An Analysis of the Trump Tax Plan: Not a Tax Reform, But Rather a Massive Tax Cut for the Rich

A.  Introduction

The Trump administration released on September 27 its proposed tax plan.  It was exceedingly skimpy (only nine pages long, including the title page, and with all the white space could have been presented on half that number of pages).  Importantly, it was explicitly vague on many of the measures, such as what tax loopholes would be closed to partially pay for the tax cuts (simply saying they would do this somehow).  One can, however, examine measures that were explicitly presented, and from these it is clear that this is primarily a plan for massive tax cuts for the rich.

It is also clear that this is not a tax reform.  A tax reform would be revenue neutral.  The measures proposed would not be.  And a reform would focus on changes in the structure of the tax system.  There is little of that here, but rather proposals to cut various tax rates (including in several cases to zero), primarily for the benefit of those who are well off.

One can see this in the way the tax plan was approached.  In a true tax reform, one would start by examining the system, and whether certain deductions and tax exemptions are not warranted by good policy (but rather serve only certain vested interests).  Closing such loopholes would lead to higher revenues being collected.  One would then determine what the new tax rates could be (i.e. by how much they could be cut) to leave the overall level of tax collection the same.

But that was not done here.  Rather, they start with specific proposals on what the new tax rates “should” be (12%, 25%, and 35% for individuals, and 20% for corporations), and then make only vague references to certain, unspecified, deductions and tax exemptions being eliminated or reduced, in order not to lose too much in revenues (they assert).  They have the process backward.

And it is clear that these tax cuts, should they be enacted by Congress, would massively increase the fiscal deficit.  While it is impossible to come up with a precise estimate of how much the tax plan would cost in lost revenues, due to the vagueness on the parameters and on a number of the proposals, Republicans have already factored into the long-term budget a reduction in tax revenues of $1.5 trillion over ten years.  And estimates of the net cost of the Trump plan range from a low of $2.2 trillion over ten years ($2.7 trillion when additional interest is counted, as it should be), to as high as $5 trillion over ten years.  No one can really say as yet, given the deliberate lack of detail.

But any of these figures on the cost are not small.  The total federal debt held by the public as of the end of September, 2017, was $14.7 trillion.  The cost in lost revenue could equal more than a third of this.  Yet Republicans in Congress blocked the fiscal expenditures we desperately needed in the years from 2010 onwards during the Obama years, when unemployment was still high, there was excess capacity in our underutilized factories, and the country needed to rebuild its infrastructure (as we still do).  The argument then was that we could not add to our national debt.  But now the same politicians see no problem with adding massively to that debt to cover tax cuts that will primarily benefit the rich.  The sheer hypocrisy is breath-taking.

Not surprisingly, Trump officials are saying that there will be no such cost due to a resulting spur to our economic growth.  Trump himself asserted that his tax plan would lead the economy to grow at a 6% pace.  No economist sees this as remotely plausible.  Even Trump’s economic aides, such as Gary Cohn who was principally responsible for the plan, are far more cautious and say only that the plan will lead to growth of “substantially over 3 percent”.  But even this has no basis in what has been observed historically after the Reagan and Bush tax cuts, nor what one would expect from elementary economic analysis.

The lack of specificity in many of the proposals in the tax plan issued on September 27 makes it impossible to assess it in full, as major elements are simply only alluded to.  For example, it says that a number of tax deductions (both personal and corporate) will be eliminated or reduced, but does not say which (other than that they propose to keep the deductions for home mortgage interest and for charity).  As another example, the plan says the number of personal income tax brackets would be reduced from seven currently to just three broad ones (at 12%, 25%, and 35%), but does not say at what income levels each would apply.  Specifics were simply left out.

For a tax plan where work has been intensively underway for already the eight months of this administration (and indeed from before, as campaign proposals were developed), such vagueness must be deliberate.  The possible reasons include:  1) That the specifics would be embarrassing, as they would make clear the political interests that would gain or lose under the plan; 2) That revealing the specifics would spark immediate opposition from those who would lose (or not gain as others would); 3) That revealing the specifics would make clear that they would not in fact suffice to achieve what the Trump administration is asserting (e.g. that ending certain tax deductions will make the plan progressive, or generate revenues sufficient to offset the tax rate cuts); and/or 4) That they really do not know what to do or what could be done to fix the issue.

One can, however, look at what is there, even if the overall plan is incomplete.  This blog post will do that.

B.  Personal Income Taxes

The proposals are (starting with those which are most clear):

a)  Elimination of the Estate Tax:  Only the rich pay this.  It only applies to estates given to heirs of $10.98 million or more (for a married couple).  This only affects the top 0.2%, most wealthy, households in the US.

b)  Elimination of the Alternative Minimum Tax:  This also only applies to those who are rich enough for it to apply and who benefit from a range of tax deductions and other benefits, who would otherwise pay little in tax.  It would be better to end such tax deductions and other special tax benefits that primarily help this group, thus making the Alternative Minimum Tax irrelevant, than to end it even though it had remained relevant.

c)  A reduction in the top income tax rate from 39.6% to 35%:  This is a clear gain to those whose income is so high that they would, under the current tax brackets, owe tax at a marginal rate of 39.6%.  But this bracket only kicks in for households with an adjusted gross income of $470,700 or more (in 2017).  This is very close to the minimum income of those in the top 1% of the income distribution ($465,626 in 2014), and the average household income of those in that very well-off group was $1,260,508 in 2014.  Thus this would be a benefit only to the top 1%, who on average earn over $1 million a year.

The Trump plan document does include a rather odd statement that the congressional tax-writing committees could consider adding an additional, higher, tax bracket, for the very rich, but it is not at all clear what this might be.  They do not say.  And since the tax legislation will be written by the congressional committees, who are free to include whatever they choose, this gratuitous comment is meaningless, and was presumably added purely for political reasons.

d)  A consolidation in the number of tax brackets from seven currently to just three, of 12%, 25%, and 35%:  Aside from the clear benefit to those now in the 39.6% bracket, noted above, one cannot say precisely what the impact the new tax brackets would have for the other groups since the income levels at which each would kick in was left unspecified.  It might have been embarrassing, or contentious, to do so.  But one can say that any such consolidation would lead to less progressivity in the tax system, as each of the new brackets would apply to a broader range of incomes.  Instead of the rates rising as incomes move up from one bracket to the next, there would now be a broader range at which they would be kept flat.  For example, suppose the Trump plan would be for the new 25% rate to span what is now taxed at 25% or 28%.  That range would then apply to household incomes (for married couples filing jointly, and in 2017) from $75,900 on the low end to $233,350 at the high end.  The low-end figure is just above the household income figure of $74,869 (in 2016) for those reaching the 60th percentile of the income distribution (see Table A-2 of this Census Bureau report), while the top-end is just above the $225,251 income figure for those reaching the 95th percentile.  A system is not terribly progressive when those in the middle class (at the 60th percentile) pay at the same rate as those who are quite well off (in the 95th percentile).

e)  A ceiling on the tax rate paid on personal income received through “pass-through” business entities of just 25%:  This would be one of the more regressive of the measures proposed in the Trump tax plan (as well as one especially beneficial to Trump himself).  Under current tax law, most US businesses (95% of them) are incorporated as business entities that do not pay taxes at the corporate level, but rather pass through their incomes to their owners or partners, who then pay tax on that income at their normal, personal, rates.  These so-called “pass-through” business entities include sole proprietorships, partnerships, Limited Liability Companies (LLCs), and sub-chapter S corporations (from the section in the tax code).  And they are important, not only in number but also in incomes generated:  In the aggregate, such pass-through business entities generate more in income than the traditional large corporations (formally C corporations) that most people refer to when saying corporation.  C corporations must pay a corporate income tax (to be discussed below), while pass-through entities avoid such taxes at the company level.

The Trump tax plan would cap the tax rate on such pass-through income at 25%.  This would not only create a new level of complexity (a new category of income on which a different tax is due), but would also only be of benefit to those who would otherwise owe taxes at a higher rate (the 35% bracket in the Trump plan).  If one were already in the 25% bracket, or a lower one, that ceiling would make no difference at all and would be of no benefit.  But for those rich enough to be in the higher bracket, the benefit would be huge.

