Friday, January 19, 2018

How to Fix A Structural Budget Deficit

There is a growing awareness among our legislators that this is not the time to raise taxes. There also seems to be at least an emerging awareness that we need long-term, permanent reductions in government spending. These insights are welcome and give us reasons to be cautiously optimistic about the coming legislative session. 

Even more encouraging is the fact that the Consensus Revenue Estimating Group - belatedly - has done away with its old habit of predicting a return to the days of abundant tax revenue. In their latest report, in fact, CREG suggests that over the next few years, tax revenue will be flat. Hopefully, our legislators and our gubernatorial candidates will take this message seriously. In the background of the legislative chatter, I hear scattered examples of conventional economic reasoning suggesting that "in the long run" we will return to a higher level of economic activity.

The difference between what the CREG report says - which is also what I have been saying for a year and a half - and the conventional-wisdom chatter is more than a technical issue for econonerds. The difference has direct implications for actual legislation, and for the future health of our state government finances - and our state's entire economy.

To see the difference, let us go through a brief technical exercise. Economists usually reason about the economy in terms of short and long-run economic activity. The short run is usually a business cycle consisting of: 

a) a growth period with full employment and strong GDP growth, and 
b) a recession with unemployment and weak or no GDP growth. 

Fiscally, in terms of the government budget, the growth period is supposed to be a period of budget surpluses, while recessions are characterized by deficits. 

The long run, on the other hand, is often characterized as a "path" of economic activity beyond the business cycle. It is the focal point of economic theories focusing on capital formation, labor supply, "natural" unemployment and the structural composition of the economy. Here, the standard idea is that the economy is on a long-term growth path that stays stable, unchanged, over time. 

Short-term swings in the business cycle are then placed as fluctuations around the long-term growth path:

Figure 1
The problem with this standard theory is that it is not true. Conceptually, as a theoretical framework, it makes sense because it allows us to understand the basic framework of dynamic reasoning. Empirically, though, it has been proven false. Figure 2 reports annual real growth - quarterly numbers - for the U.S. GDP over the past several decades:

Figure 2
Source: Bureau of Economic Analysis

Long term, we have shifted from a four-percent growth economy to a three-percent growth economy, down to a two-percent growth economy. 

Let us assume, for a moment, that this is actually what has happened in Wyoming, as well. If so, our long-term growth path is not at all as stable as standard theory says:

Figure 3
When a long-term growth path shifts downward like this, it does of course have consequences for the fiscal situation of a government. To see what those consequences are, let us add the short-term business cycle as it would look when the long-term growth path shifts down like this:

Figure 4

If our recession coincides with a downshift in long-term economic activity, then the downslope into the recession will be far stronger than it otherwise would. 

A steep, rapid decline in economic activity, from the growth top in Figure 4 to its recession trough, causes a rapid loss of tax revenue - precisely as we have seen over the past two years. Now for the real juice in this: with the long-term decline leading, or causing the recession, this means that the short-term downslope is not going to be followed by a recovery. Whatever cyclical swings we see in the future will be determined by a new, lower level of long-term economic activity. 

Suppose, now, that we have calibrated our government spending to rely on tax revenue at the old, higher long-term level of economic activity. What happens when tax revenue permanently shifts down? Obviously, we open a budget gap that will remain there for the foreseeable future. Furthermore, if spending is calibrated to grow on par with, say, three percent GDP growth, while tax revenue shift down to a long-term path of, say, two percent growth, then - as simple arithmetic would dictate - the budget deficit will expand over time. 

With this macroeconomic framework for our state budget, it is time for our legislators, our current governor and our next governor to start thinking in terms of permanent solutions. Our budget deficit is not a temporary problem. Three quick ideas for how to fix it:

2. Transparency and efficiency reforms to create some "wiggle room" in the budget for broader spending reforms.
3. Long-term regulatory reforms - regulations cost businesses $50 for every $100 they pay in taxes - and long-term, structural spending reforms to permanently downsize our government.

I am cautiously optimistic that we can move our state onto this trajectory toward growth and prosperity.

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