# Public Finance Lessons from the US

Date June 6, 2002 Rudolph PENNER(Senior Fellow, Urban Institute)Eugene STEUERLE(Senior Fellow, Urban Institute)

## Summary

Rudolph Penner

Let me begin with the development of a very large American budget deficit. It grew in the early 1980s, when the Reagan Administration cut taxes and increased defense spending. This was on top of a major recession, the deepest since the Great Depression. The deficit peaked at six percent of GDP in 1983. Adjusted for the business cycle, the peak occurred in 1986 at 4.8% of GDP. Japan's deficit today is at seven percent of GDP.

There was an almost immediate reaction to this large deficit. It was really the Congress that exerted leadership to get rid of the deficit through a series of legislative actions. The first of such bills was in 1982: the Tax Equity and Fiscal Responsibility Act. This act took back some of the tax reductions that had passed in 1981. In 1983, our Social Security pensions got in trouble; the reforms that were put in place raised payroll taxes and slowed the growth of benefits. Then there was a business tax increase in 1984.

But these three actions merely slowed down the increase in the deficit. They did not reverse the effects of the defense spending. So Congress became frustrated by the lack of progress. So they passed a very drastic measure called the Gramm Rudman Hollings in 1985, which set a target for the deficit and enforced it with automatic spending cuts if the target was not reached.

When the 1985 bill did not work, there was a major budget agreement between the older President Bush and Congress in 1990 that curbed spending growth in the long run. It was enforced by the Budget Enforcement Act. This act worked extremely well, but the immediate effects were disguised by the recession of 1990.

So when the Clinton Administration came in, they felt the need to go further. They designed a major deficit reduction package. It differed from all the others in that previous packages had the support of large numbers of people in both political parties. The 1993 action was very partisan: all Republicans voted against it. Then, there was a budget initiative by the Republicans in 1997, which differed from other actions in that it cut taxes and slowed spending growth in the health area.

These actions and a rapidly growing economy gave the US a budget surplus in the 1990s of more than two percent of GDP. But we are again in deficit, and if I were to make a forecast for this year, I would say the US deficit would be about one percent of GDP. This all happened because as soon as we thought we had cured the problem, we became very undisciplined. The Budget Enforcement Act, which had been very effective in getting rid of deficits, was effectively ignored. Congress just stopped paying attention to the rules they had created earlier.

In 2000, the spending target was exceeded by over $60 billion, and in 2001 by over$90 billion. They basically lost all rationality. On top of all that, we had a substantial tax cut in 2001 that will cost more than one percent of GDP in the long run. Moreover we had the events of September 11, which imposed military and homeland security costs. The war itself was relatively cheap at around \$10 billion. It has got to be the cheapest war in our history; this is testimony to both the size of US GDP and to the technology of precision weaponry.

As in Japan, the US will face extraordinary fiscal pressures because of the aging of the population and the soaring cost of healthcare. These two trends will start to hurt the US by 2010. So our aging is more delayed than Japan's.

Is there anything for Japan to learn from US successes and mistakes? Japan has a few fiscal disadvantages. The first point to make is that the constitutions of the US and Japan are very different when it comes to budgeting powers. Japan has a parliamentary system; the US has a system that gives its legislature much more power. The President formulates a budget, but that budget is only a set of recommendations to Congress, which they can ignore at will. The President has veto power, but that can be overridden by a two-thirds majority.

If you read Japan's constitution literally, it says that the legislature must approve the budget. But the problem in a parliamentary system is that if the budget is defeated, the government often falls; that is such a powerful weapon that the parliament is reluctant to use it. So the practical result is that parliaments don't operate much discretion over the budget. They typically accept what the executive branch recommends. Thus finance ministries are very powerful.

There are other differences between the US and Japan. Japan's population is aging more rapidly. Its public debt situation is worse than any the US has ever confronted. There is a risk in Japan that when interest rates go up, you could face an explosive debt situation, where interest bill rises faster than income. Most countries would choose to deal with this by issuing money rather than issuing debt, and you get hyperinflation.

Japan's banking crisis is similar to the US's thrift crisis, but Japan's debts are larger. The structure of Japan's local governments versus the central government creates a difficult situation. Japan's local governments are much more dependent on central government financial support. The US was able to cut grants to state governments during times of austerity.