Who would gain from this?  Anyone who could organize themselves as a pass-through entity (or could do so in agreement with their employer).  This would include independent consultants; other professionals such as lawyers, lobbyists, accountants, and financial advisors; financial entities and the partners investing in private-equity, venture-capital, and hedge funds; and real estate developers.  Trump would personally benefit as he owns or controls over 500 LLCs, according to Federal Election Commission filings.  And others could reorganize into such an entity when they have a tax incentive to do so.  For example, the basketball coach at the University of Kansas did this when Kansas created such a loophole for what would otherwise be due under its state income taxes.

f)  The tax cuts for middle-income groups would be small or non-existent:  While the Trump tax proposal, as published, repeatedly asserts that they would reduce taxes due by the middle class, there is little to suggest in the plan that that would be the case.  The primary benefit, they tout (and lead off with) is a proposal to almost double the standard deduction to $24,000 (for a married couple filing jointly).  That standard deduction is currently $12,700.  But the Trump plan would also eliminate the personal exemption, which is $4,050 per person in 2017.  Combining the standard deduction and personal exemptions, a family of four would have $28,900 of exempt income in 2017 under current law ($12,700 for the standard deduction, and personal exemptions of four times $4,050), but only $24,000 under the Trump plan.  They would not be better off, and indeed could be worse off.  The Trump plan is also proposing that the child tax credit (currently a maximum of $1,000 per child, and phased out at higher incomes) should be raised (both in amount, and at the incomes at which it is phased out), but no specifics are given so one cannot say whether this would be significant.

g)  Deduction for state and local taxes paid:  While not stated explicitly, the plan does imply that the deduction for state and local taxes paid would be eliminated.  It also has been much discussed publicly, so leaving out explicit mention was not an oversight.  What the Trump plan does say is the “most itemized deductions” would be eliminated, other than the deductions for home mortgage interest and for charity.

Eliminating the deduction for state and local taxes appears to be purely political.  It would adversely affect mostly those who live in states that vote for Democrats.  And it is odd to consider this tax deduction as a loophole.  One has to pay your taxes (including state and local taxes), or you go to jail.  It is not something you do voluntarily, in part to benefit from a tax deduction.  In contrast, a deduction such as for home mortgage interest is voluntary, one benefits directly from buying and owning a nice house, and such a deduction benefits more those who are able to buy a big and expensive home and who qualify for taking out a large mortgage.

h)  Importantly, there was much that was not mentioned:  One must also keep in mind what was not mentioned and hence would not be changed under the Trump proposals.  For example, no mention was made of the highly favorable tax rates on long-term capital gains (for assets held one year or more) of just 20%.  Those with a high level of wealth, i.e. the wealthy, gain greatly from this.  Nor was there any mention of such widely discussed loopholes as the “carried interest” exception (where certain investment fund managers are able to count their gains from the investment deals they work on as if it were capital gains, rather than a return on their work, as it would be for the lawyers and accountants on such deals), or the ability to be paid in stock options at the favorable capital gains rates.

C.  Corporate Income Taxes

More than the tax cuts enacted under Presidents Reagan and Bush, the Trump tax plan focuses on cuts to corporate income (profit) taxes.  Proposals include:

a)  A cut in the corporate income tax rate from the current 35% to just 20%:  This is a massive cut.  But it should also be recognized that the actual corporate income tax paid is far lower than the headline rate.  As noted in an earlier post on this blog, the actual average rate paid has been coming down for decades, and is now around 20%.  There are many, perfectly legal, ways to circumvent this tax.  But setting the rate now at 20% will not mean that taxes equal to 20% of corporate profits will be collected.  Rather, unless the mechanisms used to reduce corporate tax liability from the headline rate of 35% are addressed, those mechanisms will be used to reduce the new collections from the new 20% headline rate to something far less again.

b)  Allow 100% of investment expenses to be deducted from profits in the first year, while limiting “partially” interest expense on borrowing:  This provision, commonly referred to as full “expensing” of investment expenditures, would reduce taxable profits by whatever is spent on investment.  Investments are expected to last for a number of years, and under normal accounting the expense counted is not the full investment expenditure but rather only the estimated depreciation of that investment in the current year.  However, in recent decades an acceleration in what is allowed for depreciation has been allowed in the tax code in order to provide an additional incentive to invest.  The new proposal would bring that acceleration all the way to 100%, which as far as it can go.

This would provide an incentive to invest more, which is not a bad thing, although it still would also have the effect of reducing what would be collected in corporate income taxes.  It would have to be paid for somehow.  The Trump proposal would partially offset the cost of full expensing of investments by limiting “partially” the interest costs on borrowing that can be deducted as a cost when calculating taxable profits.  The interest cost of borrowing (on loans, or bonds, or whatever) is currently counted in full as an expense, just like any other expense of running the business.  How partial that limitation on interest expenses would be is not said.

But even if interest expenses were excluded in full from allowable business expenses, it is unlikely that this would come close to offsetting the reduction in tax revenues from allowing investment expenditures to be fully expensed.  As a simple example, suppose a firm would make an investment of $100, in an asset that would last 10 years (and with depreciation of 10% of the original cost each year).  For this investment, the firm would borrow $100, on which it pays interest at 5%.  Under the current tax system, the firm in the first year would deduct from its profits the depreciation expense of $10 (10% of $100) plus the interest cost of $5, for a total of $15.  Under the Trump plan, the firm would be able to count as an expense in the first year the full $100, but not the $5 of interest.  That is far better for the firm.  Of course, the situation would then be different in the second and subsequent years, as depreciation would no longer be counted (the investment was fully expensed in the first year), but it is always better to bring expenses forward.  And there likely will be further investments in subsequent years as well, keeping what counts as taxable profits low.

c)  Tax amnesty for profits held abroad:  US corporations hold an estimated $2.6 trillion in assets overseas, in part because overseas earnings are not subject to the corporate income tax until they are repatriated to the US.  Such a provision might have made sense decades ago, when information systems were more primitive, but does not anymore.  This provision in the US tax code creates the incentive to avoid current taxes by keeping such earnings overseas.  These earnings could come from regular operations such as to sell and service equipment for foreign customers, or from overseas production operations.  Or such earnings could be generated through aggressive tax schemes, such as from transferring patent and trademark rights to overseas jurisdictions in low-tax or no-tax jurisdictions such as the Cayman Islands.  But whichever way such profits are generated, the US tax system creates the incentive to hold them abroad by not taxing them until they are repatriated to the US.

This is an issue, and could be addressed directly by changing the law to make overseas earnings subject to tax in the year the earnings are generated.  The tax on what has been accumulated in the past could perhaps be spread out equally over some time period, to reduce the shock, such as say over five years.  The Trump plan would in fact start to do this, but only partially as the tax on such accumulated earnings would be set at some special (and unannounced) low rates.  All it says is that while both rates would be low, there would be a lower rate applied if the foreign earnings are held in “illiquid” assets than in liquid ones.  Precisely how this distinction would be defined and enforced is not stated.

This would in essence be a partial amnesty for capital earnings held abroad.  Companies that have held their profits abroad (to avoid US taxes) would be rewarded with a huge windfall from that special low tax rate (or rates), totalling in the hundreds of billions of dollars, with the precise gain on that $2.6 trillion held overseas dependant on how low the Trump plan would set the tax rates on those earnings.

It is not surprising that US corporations have acted this way.  There was an earlier partial amnesty, and it was reasonable for them to assume there would be future ones (as the Trump tax plan is indeed now proposing).  In one of the worst pieces of tax policy implemented in the George W. Bush administration, an amnesty approved in 2004 allowed US corporations with accumulated earnings abroad to repatriate that capital at a special, low, tax rate of just 5.25%.  It was not surprising that the corporations would assume this would happen again, and hence they had every incentive to keep earnings abroad whenever possible, leading directly to the $2.6 trillion now held abroad.

Furthermore, the argument was made that the 2004 amnesty would lead the firms to undertake additional investment in the US, with additional employment, using the repatriated funds.  But analyses undertaken later found no evidence that that happened.  Indeed, subsequent employment fell at the firms that repatriated accumulated overseas earnings.  Rather, the funds repatriated largely went to share repurchases and increased dividends.  This should not, however, have been surprising.  Firms will invest if they have what they see to be a profitable opportunity.  If they need funds, they can borrow, and such multinational corporations generally have no problem in doing so.  Indeed, they can use their accumulated overseas earnings as collateral on such loans (as Apple has done) to get especially low rates on such loans.  Yet the Trump administration asserts, with no evidence and indeed in contradiction to the earlier experience, that their proposed amnesty on earnings held abroad will this time lead to more investment and jobs by these firms in the US.

d)  Cut to zero corporate taxes on future overseas earnings:  The amnesty discussed above would apply to the current stock of accumulated earnings held by US corporations abroad.  Going forward, the Trump administration proposes that earnings of overseas subsidiaries (with ownership of as little as 10% in those firms) would be fully exempt from US taxes.  While it is true that there then would be no incentive to accumulate earnings abroad, the same would be the case if those earnings would simply be made subject to the same current year corporate income taxes as the US parent is liable for, and not taxable only when those earnings are repatriated.

