that had been planning a $2 million addition to its mansion. If it faced a marginal consumption-tax rate of 100 percent, that addition would now cost $4 million—$2 million for the contractor, and another $2 million for the extra tax. Even the wealthy respond to price incentives. (That’s why they live in smaller houses in New York than in Seattle.) So the tax would be a powerful incentive for this family to scale back its plans. It could build an addition half as big without spending more than it originally planned.

The fiscal magic occurs because other wealthy families who’d also planned additions to their mansions would respond in a similar way. No one denies that, beyond some point, it’s relative, not absolute, mansion size that really matters. So the smaller additions would serve just as well as if all had built larger ones.

The tax would have similar effects in other luxury domains. The amounts spent on multimillion-dollar coming-of-age parties would grow less quickly, as would the amounts spend on weddings, yachts, jewelry, and other items. And these changes would attenuate the indirect effects that have so severely squeezed middle-class families. Without reference to those indirect effects, there’s no way to explain why the median size of a new single-family house in 2007 was 2,300 square feet, up nearly 50 percent from what it was in 1980, or why the average real cost of an American wedding grew almost threefold during the same period. If consumption at the top grew more slowly, pressure on people in the middle would also grow more slowly.

Although a progressive consumption tax would reduce inequality in consumption spending, it would almost surely have the opposite effect on wealth inequality, since the rich could better take advantage of the savings exemption. Because the wealthy would die with larger estates than before, it would be important to maintain a strong estate tax as part of the system.

With the unemployment rate still near 9 percent, now would be, of course, an inopportune moment to implement a progressive consumption tax. But if we passed the tax into law now and scheduled it for gradual phase-in only after the economy had again reached full employment, we’d kill three birds with one stone.

First, by committing ourselves to a larger revenue stream in the future, we’d reassure those who worry, with good reason, that government cannot forever spend more than it takes in. Second, by gradually shifting resources toward additional investment, we’d foster more rapid growth in productivity and income. Third, and most important, the mere knowledge that the tax was coming would precipitate a massive burst of private economic stimulus that would help get the economy back on its feet. Anyone who was thinking about buying a bigger yacht would rush to do so before the tax took effect.

Of course, that’s hardly the best way to stimulate a depressed economy. Far better, as noted, would be to invest hundreds of billions of dollars on desperately overdue infrastructure repairs.

But although conservatives in Congress have consistently demonstrated their ability and willingness to block such measures, they have always been responsive to proposals to tax consumption instead of income. They generally favor a flat tax, but because flat taxes would dramatically worsen income inequality, they are unlikely ever to be adopted. Once it’s clear that a flat tax isn’t an option, a progressive consumption tax begins to look more attractive.

So there’s hope, after all. A simple change in the tax structure could help end the current downturn quickly while at the same time liberating more than enough resources to end deficit worries once and for all.

What’s not to like?

This essay was published in Newsweek International's Special Edition, 'Issues 2012,' on sale from December 2011-February 2012.