But Japan does have a number of fiscal advantages, as well. It does not have to support a huge military. Its health costs start out to be much lower per person. Japan has a good system in its public pension program of having to review pensions every five years; this country at least does something in this area, while the US does nothing. It is also easier for Japan to cut back on its pensions because it starts out with a more generous system. Also it has great potential for economic growth, in its female labor force.

What are the lessons for Japan? The US's Budget Enforcement Act really disciplined decisions. It imposed caps on discretionary spending and it imposed pay-as-you-go rules. This worked very well until 1998, when the US got its first surplus. First, debt reduction needs public consensus that deficits are bad. It has to been done gradually; it took the US 16 years. Can Japan develop the same consensus about fiscal policy? I am not sure. Japan could use better legislative staff and more think tanks like RIETI to stimulate public debate.

The great surge in economic growth during the 1990s was a necessary, though not sufficient, condition to rid the deficit in the US. The US deregulated its economy, it had an immigration policy that provided eager workers, and it greatly increased female labor force participation. And the US's monetary policy was extremely skillful. In other words, it was not just luck.

Eugene Steuerle

A great deal of momentum for tax reform started with an effort to reduce tax rates. Ronald Reagan was elected on a platform to reduce taxes and to address the inflation problem that had bedeviled the Carter Administration.

With inflation, property values were going up rapidly, which made taxes rise rapidly as well. Meanwhile, there was a huge bracket creep in income taxes. Incomes were rising due to inflation, but as a consequence, incomes were put in higher tax brackets. The marginal rate could easily double. This helped elect President Reagan.

To support President Reagan's aversion to taxes, a group came along called the supply-siders. Their focus was on marginal tax rates, which is consistent with economic theory. They argued that tax cuts would have such a dramatic effect on the economy that the cuts would actually pay for themselves. Actually, Reagan's tax cuts were very much like the tax cuts in the 1960s by President Kennedy.

There had been earlier tax reforms in the 1960s. President Kennedy tried to create more neutrality in the system and broaden the tax base. The focus at the time was on Keynesian tax cuts. President Kennedy was enamored with his Harvard professors, who were Keynesians, John Kenneth Galbraith, among them. He argued in favor of an investment tax credit. We will see that later, in 1986, this type of tax credit caused distortions in the tax system because it favored certain types of capital investments over others.

The next major tax reform was under President Carter in 1978. As his popularity was rapidly waning, by the end of the year he had turned his tax reform into a round of tax cutting. As you can see, it is difficult to reform the tax system when you have to tell somebody that they will loose benefits.

Two issues dominate tax reform. The first is that if Congress gets involved with debates on the size of government, they could not get involved with the more narrow issue of broadening the tax base. The other issue is progressivity. When Congress gets involved in the debate about whether taxes should be more progressive or less progressive, it is very hard for them to address what I am calling reform issues (equal treatment of equals and neutrality issues).

By 1984, the Reagan Administration was fighting to keep its 1981 tax cuts. At this time, the President was very much out of the loop in the effort to cut back on the deficit, which was lead by Congress and in particular Republican leaders such as Senators Robert Dole, Pete Domenici, and Howard Baker.

Two items helped to bring about a consensus: taxation of the poor and of the family. The high inflation rate, particularly in the 1970s, had led to a situation where more poor people were being subject to income taxes. So liberals opposed this and jumped onboard efforts for tax reform. Conservatives had taken off on taxation of the family; research showed that families with children were facing much higher tax increases than families without children. So they united on this issue of reducing taxes for the poor and having a system that did not penalize families that had children.

In 1984, the Treasury Department tried to offer Congress concrete options for dealing with these issues that were both income and revenue neutral. We did all of the neutrality, efficiency, and horizontal equity issues independently of tax breaks. So we came in through the backdoor and determined what rate structure we wanted to meet our revenue and distributional goals. We ended up having four rounds of tax reform proposals; it was extremely arduous.

What was achieved? We did lower rates, which helped monetary policy to be more effective. We removed a lot of the attempts to perform industrial policy through the tax code. We largely removed the tax shelter market. And we reduced tax expenditures. You get a double benefit when you broaden the base and lower the rate because when you lower the rate, even if you fail to broaden the base and certain tax breaks remain, the exclusions are worth less because the rate is lower. We maintained revenues and we provided more work incentives.