It is also not at all clear to me how exempting these overseas earnings from any US taxes would lead to more investment and more jobs in the US.  Indeed, the incentive would appear to me to be the opposite.  If a plant is sited in the US and used to sell product in the US market or to export it to Europe or Asia, say, earnings from those operations would be subject to the regular US corporate income taxes (at a 20% rate in the Trump proposals).  However, if the plant is sited in Mexico, with the production then sold in the US market or exported from there to Europe or Asia, earnings from those operations would not be subject to any US tax.  Mexico might charge some tax, but if the firm can negotiate a good deal (much as firms from overseas have negotiated such deals with various states in the US to site their plants in those states), the Trump proposal would create an incentive to move investment and jobs to foreign locations.

D.  Conclusion

The Trump administration’s tax plan is extremely skimpy on the specifics.  As one commentator (Allan Sloan) noted, it looks like it was “written in a bar one evening over a batch of beers for a Tax 101 class rather than by serious people who spent weeks working with tax issues”.

It is, of course, still just a proposal.  The congressional committees will be the ones who will draft the specific law, and who will then of necessity fill in the details.  The final product could look quite different from what has been presented here.  But the Trump administration proposal has been worked out during many months of discussions with the key Republican leaders in the House and the Senate who will be involved.  Indeed, the plan has been presented in the media not always as the Trump administration plan, but rather the plan of the “Big Six”, where the Big Six is made up of House Speaker Paul Ryan, Senate Majority Leader Mitch McConnell, House Ways and Means Committee Chairman Kevin Brady, Senate Finance Committee Chairman Orrin Hatch, plus National Economic Council Director Gary Cohn and Treasury Secretary Steven Mnuchin of the Trump administration.  If this group is indeed fully behind it, then one can expect the final version to be voted on will be very similar to what was outlined here.

But skimpy as it is, one can say with some certainty that the tax plan:

a)  Will be expensive, with a ten-year cost in the trillions of dollars;

b)  Is not in fact a tax reform, but rather a set of very large tax cuts;

and c)  Overwhelmingly benefits the rich.

The Impact of the Reagan and Bush Tax Cuts: Not a Boost to Employment, nor to Growth, nor to the Fiscal Accounts

Private Employment Following Tax Law Changes

A.  Introduction

The belief that tax cuts will spur growth and new jobs, and indeed even lead to an improvement in the fiscal accounts, remains a firm part of Republican dogma.  The tax plans released by the main Republican presidential candidates this year all presume, for example, that a spectacular jump in growth will keep fiscal deficits from increasing, despite sharp cuts in tax rates.  And conversely, Republican dogma also holds that tax increases will kill growth and thus then lead to a worsening in the fiscal accounts.  The “evidence” cited for these beliefs is the supposed strong recovery of the economy in the 1980s under Reagan.

But the facts do not back this up.  There have been four major rounds of changes in the tax code since Reagan, and one can look at what happened after each.  While it is overly simplistic to assign all of what followed solely to the changes in tax rates, looking at what actually happened will at least allow us to examine the assertion underlying these claims that the Reagan tax cuts led to spectacular growth.

The four major changes in the tax code were the following.  While each of the laws made numerous changes in the tax code, I will focus here on the changes made in the highest marginal rate of tax on income.  The so-called “supply-siders” treat the highest marginal rate to be of fundamental importance since, under their view, this will determine whether individuals will make the effort to work or not, and by how much.  The four episodes were:

a)  The Reagan tax cuts signed into law in August 1981, which took effect starting in 1982. The highest marginal income tax rate was reduced from 70% before to 50% from 1982 onwards.  There was an additional round of tax cuts under a separate law passed in 1986, which brought this rate down further to 38.5% in 1987 and to 28% from 1988 onwards. While this could have been treated as a separate tax change episode, I have left this here as part of the Reagan legacy.  Under the Republican dogma, this should have led to an additional stimulant to growth.  We will see if that was the case.  There was also a more minor change under George H.W. Bush as part of a 1990 budget compromise, which brought the top rate partially back from 28.0% to 31.0% effective in 1991.  While famous as it went against Bush’s “read my lips” pledge, the change was relatively small.

b)  The tax rate increases in the first year of the Clinton presidency.  This was signed into law in August 1993, with the tax rate increases applying in that year.  The top marginal income tax rate was raised to 39.6%.

c)  The tax cuts in the George W. Bush presidency that brought the top rate down from 39.6% to 38.6% in 2002 and to 35.0% in 2003.  The initial law was signed in June 2001, and then an additional act passed in 2003 made further tax cuts and brought forward in time tax cuts being phased in under the 2001 law.

d)  The tax rate increases for those with very high incomes signed into law in December 2012, just after Obama was re-elected, that brought the marginal rate for the highest income earners back to 39.6%.

We therefore have four episodes to look at:  two of tax cuts and two of tax increases.  For each, I will trace what happened from when the tax law changes were signed up to the end of the administration responsible (treating Reagan and Bush I as one).  The questions to address are whether the tax cut episodes led to exceptionally good job growth and GDP growth, while the the tax increases led to exceptionally poor job and GDP growth. We will then look at what happened to the fiscal accounts.

B.  Jobs and GDP Growth Following the Changes in Tax Law

The chart at the top of this post shows what happened to private employment, by calendar quarter relative to a base = 100 for the quarter when the new law was signed. The data is from the Bureau of Labor Statistics (downloaded, for convenience, from FRED).  A chart using total employment would look almost exactly the same (but one could argue that government employment should be excluded as it is driven by other factors).

As the chart shows, private job growth was best following the Clinton and Obama tax increases, was worse under Reagan-Bush I, and abysmal under Bush II.  There is absolutely no indication that big tax cuts, such as those under Reagan and then Bush II, are good for job growth.  I would emphasize that one should not then jump to the conclusion that tax increases are therefore good for job growth.  That would be overly simplistic.  But what the chart does show is that the oft-stated claim by Republican pundits that the Reagan tax cuts were wonderful for job growth simply has no basis in fact.

How about the possible impact on GDP growth?  A similar chart shows (based on BEA data on the GDP accounts):

Real GDP Following Tax Law Changes

Once again, growth was best following the Clinton tax increases.  Under Reagan, GDP growth first fell following the tax cuts being signed into law (as the economy moved down into a recession, which by NBER dating began almost exactly as the Reagan tax cut law was being signed), and then recovered.  But the path never catches up with that followed during the Clinton years.  Indeed after a partial catch-up over the initial three years (12 calendar quarters), the GDP path began to fall steadily behind the pace enjoyed under Clinton.  Higher taxes under Clinton were clearly not a hindrance to growth.

The Bush II and Obama paths are quite similar, even though growth during these Obama years has had to go up against the strong headwinds of fiscal drag from government spending cuts.  Federal government spending on goods and services (from the GDP accounts, with the figures in real, inflation-adjusted, terms) rose at a 4.4% per annum pace during the eight years of the Bush II administration, and rose at a 5.6% rate during Bush’s first term.  Federal government spending since the late 2012 tax increases were signed under Obama have fallen, in contrast, at a 2.8% per annum rate.

There is therefore also no evidence here that tax cuts are especially good for growth and tax increases especially bad for growth.  If anything, the data points the other way.

C.  The Impact on the Fiscal Accounts

The argument of those favoring tax cuts goes beyond the assertion that they will be good for growth in jobs and in GDP.  Some indeed go so far as to assert that the resulting stimulus to growth will be so strong that tax revenues will actually rise as a result, since while the tax rates will be lower, they will be applied against resulting higher incomes and hence “pay for themselves”.  This would be nice, if true.  Something for nothing. Unfortunately, it is a fairy tale.

