Tuesday, February 07, 2012

The Outlook for U.S. Monetary and Fiscal Policy

Comments for the Record

U.S. Senate
Committee on the Budget

The Outlook for U.S. Monetary and Fiscal Policy
608 Dirksen Senate Office Building
February 7, 2012, 10:00 AM

By Michael G. Bindner
Center for Fiscal Equity


Chairman Ryan and Ranking Member Van Hollen, thank you for the opportunity to submit comments for the record on this issue. Our comments address three issues: tax policy, the housing crisis and the economic model described in our comments from February 1, 2012. Please feel free to share these comments with the Federal Reserve so that they may react to them.

The first determinate of our economy will be what happens to the capital gains and dividend tax special rates. We believe that rates this low give investors and management too great an incentive to cut labor costs – so that instead of being job creating tax rates, they are actually job killing tax rates, which in part explains why the recession has continued, with layoffs proceeding whenever doing so increases profit margins.

This phenomenon is short lived, however. As the Tax Policy Center has previously reported, Capital Gains special rates not only return to 20% on January 1 of next year, but the Pease provisions and health insurance payroll tax as part of health care reform bring the taxation on capital gains to 25%. Dividends will be taxed as normal income, with Hospital Insurance provisions applying to this income as well over $250,000.

Unless there is more compromise in the next year than there was in the last, tax rate increases on capital will automatically end incentives to cut labor costs, taking profits at the expense of workers. We suspect that any compromise that is negotiated, possibly as part of a deal to cut corporate income tax rates and declare a tax repatriation holiday, will include an early increase of dividend and capital gains rates, but not an extension of them, given the Executive’s superior bargaining position and fears by investors that no deal means a tax increase.

The second determinate of economic growth, and the one that the Federal Reserve has the most say in, is the response to the housing crisis. While a recession was certainly part of the recent financial crisis, by far the biggest component is the decline in asset prices below the level at which they are financed. These prices are still depressed, which is why the current economy, despite the recovery, qualifies as a full-blown Depression. Fiscal policy is not enough to ease these conditions. The root cause, the existence of a large number of underwater mortgages, must be addressed.

Our sources indicate that the first round of quantitative easing included mortgage modification for some borrowers in terms of balance reduction, although this was not publicized, and that this is also a likely feature of the current round of quantitative easing where the Federal Reserve is buying Mortgage Backed Securities.

We urge the Federal Reserve to not only keep going with this policy (or include balance reduction by servicers if it is not already doing so), but to increase it by buying the under-water portfolio of Freddie Mac and Fannie Mae in its entirety, at least for borrowers who are still in their homes. Other government held mortgages, including VA, FHA and state housing authority mortgages could also be purchased and modified to increase the impact of this correction.

There are concerns that this correction would hurt irresponsible borrowers. This concern is overblown, as most irresponsible borrowers have already lost their homes. The remaining under-water borrowers are simply victims of bad timing and are no more culpable than economic forecasters who also should have noted that the housing market was unsustainable. Helping these borrowers will provide those in danger of losing their homes to keep them, while allowing others who can afford their mortgage payments to sell their current homes at market value and upgrade to larger homes in keeping with their ability to pay, without the incentive to walk away from properties that may never again rise in value above the amount of the purchase price. As importantly, this new round of home sales will reverse the decline in home prices, thus benefiting the entire housing market, including borrowers with mortgages held in the commercial markets.

The third determinate is the overall impact of government borrowing on economic growth. Center for Fiscal Equity models how deficit financing affects economic growth rates in the aggregate, which we call the financial margin, where the financial margin is the deficit/surplus added to outlays for net interest, all expressed as a percentage of Gross Domestic Product (GDP) and regressed onto growth in real GDP in the next year, removing inflation from the analysis.

We will briefly repeat the data and results, limiting our dataset to 1991 and beyond..

(Please see http://fiscalequity.blogspot.com/2011/09/economic-models-available-to-joint.html  for data tables and graphics relating to this analysis).


When George H.W. Bush and Bill Clinton raised taxes and controlled spending, more growth resulted, with 0.33% of growth resulting from each additional percentage of debt reduction, in a model that explains 72 percent of the variation, with a base growth rate of 3.4%.

The curve changes to negative once fiscal policy changed direction. In a model that explains 57% of the variation and a base growth rate of 2.4%, achieving a 1% growth rate requires an additional 0.27 percent of GDP loss in the financial margin – meaning the anemic growth of the last decade was fueled by deficits.

We believe that a Keynesian relationship explains these findings. When fiscal policy in the aggregate takes more money out of the bond markets after taxes have been cut, the running of deficits (net of interest payments) reduces savings and increases consumption by both the government and households.

When budget balancing using tax increases aimed at lower wage workers occurs, such as an increase in the payroll tax or “sin taxes” or through cuts to spending, such as Gramm-Rudman-Hollings, and deficits are smaller compared to net interest, the economy contracts as the savings sector on average increases at the expense of both government and household spending.

When budget balancing occurs because of higher marginal tax rates, however, money is removed from the savings sector in comparison to the consumption sector, making more credit available as well as higher government and household consumption.

This is essentially what happened when Presidents Bush and Clinton raised taxes in the 90s. Even though the budget neared and achieved balance, consumption continued in both the government and household sectors, although there were cuts, both absolute and programmatic, in the defense sector, while credit was widely available.

When capital gains tax rates were cut in 1997, however, the savings sector received a greater share of output, resulting in an investment boom which we now know exceeded the availability of high value investment opportunities, driving up both asset prices and allowing junk investments to enter the market, which could not provide adequate returns in most cases, causing the 2001 recession. The tax cuts of 2001 and 2003 reduced revenue and increased deficits to record levels in the post-war era, with further asset inflation leading to the current economic depression, especially in the housing market.

This brings us to the current economic situation. The Great Recession as obviously shifted the Financial Margin curve. While the current curve has few data points, these observations are consistent with both theory and economic data in the post-war era.

Based on FY2011 budgetary results, we estimate FY2012 growth to be 1.6%. . In this model, lower spending results in a more anemic recovery. Our comments raise serious issues that must be dealt with in determining fiscal policy in the near term. Further adherence to current tax policy may lock us into a model where unsustainable debt is necessary to sustain the economy. Finding a way out of this debt by reverting to a more rational tax policy, based on these data, is essential.

Thank you again for the opportunity to present our comments. We are always available to members, staff and the general public to discuss these issues.

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