That does not mean there were no failures. Many of the individual tax breaks remained; in fact, since 1986, they have expanded. There was substantial complexity added because a number of the compromises made were not simple. And there were many reforms we simply abandoned. There was also some hidden tax breaks.

In sum, comprehensive reform is possible. The interesting thing about the US experience in 1984 and 1986 is that there really was not an emergency to force reform. There was the growth of the tax shelter market, so there was a reason to undertake tax reform. But it was not an emergency.

It is clear that we needed some liberal-conservative consensus to keep momentum going. We needed both sides of the isle to feel that they had something to gain from tax reform. I would also argue that principles are important. It is best to start with principles and outline options, and then deal with political constraints. Finally, I should say that the reform debate never ends.

Q: President Bush felt that he was unfairly bashed for his tax cuts. What kind of dynamics do you expect regarding this debate in the future?

Eugene Steuerle: This issue has been around since 1981. The argument is that high tax rates distort behavior and if you lower taxes, there will be an increase in work effort and saving, which expands the economy and therefore expands tax revenues. The result is that the cost of a tax cut is lower. In truth, there is good reason to support that theory. Every government action is, in some way, interference in the economy. Ultimately, if the legislature decides which taxes to impose, at least it is part of the democratic process, as opposed to a revenue estimator.

Rudolph Penner: To make five or ten year estimations of the costs of government actions, you need macroeconomic assumptions. The Congressional Budget Office provides Congress with a whole list of macroeconomic assumptions such as price indexes and economic growth. In this way, analysts can estimate the costs of legislation. Imagine the chaos, though, if each analyst chose his own economic assumptions. You get a very different notion from a five-year projection from one that covers ten years.

Q: There is a big difference between the US and Japan. That is, our deficit is financed by our savings. The US borrowed from abroad. Does this lead to different policy decisions? Japan is considering a consumption tax. What is the best timing for this?

Rudolph Penner: I do not think it is as important where the saving comes from. One problem with government budget deficits is that they change the national savings rate. But Japan is getting near a dangerous zone where it risks a debt explosion, by which I mean a situation where debt is rising so fast that you cannot politically raise taxes to keep up with it. This is an arithmetic problem; it has nothing to do with how much the nation is saving. Hyperinflation, which would ensue, would be the ultimate danger.

Eugene Steuerle: The aging of the population is a huge budgetary issue. But in the larger economic context, the consequential decline of the workforce is unsustainable. A consumption tax has to be part of a policy that deals with the broader aging and workforce issues. Otherwise, one consumption tax increase will not be enough and you will just be going down a hill.

Rudolph Penner: The most serious macroeconomic issue Japan faces right now is deflation. It is destructive because most productive thing to do with savings is to sit on your money and watch its purchasing power grow, rather than investing in real assets. I have seen a proposal that has Japan increasing the consumption tax and reducing the income tax; and that has some appeal. You give a little boost to the price level and help to start inflation going again.

Q: Martin Feldstein says we should reduce the consumption tax and increase it every few months by a few percentage points. This is a good proposal because it stimulates consumption in the short term. Some say that once the consumption tax is reduced, it is impossible to increase it again. Nevertheless, I think it is possible in the Japanese legal framework.

Q: Mr. Penner emphasizes the need for consensus on the long-term risks of a budget deficit. Are you speaking of a consensus among the political elites or the mass public?

Rudolph Penner: It is both. The most important, in the US case however, was getting consensus among the political elites and having talented leaders in Congress. The leaders in the US played to the intuitive feeling to the American public that there are limits to a budget.

Q: There is a consensus among political elites in Japan on the long-term risks of a budget deficit.

Rudolph Penner: I am pleased to hear that. Understand, however, that there would big fights in the US about whether tax increases or spending cuts were better. But there was a consensus that something had to be done. It was not easy. We were lucky to have had skillful legislatures.

Q: Congress has kept the distinction of items that are on and off budget. In Japan, there is no on or off budget distinction. Is the distinction good or bad?

Rudolph Penner: I think we should obtain a unified budget. In Europe social security reforms were triggered by concerns about the budget as a whole. In the US, we focus on when the social security trust fund will be empty, which will be about 2030. But the economic problems will come much earlier. So I wish we had never invented the trust fund because it misleads people.

The speakers' visit to Japan was sponsored by the National Institute for Research Advancement (NIRA).

*This summary was compiled by RIETI Editorial staff.