What happened to federal income taxes following the changes in the tax rates?  Using CBO data on the historical fiscal accounts:

Real Federal Income Tax Revenues Following Tax Law Changes

Federal income tax revenues (in real terms) either fell or at best stagnated following the Reagan and then the Bush II tax cuts.  The revenues rose following the Clinton and Obama tax increases.  The impact is clear.

While one would think this should be obvious, the supply-siders who continue to dominate Republican thinking on these issues assert the opposite has been the case (and would be, going forward).  Indeed, in what must be one of the worst economic forecasts ever made in recent decades by economists (and there have been many bad forecasts), analysts at the Center for Data Analysis at the conservative Heritage Foundation concluded in 2001 that the Bush II tax cuts would lead government to “effectively pay off the publicly held federal debt by FY 2010”.  Publicly held federal debt would fall below 5% of GDP by FY2011 they said, and could not go any lower as some federal debt is needed for purposes such as monetary operations.  But actual publicly held federal debt reached 66% of GDP that year.  That is not a small difference.

Higher tax revenues help then make it possible to bring down the fiscal deficit.  While the deficit will also depend on public spending, a higher revenue base, all else being equal, will lead to a lower deficit.

So what happened to the fiscal deficit following these four episodes of major tax rate changes?  (Note to reader:  A reduction in the fiscal deficit is shown as a positive change in the figure.)

Change in Fiscal Deficit Relative to Base Year Following Tax Law Changes

The deficit as a share of GDP was sharply reduced under Clinton and even more so under Obama.  Indeed, under Clinton the fiscal accounts moved from a deficit of 4.5% of GDP in FY1992 to a surplus of 2.3% of GDP in FY2000, an improvement of close to 7% points of GDP.  And in the period since the tax increases under Obama, the deficit has been reduced by over 4% points of GDP, in just three years.  This has been a very rapid base, faster than that seen even during the Clinton years.  Indeed, the pace of fiscal deficit reduction has been too fast, a consequence of the federal government spending cuts discussed above.  This fiscal drag held back the pace of recovery from the downturn Obama inherited in 2009, but at least the economy has recovered.

In contrast, the fiscal deficit deteriorated sharply following the Reagan tax cuts, and got especially worse following the Bush II tax cuts.  The federal fiscal deficit was 2.5% of GDP in FY1981, when Reagan took office, went as high as 5.9% of GDP in FY1983, and was 4.5% of GDP in FY1992, the last year of Bush I (it was 2.5% of GDP in FY2015 under Obama).  Bush II inherited the Clinton surplus when he took office, but brought this down quickly (on a path initially similar to that seen under Reagan).  The deficit was then 3.1% of GDP in FY2008, the last full year when Bush II was in office, and hit 9.8% of GDP in FY2009 due largely to the collapsing economy (with Bush II in office for the first third of this fiscal year).

Republicans continue to complain of high fiscal deficits under the Democrats.  But the deficits were cut sharply under the Democrats, moving all the way to a substantial surplus under Clinton.  And the FY2015 deficit of 2.5% of GDP under Obama is not only far below the 9.8% deficit of FY2009, the year he took office, but is indeed lower than the deficit was in any year under Reagan and Bush I.  The tax increases signed into law by Clinton and Obama certainly helped this to be achieved.

D.  Conclusion

The still widespread belief among Republicans that tax cuts will spur growth in jobs and in GDP is simply not borne out be the facts.  Growth was better following the tax increases of recent decades than it was following the tax cuts.

I would not conclude from this, however, that tax increases are therefore necessarily good for growth.  The truth is that tax changes such as those examined here simply will not have much of an impact in one direction or the other on jobs and output, especially when a period of several years is considered.  Job and output growth largely depends on other factors.  Changes in marginal income tax rates simply will not matter much if at all. Economic performance was much better under the Clinton and Obama administrations not because they raised income taxes (even though they did), but because these administrations managed better a whole host of factors affecting the economy than was done under Reagan, Bush I, or Bush II.

Where the income tax rates do matter is in how much is collected in income taxes.  When tax rates are raised, more is collected, and when tax rates are cut, less is collected.  This, along with the management of other factors, then led to sharp reductions in the fiscal deficit under Clinton and Obama (and indeed to a significant surplus by the end of the Clinton administration), while fiscal deficits increased under Reagan, Bush I, and Bush II.

Higher tax collections when tax rates go up and lower collections when they go down should not be a surprising finding.  Indeed, it should be obvious.  Yet one still sees, for example in the tax plans issued by the Republican presidential candidates this year, reliance on the belief that a miraculous jump in growth will keep deficits from growing.

There is no evidence that such miracles happen.

The Tax Plans of the Republican Presidential Candidates Are Not Even Close to Serious

TPC Evaluations of Tax Losses in the Republican Tax Plans, 2016

A.  Introduction

There is a good deal in the current campaign of candidates seeking the Republican presidential campaign that is worrying.  When one of the main remaining candidates (Marco Rubio) tries to belittle one of the other candidates (Donald Trump) on national television by alluding to the size of his penis, one has to wonder.  This would be considered juvenile even in a campaign for a high school class president.  Yet one of these candidates will almost certainly receive the nomination of the Republican Party to be the President of the United States.

This blog seeks, however, to focus on economic issues.  And a key economic issue in modern day political campaigns is what the candidate would seek to do, if elected to office, about tax policy.  Major candidates have therefore set out detailed proposals while campaigning, with these proposals developed by teams of trusted advisors who are specialists in the area, and then put out by the candidate as what he (or she) would try to enact if elected.

The major Republican candidates have done this, and four of these (the proposals of Donald Trump, Ted Cruz, Marco Rubio, and Jeb Bush) have been analyzed in depth by the non-partisan Tax Policy Center (a joint center sponsored by the Urban Institute and the Brookings Institution).  (The Tax Policy Center has also just recently issued similar analyses of the tax plans of Hillary Clinton and Bernie Sanders.)

Among the issues examined by the Tax Policy Center was what the impact would be on revenues collected of the Republican plans.  This blog post will look at those estimates, and calculate what they imply for government expenditure cuts if, as each of the candidates insist, they would not allow deficits to rise.  And what they imply is that these plans, like much else in this campaign, simply are not serious.

B.  The Revenue Losses from the Republican Plans

The chart at the top of this post shows what the Tax Policy Center calculates the government revenue losses would be if the tax plans of the major Republican candidates were implemented.  Ten year totals (for fiscal years 2017 to 2026) are shown rather than year by year numbers to keep things simple, even though the plans would still be ramping up in 2017 with the full impact not seen until 2018.  The total revenue losses would range from $6.8 trillion for Bush as well as Rubio, to $8.6 trillion for Cruz, to $9.5 trillion for Trump.

To put this in perspective, the chart includes (on the right) the projected total government discretionary budget expenditures for all purposes other than defense over this same ten year period.  The figures are from the most recent (January 2016) ten year budget forecasts of the Congressional Budget Office, and will exclude defense as well expenditures for mandatory programs (two-thirds of which are for Social Security and Medicare) and for interest on public debt.

Forecast non-defense discretionary expenditures total $6.5 trillion over this ten year period.  This is less than what the revenue losses would be under any of the Republican plans.  That is, even with the total elimination of government discretionary spending on everything other than defense, the deficit would increase.  Yet these Republicans insist that their plans would not increase the deficit.

Cutting non-defense discretionary expenditures to zero is of course absurd.  For those concerned with security, one should note there would be no more federal prisons, no more prosecutors, no FBI, no more border control.  There would be no more federal disease control, no more federally funded medical research, no more federal support for infrastructure building or maintenance, no more NASA or supported science research, and so on.  Everything would be eliminated, not just cut.

Taking this a step further, one can look at how much defense spending would need to be cut, on top of the elimination of all non-defense expenditure, to make up for the lost revenues:

Implied Defense Reductions, FY2017 to 2026, TPC

The necessary cuts in the defense budget would range from 5% of forecast ten-year defense expenditures for Bush and Rubio, to 32% for Cruz, to 47% (!) for Trump.  Yet Cruz, Rubio and Bush have all also called for sharp increases in defense spending.  Ted Cruz has laid out an ambitious plan for a bigger military that an analyst at the conservative Cato Institute would cost an extra $2.6 trillion over eight years, an increase in defense spending of over 50%.  Bush and Kasich have each proposed increases in defense spending of $1 trillion over ten years, an increase of over 15%.  Rubio is also arguing for big (but unspecified) increases in defense spending.  Things are perhaps less clear for Donald Trump, who has asserted he is “gonna build a military that’s gonna be much stronger than it is right now”, but “for a lot less”.  How he would do this he does not say, and it is doubtful he would get a “much stronger” military if its budget is to be cut by close to half.

