Fiscal Policy in the Long and Short Runs

The Times' Edmund Andrews has a useful look (with nice charts) at the fiscal policy challenges that will confront the next administration. One major issue is that the tax cuts passed in 2001 and 2003 are scheduled to expire:

Extending them would reduce revenues by about $3 trillion over the next 10 years, according to the Congressional Budget Office. Those reductions would coincide with sharply rising costs for Social Security and Medicare as millions of baby boomers enter retirement.

Senator John McCain of Arizona, the front-runner for the Republican nomination for president, has flip-flopped on the issue. In 2001 and 2003, he alienated many Republicans by voting against the tax cuts, arguing that they were too heavily tilted toward the rich. But as a presidential candidate, Mr. McCain competed fiercely with his Republican rivals in vowing to not only make the tax cuts permanent but also to cut the corporate tax rate....

The Democratic contenders, Senator Barack Obama and Senator Hillary Rodham Clinton, would extend the tax cuts for most people but revoke them for families earning more than $250,000 a year. “I am not bashful about that,” Mr. Obama said at the Democratic candidates’ debate on Jan. 31. “What we have right now is a situation where we cut taxes for people who don’t need them.”

Clinton and Obama plan to use the additional revenue to finance their health care plans. Obama has also expressed a willingness to consider raising the social security payroll tax on earnings over the current cap of about $90,000 (see earlier post).

The steps discussed so far on the campaign trail are unlikely to close the gap between revenue and spending (and McCain, if he doesn't change his mind again, would widen it). None of the candidates (except Huckabee) has offered plans for fundamental changes to the tax system. Andrews puts it in context nicely:

Historically, federal taxes have averaged about 18.5 percent of the gross domestic product.

That percentage sank to 16.3 percent of the G.D.P. in 2004, largely because of Mr. Bush’s tax cuts, but it edged up to 18.8 percent last year as a result of booming corporate profits and investment income.

But government spending remains above 20 percent of G.D.P., and the gap between taxes and spending is likely to widen sharply as a result of the economic slowdown this year.

President Bush’s budget plan for 2009, which includes money for an economic stimulus package, calls for the federal deficit to more than double, to $410 billion, this year.

That is, in addition to the gap between revenue and spending expected over the long run, we can expect the deficit to increase in the short run, and that's not entirely a bad thing. The expected increase in the deficit this year is partly a reflection of the "automatic stabilizer" role of the federal budget - since most taxes are proportional to income, revenues automatically fall when incomes decrease, and spending on some government transfer programs like unemployment insurance rises in a downturn. On top of that, we are indeed going to get a "fiscal stimulus" - a one-off tax rebate intended to increase aggregate demand this year. The efficacy of this has been much-debated; I think Jared Bernstein has it about right:

It's both good news and a missed opportunity to craft a much more effective package.

On the plus side, those who said the political system was too clogged with partisanship to get this out the door quickly are proved wrong. The package is also much improved from the White House's first pass, which excluded low-income families and about 20 million elderly persons.

On the negative side, they could have crafted a package that would have had a lot more bang-for-the-buck....

By leaving out extended unemployment benefits and other more directly stimulative measures, like helping revenue-strapped states invest in infrastructure (roads, school repairs), the Congress and the White House missed the chance to get a significantly bigger return on our investment...

That said, and I know there's a fair bit of skepticism on this point, this package will surely help. It won't stave off recession, but it will mitigate the pain for many.