C.  Conclusion

The Republican candidates assert their tax cut plans would not, however, lead to deficit increases, nor that they would cut defense spending (at least other than Trump).  Rather, they would cut non-defense spending.  However, as seen above, even if non-defense spending were cut to zero, budget deficits would increase unless there were also sharp cuts in mandatory programs (which are mostly Social Security and Medicare).

How do they believe they can do this?  Because they assert their tax plans would lead to big, indeed miraculous, leaps in growth.  Yet there is no evidence that such tax plans would do this.  Indeed, they are so large that the disruption in finances would almost certainly have large negative consequences for growth.

Economic theory does suggest that tax systems can affect growth.  The Tax Policy Center evaluations of the Republican tax plans, cited above, each have a balanced discussion of what they might be.  But as they point out, one would expect from economic theory that there would be both positive and negative effects, offsetting each other to at least some degree, and that in any case the overall impact in either direction is likely to be small. What the net impact will be, and in what direction, is then an empirical question, and careful studies of historical examples of tax reforms suggests that the overall impact on growth is, indeed, small.

One also does not find any evidence in the US historical data that tax cuts lead to more rapid growth.  As an earlier post on this blog found, federal taxes as a share of GDP were substantially lower in the decade following the Bush tax cuts of 2001 than for any decade in the previous half century, but this was not associated with higher GDP or jobs growth. Rather, it was associated with the lowest growth of GDP or jobs of any decade since at least the 1960s.  Furthermore, one cannot find any indication that a reduction of the highest marginal income tax rate (a focus of the Republican tax plans) led to higher growth.  The highest marginal federal income tax rate was 91 or 92% in the 1950s under Eisenhower, and always 70% or higher during the 1960s, but growth in GDP and in jobs during those periods were reasonably good, especially in comparison to what they have been since the Bush tax cuts of 2001.  High marginal income tax rates in the 1950s and 1960s did not kill growth.

One should not then expect miracles.  The Republican tax plans simply cannot be taken seriously.  But perhaps I am being silly to expect that in this campaign for the presidency.

The Failure of the Austerity Strategy Imposed on Greece, With Some Suggestions on What To Do (and What Not To Do) Now

Greece - GDP 2008-2014 Projection vs Actual

A.  Introduction

It appears likely now that Greece will continue, at least for a few more months, with the austerity program that European governments (led by Germany) are insisting on.  In return, Greece will receive sufficient “new” funding that will allow it to pay the debt service coming due on its government debt (including debt service that was supposed to have been paid in June, but was not), as well as continued access to the liquidity lines with the European Central Bank that allow it to remain in the Eurozone.  But it is not clear how long Greece can continue on this path.

The measures being imposed by the Eurozone members are along the same lines as have been followed since the program began in 2010:  Primarily tax increases and cuts in government spending.  The most important measures (in terms of the predicted impact on euros spent or saved) in the new program are increases in value-added taxes and cuts in government pensions.  This has been a classic austerity strategy.  The theory is that in order to pay down debts coming due, a government needs to increase taxes and cut how much it has been spending.  In this way, the theory goes, the government will reduce its deficit and soon generate a surplus that will allow it first to reduce how much it needs to borrow and then start to reduce the debt it has outstanding.

The proponents of this austerity strategy, with Germany in the lead, argue that in this way and only in this way will the economy start to grow.  Others argue that austerity in conditions such as where Greece finds itself now will instead cut rather than enhance growth, and in fact lead to an economic decline.  The priority should instead be on actions that will lead to growth by raising rather than reducing demand.  Once the economy returns to full employment, one will be able to generate the public sector savings which will allow debt to be paid.  Without growth, the situation will only get worse.

One does not need to argue these points in the abstract.  Greece is now in its sixth year of the austerity program that Germany and others have insisted upon.  One can compare what has in fact happened to the economy to what was expected when the austerity program started.  The Greek program is the work of a combined group (nicknamed the “Troika”) made up of the EU, the ECB (European Central Bank), and the IMF.  The IMF support was via a Stand-By Arrangement, and for this the IMF prepares and makes available a Staff Report on the program and what it expects will follow for the economy. The EU and the ECB co-developed these forecasts with the IMF, or at least agreed with them.  This can therefore provide a baseline of what the Troika believed would follow from the austerity program in Greece.  And this can be compared to what actually happened.

The “projected” figures are therefore calculated from figures provided in the May 2010 IMF Staff Report for the Stand-By Arrangement for Greece.  What actually happened can be calculated from figures provided in the IMF WEO Database (most recently updated in April 2015).  I used the IMF WEO Database for the data on what happened as the IMF will define similarly in both IMF sources the various categories (such as what is included in “government” or in “public debt”).  Hence they can be directly compared.

This blog post will focus on a series of simple graphs that compare what was projected to what actually happened.  Note that the figures for 2014 should all be taken as preliminary. The concluding section of the post will review what might be done now (and what should not be done now).

As will be seen, the program failed terribly.  I should of course add that Germany and the Troika members do not believe that this failure was due to a failure in the design of the program, but rather was a result of the governments of Greece (several now) failing to apply the program with sufficient vigor.  But we will see that Greece actually went further than the original program anticipated in cutting government expenditures and in increasing taxes.  To be honest, I was myself surprised at how far they went, until I looked at the numbers.

Austerity was applied.  But it failed to lead to growth.

B.  The Path of Real GDP

To start with the most basic, did the austerity strategy lead to a resumption of growth or not?  The graph at the top of this post shows what was forecast to happen to real GDP in the Troika’s program, and what actually happened.  The base year is taken as 2008. Output had peaked early in that year before starting to turn down later in the year following the economic and financial collapse in the US.  (Note:  For 2008 as a whole, real GDP in Greece was only slightly below, by 0.4%, what it was in 2007 as a whole.)

The IMF Stand-by Arrangement for Greece was approved in mid-2010, with output falling sharply at the time.  The IMF then predicted that Greek GDP would fall further in 2011 (a decline of 2.6%), but that with adoption of the program, would then start to grow from 2012 onwards.

That did not happen.  The situation in 2010 was in fact already worse than what the IMF thought at the time, with a sharper contraction already underway in 2009 than the estimates then indicated and with this then continuing into 2010 despite the agreement with the Troika.  National estimates for aggregates like GDP are always estimates, and it is not unusual (including for the US) that later, more complete, estimates can differ significantly from what was initially estimated and announced.

Going forward, GDP growth was then far worse than what the IMF thought would follow with the new program.  GDP fell by 8.9% in 2011, rather than the 2.6% fall the IMF predicted.  GDP then fell by a further 6.6% in 2012 and a further 3.9% in 2013.  The widening gap between the forecast and the reality is especially clear if one shifts the base for comparison to 2010, the start of the IMF supported program:

Greece - GDP 2010-2014 Projection vs Actual

Growth appears to have returned in 2014, but by just 0.8% according to preliminary estimates (and subject to change).  But with the turmoil so far in 2015, everyone expects that GDP is once again falling.  The austerity strategy has certainly not delivered on growth.

C.  Real Government Expenditures, Taxes, the Primary Balance, and Public Debt

Advocates of the austerity strategy have argued not that the austerity strategy failed, but rather that Greece did not apply it with sufficient seriousness.  However, Greece has in fact cut government expenditures by substantially more than was called for in the IMF (and Troika) program:

Greece - Govt Expendite 2008-2014 Projection vs Actual

By 2014, real government expenditures were 17% below what the IMF had projected would be spent in that year, were 27% below where they had been in 2010 at the start of the program, and were 32% below where they had been in 2008.  Real government expenditures were in each year far less, by substantial margins, than had been called for under the initial IMF program.

It is hard to see how one can argue that Greece failed to cut its government spending with sufficient seriousness when government spending fell by so much, and by so much more than was called for in the original program.

Taxes were also raised by substantially more than called for in the initial IMF program:

Greece - Govt Revenue 2008-2014 Projection vs Actual

 

Tax effort and effect is best measured as a share of GDP.  The IMF program called for government revenues to rise as a share of GDP from 37% in 2009 and an anticipated 40.5% in 2010, to a peak of 43% in 2013 (a rise of 2 1/2% over 2010) after which they would fall.  What happened is that taxes were already substantially higher in 2009 (at almost 39% of GDP) than what the earlier statistics had indicated, and then rose from 41% of GDP in 2010 to a peak of 45% in 2013 (a rise of 4% over 2010).

Taxes as a share of GDP have therefore been substantially higher throughout the program than what had been anticipated, and the increase from 2010 to the peak in 2013 was far more than originally anticipated as well.  It is hard to see how one can argue that Greece has not made a major effort to secure the tax revenues that the austerity program called for.

With government spending being cut and government revenues rising, the fiscal deficit fell. For purposes of understanding the resulting government debt dynamics, economists focus on a fiscal deficit concept called the “primary balance” (or “primary deficit”, when in deficit).  The primary balance is defined as government revenues minus government expenditures on all items other than interest (and principal) on its debt.  It will therefore measure the resources available to cover interest (and principal, if all of interest can be covered).  If insufficient to cover interest coming due, then additional net borrowing will be necessary (thus adding to the stock of debt outstanding) to cover that interest.

With expenditures falling and revenues rising, the government’s primary balance improved sharply over the program period:

Greece - Primary Balance 2008-2014 Projection vs Actual

The primary balance improved from a deficit of 10.2% of GDP in 2009 to 5.2% of GDP in 2010, and then rose steadily to a primary surplus of 1.2% of GDP in 2013 and an estimated 1.5% of GDP in 2014 (where the 2014 estimate should be taken as preliminary). A rise in the primary balance of close to 12% of GDP in just five years is huge.

However, the primary balance tracked below what the IMF program had called for.  How could this be if government spending was less and government revenues higher?  There were two main reasons:  First, the estimates the IMF had to work with in 2010 for the primary deficit in that year and in the preceding years were seriously wrong.  The primary deficit in 2010 turned out to be (based on later estimates) 2.8% points of GDP higher than had originally been expected for that year.  That gap then carried forward into the future years, although narrowing somewhat (until 2014) due to the over-performance on raising taxes and reducing government expenditures.

Second, while the path of government expenditures in real terms was well below that projected for the IMF program (see the chart above), the decline in government expenditures as a share of GDP was less because GDP was so much less than forecast. If, for example, government expenditures are cut by 20% but GDP also falls by 20%, then government expenditures as a share of GDP will not change.  They still did fall as a share of GDP between 2009 and 2014 (by 7.7% points of GDP), but not by as much as they would have had GDP not collapsed.

Finally, from the primary balance and the interest due one can work out the path of government debt to GDP:

Greece - Govt Debt to GDP 2008-2014 Projection vs Actual

The chart shows the path projected for public debt to GDP in the IMF program (in blue) and the path it actually followed (in black).  Despite lower government expenditures than called for in the program and higher government revenues as a share of GDP, as well as a significant write-down of 50% on privately held government debt in 2012 (not anticipated in the original IMF program), the public debt to GDP ratio Greece now faces (177% as of the end of 2014, and rising) is well above what had been projected in the program (153% as of the end of 2014, and falling).

Why?  Again, the primary reason is that GDP contracted sharply and is now far below what the IMF had forecast.  If debt followed the path it actually did take but GDP had been as the IMF forecast, the debt to GDP ratio as of the end of 2014 would have been 131% and falling (the path shown in green on the chart).  This would have been well less than the 153% ratio the IMF forecast for 2014, due both to private debt write-off and to the fiscal over-performance.  Or if debt had followed the path projected in the IMF program while GDP took the path it in fact did take, the debt to GDP ratio would have been 207% in 2014 (the path in red on the chart) due to the lower GDP, or well above the actual ratio of 177% in that year.

One cannot argue that Greece failed to abide by its government expenditure and revenue commitments sought in the IMF program.  Indeed, it over-performed.  But the program failed, and failed dramatically, because it did not recognize that by implementing such austerity measures, GDP would collapse.  The program was fundamentally flawed in its design.

D.  Other Measures

While the fiscal accounts are central to understanding the Greek tragedy, it is of interest to examine two other variables as well.  First, the path taken by the external current account balance:

Greece - Current Acct 2008-2014 Projection vs Actual

For countries who have their own currency, but who borrow in a foreign currency, crises will normally manifest themselves through a balance of payments crisis.  This is not central in Greece as it does not have its own currency (it is in the Eurozone) and almost all of its public borrowing has been in euros.  Still, it is of interest that the current account balance of Greece (exports of all goods and services less imports of all goods and services) moved from a massive deficit of over 14% of GDP in 2008 to a surplus in 2013 and 2014. Relative to 2010, Greek exports of goods and services (in volume terms) were 12% higher in 2014, while Greek imports were 19% lower.

The IMF had projected that the external current account would still be in deficit in those years.  This shift was achieved despite Greece not being able, as part of the Eurozone, to control its own exchange rate.  The rate relative to its Eurozone partners is of course fixed, and the rate relative to countries outside of the Eurozone is controlled not by events in Greece but by policy for the Eurozone as a whole.  Rather, Greek exports rose and imports fell because the economy was so depressed that domestic producers who could export did, while imports fell in line with lower GDP (real GDP was 17.5% lower in 2014 than in 2010).  Lower wages were central to this, and will be discussed further below.

Finally, with the economy so depressed, unemployment rose, to a peak of 27.5% in 2013:

Greece - Unemployment Rate 2008-2014 Projection vs Actual

While the preliminary estimate is that unemployment then fell in 2014, most observers expect that it will go up again in 2015 due to the economic turmoil this year.  And youth unemployment is at 50%.

E.  What Can Be Done

I do not know Greece well, and certainly not enough to suggest anything that would be close to a complete program.  But perhaps a few points may be of interest, starting first with some things not to do (or at least are not a priority to do), and then some things that should be done (even if unlikely to happen):

1)  What not to do, or at least not worry about now:

a)  Do not continue doing what has failed so far:  While it should be obvious, if a particular strategy has failed, one should stop pursuing it.  Keeping the basic austerity strategy, with just a few tweeks, will not solve the problem.

b)  Do not make the austerity program even more severe:  Most clearly, the austerity program has savaged the economy, and one should not make things worse by tightening it even further.  Yet that is the direction that things appear to be heading in.

Negotiations are now underway as I write this between the Government of Greece and the Troika on the extension of the austerity program.  A focus is the government’s primary balance.  The original IMF program called for a primary surplus of 3% of GDP in 2015, and that has been still the official program goal despite all the turmoil between 2010 and now. The IMF program (as updated in June 2014) then envisioned the primary surplus rising to 4.5% of GDP in 2016 and and again in 2017.  Germany wanted at least this much, if not more.

Even the official Greek proposal to the Troika of July 10 had the primary surplus rising over time, from 1% of GDP in 2015, to 2%, 3%, and 3 1/2% in 2016, 2017, and 2018, respectively.  With the chaos this year, few expect Greece to be able to achieve a primary surplus target of even 1% of GDP (if one does not ignore payment arrears).  And while the IMF estimate from this past spring was that the primary surplus in 2014 reached 1.5% of GDP (reflected in the chart above), this was a preliminary estimate, and many observers believe that updated estimates will show it was in fact lower.

With even the Greek Government proposal conceding that an effort would be made to reach higher and higher primary balance surpluses, the final program as negotiated will almost certainly reflect some such increase.  This would be a mistake.  It will push the economy down further, or at least reduce it to below where it would otherwise be had the primary surplus target been kept flat.

c)  Do not negotiate over the stock of debt now:  There has been much more discussion over the last month on a need to negotiate now, and not later (some assert), a sharp cut to the stock of Greece’s public debt outstanding.  This was sparked in part by the public release on July 14 by the IMF of an updated debt sustainability analysis, which stated bluntly that the level of Greek public debt was unsustainable, that it could never be repaid in full, and that therefore a reduction in that debt will at some point be inevitable through some system of write-offs.

There is no doubt that Greek public debt is at an unsustainable level.  Some portion will need to be written down.  But I see no need to focus on that issue now, with the economy still deeply depressed and in crisis.  Rather, a moratorium on debt service payments (both principal and interest) should be declared.  The notional debt outstanding would then grow over time at the rate of interest (interest due in effect being capitalized).  At some future point, when the economy has recovered and with unemployment at more normal levels, there can be a negotiation on what to do about the debt then outstanding.  One will know only at that point what the economy can afford to pay.

Note that such a moratorium on debt service is fully and exactly equivalent to debt service payments being paid, but out of “new” loans that cover the debt service due.  This has been the approach used so far, and the current negotiations appear to be calling for a continuation of this approach.  Such “new” lending conveys the impression that debt service continues to be paid, when in reality it is being capitalized through the new loans. Little is achieved by this, and it wastes scarce and valuable time, as well as political capital, to negotiate over such issues now.

d)  Structural reforms can wait:  There is also no doubt that the Greek economy faces major structural issues, that hinder performance and productivity.  There are undoubtedly too many rules and regulations, inefficient state enterprises in key sectors, and codes that limit competition.  They do need to be reformed.

But there is a question of whether this should be a focus now.  The economy is severely depressed, with record high unemployment (similar to the peak rates seen in the US during the Great Depression).  Measures to improve productivity and efficiency will be important to allow the full capacity level of Greek GDP eventually to grow, but the economy is currently operating at far below full capacity.  The priority right now should be to return employment to close to full employment levels.

One needs also to recognize that many of the measures that would improve efficiency will also have the immediate impact of reducing rather than raising employment.  Changing rules and regulations that will make it easier to fire workers will have the immediate impact of reducing employment, not raising it.  Certain state enterprises undoubtedly should be privatized, and such actions can improve efficiency.  But the immediate impact will almost certainly be cuts in staffing, not increases.

Structural reforms will be important.  But they are not the critical priority now.  And far more knowledgeable commentators than myself have made the same point.  Former Federal Reserve Board Chairman Ben Bernanke made a similar point in a recent post on his blog, although more diplomatically and speaking on Europe as a whole.

2)  What should be done:

Finally, a few things to do, although it is likely they will not be politically feasible.

a)  Allow the primary balance to fall to zero, and then keep it there until the economy recovers:  As discussed above, the program being negotiated appears to be heading towards a goal of raising the primary surplus to 3 1/2% of GDP or more over the next few years.  The primary balance appears to have been in surplus in 2014 (the preliminary IMF estimate was 1.5% of GDP, but this may well be revised downwards), with a surplus also expected in 2015 (although the likelihood of this is now not clear, due to the chaotic conditions).  To raise it further from current levels, the program will call for further tax increases and government expenditure cuts.  This will, however, drive the economy down even further.

Keeping the primary balance at zero rather than something higher will at least reduce the fiscal drag that would otherwise hold back the economy.  Note also that a primary balance of zero is equivalent to a moratorium on debt service payments on public debt, which was discussed above.  Interest would then be fully capitalized, while no net amount will be paid on principal.

b)  Germany needs to take actions to allow Greece (and the Eurozone) to recover:  While I am under no illusion that Germany will change its domestic economic policies in order to assist Greece, the most important assistance Germany could provide to Greece is exactly that.

The fundamental problem in the design of the single currency system for the Eurozone system was the failure to recognize as critically important that Europe does not have a strong central government authority, with direct taxing powers, that can take action when the economy falls into a recession.  When a housing bubble bursts in Florida or Arizona, incomes in those states will be supported by US federal authorities, who will keep paying unemployment compensation; pensioners will keep receiving their Social Security and Medicare; federal transfers for education, highway programs, and other such government expenditures will continue; and if there is a national economic downturn (and assuming Congress is not controlled by ideologues opposed to any such actions) then stimulus measures can be enacted such as increased infrastructure spending.  And the Federal Reserve Board can lower interest rates to spur investment.  All of this supports demand, and keeps demand (and hence production and employment) from falling as much as it otherwise would.  This can then lead to a recovery.

The European Union in current form is not set up that way.  Central authority is weak, with no direct taxing powers and only limited expenditures.  Members of the Eurozone do not individually control their own currency.  If a member country suffers an economic downturn and faces limits on either what it can borrow in the market or in how much it is allowed to borrow in the market (by the limits set in the Fiscal Compact that Germany pushed through), it will not be able to take the measures needed to stabilize demand. Government revenues will decline in the downturn.  Any such borrowing limits will then force government expenditures to be cut.  This will lead to a further downward spiral, with tax revenues falling again and expenditures then having to be cut again if borrowing is not allowed to rise.  Greece has been caught in exactly such a spiral.

As was discussed some time ago on this blog, even Professor Martin Feldstein (a conservative economist who had been Chairman of the Council of Economic Advisers under Reagan) said such fiscal rules for the Eurozone could “produce very high unemployment rates and no route to recovery – in short, a depression”.  That is exactly what has happened in Greece.

The EU in its present form cannot, by itself as a central entity, do much to resolve this. However, member countries such as Germany are in a position to help support demand in the Eurozone, if they so wished.  But they don’t.  Germany had a current account surplus of 7.5% of GDP in 2014, and the IMF expects it will rise to 8.4% of GDP in 2015. Germany’s current account surplus hit $288 billion in 2014, the highest in the world (China was second, at $210 billion).  German unemployment is currently about 5%, but inflation is excessively low at 0.8% in 2014 and an expected 0.2% in 2015.  It could easily slip into the deflationary trap that Japan fell into in the 1990s that has continued to today.

To assist Greece and others in the Eurozone, Germany could do two things.  First, it could accede to the wage demands of its principal trade unions.  Germany’s largest trade union, IG Metall, had earlier this year asked for a general wage increase of 5.5% for 2015.  In the end, it agreed to a 3.4% increase.  A higher wage increase for German workers would speed the day to when they were in better alignment with those in Greece (which have been dropping, as we will discuss below) and others in the Eurozone.  Inflation in Germany would likely then rise from the 0.2% the IMF forecasts for 2015, but this would be a good thing.  As noted above, inflation of 0.2% is far too low, and risks dipping into deflation (prices falling), from which it can be difficult to emerge.  Thus the target set in the Eurozone is 2%, and it would be good for all if German inflation would rise to at least that.

Direct fiscal spending by Germany would also help.  It has the fiscal space.  This would spur demand in Germany, which would be beneficial for countries such as Greece and others in the Eurozone for whom Germany is their largest or one of their largest export markets.  Inflation would likely rise from its current low levels, but as noted, that would be good for all.

Of even greater direct help to Greece would be German support for EU programs that would provide direct demand support in Greece.  An example might be an acceleration of planned infrastructure investment programs in Greece, bringing them forward from future years to now.  Workers are unemployed now.  Bringing such programs forward would also be rational even if the intention was simply to minimize costs.  Unemployed workers and other resources are now available at cheap rates.  They will be more expensive if they wait until the economy is close to full employment, so that workers have an alternative. Economically, the opportunity cost of hiring workers now is extremely low.

A more balanced approach, where adjustment is not forced solely on depressed countries such as Greece but in a more balanced away between countries in surplus and those in deficit, would speed the recovery.  Far more authoritative figures than myself (such as Ben Bernanke in his blog post on Greece) have made similar arguments.  But Germany shows little sign of accepting the need for greater balance.

3)  What will likely happen:

With Germany not changing its stance, and with the Troika now negotiating an extension and indeed deepening of the austerity program Greece has been forced to follow since 2010 (in order to be allowed to remain in the Eurozone), the most likely scenario is that conditions will continue along the lines of what they have been so far under this program. The economy will remain depressed, unemployment will remain high, government revenues will fall in euro terms, and this will then lead to calls for even further government expenditure cuts.

One should not rule out that at some point some event occurs which leads to a more immediate collapse.  The banking system could collapse, for example.  Indeed, many observers have been surprised that the banking system has held up as well as it has. Liquidity support from the European Central Bank has been critical, but there are limits on how much it can or will be willing to provide.  Or a terrorist bomb at some resort could undermine the key tourism industry, for example.

Absent such uncontrollable shock events, there is also the possibility that at some point the Government of Greece might decide to exit the Eurozone.  This would also create a shock (and any such move to exit the Eurozone could not be pre-announced publicly, as it would create an immediate run on the currency), but at least some argue that following the initial chaos, this would then make it possible for Greece to recover.

The way this would work is that the new currency would be devalued relative to the euro, and by law all domestic transactions and contracts (including contracts setting wages of workers) would be re-denominated into the new currency (perhaps named the “new drachma” or something similar).  With a devaluation relative to the euro, this would then lead to wages (in euro terms) that have been reduced sharply and immediately relative to what they were before.  The lower wages would then lead to Greek products and services that are more competitive in markets such as Germany, leading to greater exports (and lower imports).  This is indeed how countries with their own currencies normally adjust.

It would, however, be achieved only by sharply lower wages.  It would also likely be accompanied by chaotic conditions in the banking system and in the economy generally in reaction to the shock of Eurozone exit.  Greece would also likely cease making payments of interest and principal on its government debt (payments that are due in euros).  This plus the exit from the Eurozone would likely sour relations with Germany and others in the Eurozone, at a time when the country needs help.

So far Greece has resisted leaving the Eurozone.  Given what it has accepted to do in the Troika program in order to stay in the Eurozone (with the resulting severely depressed economy), there can be no doubt that this intention is sincere.  Assuming then that Greece does stay in the Eurozone, what will likely happen?

Assuming no shocks (such as a collapse of the banking system), it would then be likely that the economy would muddle along for an extended period.  It would eventually recover, but only slowly.  The process would be that the high unemployment will lead to lower and lower wages over time, and these lower wages would then lead to Greek products becoming more competitive in markets such as Germany.  This is similar to the process following from a devaluation (as discussed above), but instead of this happening all at one point in time, it would develop only gradually.

The process has indeed been underway.  The key is what has happened to wages in Greece relative to where wages have gone in its trading partners.  One needs also to adjust for changes in labor productivity.  The resulting measure, which economists call nominal unit labor costs, measures the change in nominal wages (in euro terms here), per unit of effective labor (where effective labor is hours of labor adjusted for productivity growth).  While one cannot easily compare unit labor costs directly between countries at the macro level (it would vary based on employment composition, which differs by country), one can work out how much it has changed in one country versus how much it has changed in another country, and thus how much it has changed for one country relative to another.

Scaling the base to 100 for the year 2010 (the year the austerity program started in Greece), relative unit labor costs have fallen sharply in Greece relative to the rest of the Eurozone, and even more so relative to Germany (with the data computed from figures provided by Eurostat):

Greece and Eurozone Unit Labor Cost, 2010 = 100

Relative to 2010, nominal unit labor costs fell by 13% in Greece (up to 2013, the most recent date available).  Over that same period, they rose by 4% in the Eurozone as a whole and by 6% in Germany.  Thus relative to Germany, unit labor costs in Greece were 18% lower in 2013 than where they were in 2010.  This trend certainly continued in 2014.

The lower unit labor costs in Greece have led to increased competitiveness for the goods and services Greece provides.  Using the IMF WEO database figures, the volume of Greek exports of goods and services grew by a total of 12% between 2010 and 2015, while the volume of imports fell by 19%.  As noted in a chart above, the Greek current account deficit went from a large deficit in 2010 to a surplus in 2013 and again in 2014.  Greater exports and lower imports have helped Greek jobs.  And as seen in another chart above, Greek unemployment fell a bit in 2014 (although with the recent chaos, is probably rising again now).

This process should eventually lead to a recovery.  But it can be a slow and certainly painful process, and is only achieved by keeping unemployment high and wages falling.

Are Greek wages now low enough?  Changes in unit labor costs cannot really provide an answer to that.  As noted above, the figures can only be provided in terms of changes relative to some base period.  The base period chosen may largely be arbitrary.  The chart above was drawn relative to a base period of 2010, as that was the first year of the austerity program, but cannot tell us how much (and indeed even whether) wages were out of line with some desirable relative value in 2010.  And one can see in the chart above that Greek unit labor costs were rising more rapidly than unit labor costs in the Eurozone as a whole in the period prior to 2010, and especially relative to Germany.

Rebasing the figures to equal 100 in the year 2000 yields:

Greece and Eurozone Unit Labor Cost, 2000 = 100

The data is the same as before, and simply has been adjusted to reflect a different base year.  Relative to where they were in the year 2000, Greek unit labor costs in 2013 were below what they were for the Eurozone, but only starting in 2013:  They were higher for each year from 2002 to 2012.  And they were still above the change in Germany over the period:  German unit labor costs were 11% higher in 2013 than where they were in 2000, while Greek unit labor costs were 17% higher (but heading downwards fast).

Wages are therefore adjusting in Greece, and indeed adjusting quite fast.  This is leading to greater exports and lower imports.  Over time, this will lead to an economic recovery. But it will be a long and painful process, and it is difficult to predict at this point how long this process will need to continue until a full recovery is achieved.

Unless the depressed conditions in the country lead to something more radical being attempted, this is probably the most likely scenario to expect.

The recovery could be accelerated if Greece were allowed to keep the primary balance flat at say a zero balance (implying all interest on its public debt would be capitalized, and no net principal paid) rather than increased.  But this will depend on the acquiescence of the Troika, and in particular the agreement of Germany.  It is difficult to see this happening.

The Government Debt to GDP Ratio is Falling

Fed Govt Debt as Share of GDP, 2006Q1 to 2014Q3

The US federal government debt to GDP ratio is falling.  A few years ago, conservative critics (such as Congressman Paul Ryan) argued that if drastic action were not taken immediately to slash government expenditures, consequent rapidly rising federal government debt would stifle growth and spiral ever upwards.  Liberals (such as Paul Krugman) argued that the federal deficit and debt were far less of a concern than these critics asserted:  With the recovery of the economy, both would soon start to fall.  And the detailed projections from the Congressional Budget Office backed this up, with projected falls in the debt to GDP ratio for at least a few years.  There would be a rise later if nothing further is done, in particular on medical costs, but the question at issue here is whether the debt to GDP ratio could fall in the near term without drastic cuts in government expenditures.  Conservatives asserted it would not be possible.

But these were projections and assertions.  The chart above shows the actual data.  With the release this morning by the Bureau of Economic Analysis of its first estimate of 2014 third quarter GDP (growth at a fairly solid 3.5% real rate), one can now see that there has been a downward turn in the debt to GDP ratio.  The ratio peaked at 72.8% of GDP in the first quarter of 2014, and dropped to 72.2% as of the third quarter.

The federal government debt figure used here is the debt held by the public.  There are also various trust funds (most notably the Social Security Trust Fund) that formally hold government debt in trust, but this reflects internal accounting within government.  The figures come from the US Treasury, with quarterly averages taken based on an average of the amounts outstanding each day of the quarter.  This average is then taken as a share of nominal GDP for the quarter (nominal GDP since debt is also a nominal concept).  And since nominal GDP reflects the flow of production over the course of the quarter, taking the daily average debt outstanding over the course of the quarter will better reflect the debt burden than simply taking debt as of the end of the quarter and dividing this by GDP (although this is commonly done by many).

There was an earlier downward dip in the public debt to GDP ratio in the third quarter of 2013, but this was due to special circumstances surrounding the delay by Congress to approve a rise in the statutory government debt ceiling.  Various accounting tricks were used to delay recognition of items that would add to the formally defined government debt in order to keep under the ceiling, which artificially suppressed the debt to GDP ratio in that quarter.  This carried over into the fourth quarter, with the Republicans forcing a shutdown of the federal government from October 1 by not approving a new budget.  The dispute was not resolved until October 16, when deals were reached to raise the debt ceiling and to approve a budget.  The debt ratio then returned to its previous path.

The fall in the debt ratio in 2014 is more significant.  Accounting tricks are not now being used due to debt ceiling disputes, and the fall reflects the continued fall in the fiscal deficit coupled with reasonably sound growth.  The deficit is estimated to have totaled $483 billion in fiscal 2014 (which just ended on September 30), or 2.8% of GDP.  This is sharply down from the $1.4 trillion (or 9.8% of GDP) of fiscal 2009, in the first year of the downturn.  The fiscal deficit has fallen primarily due to the recovery, but also due to cuts in federal government expenditures under Obama since 2010.  While not nearly as drastic as Congressman Ryan and other conservatives had insisted would be necessary, government spending has still fallen under Obama, in contrast to the increases allowed in previous downturns.

Note that the government expenditure cuts that were done do not represent what would have been the desirable path in deficit reduction:  As discussed in an earlier post on this blog, it would have been far better to follow a fiscal path similar to that followed by Reagan and others in earlier downturns, with government spending allowed to grow so that the economy could have more quickly returned to full employment.  Once full employment was reached, one would then consider fiscal cuts, if warranted, to address any debt concerns.

The path followed has thus been far from optimal.  But it has shown that the alarms raised by the conservative critics, that the debt to GDP ratio could not fall without drastic government cutbacks (far more severe than that seen under Obama), were simply wrong.