US economic policy has become too focused on monetary policy, while putting too little weight on fiscal policy to blunt headwinds to growth. In part, that is because President Barack Obama has misjudged the problem. In part, it is because he is relying on a tool that poses fewer political difficulties than the alternatives. But he places too little weight on other means of addressing the growing long-term problem. Policy is stuck.
There are two concerns here.
The first is the view that the economy is now stuck on slow growth. In this “secular stagnation” story, told by Lawrence Summers among others, the scope for monetary policy is limited by the “zero lower bound” – the idea that, because nominal interest rates cannot fall below zero, the sharply negative real interest rates that the economy needs are unattainable. Fed cannot be as expansionary as it needs to be.
This view suggests that limits to monetary policy have held back growth. Putting aside the Federal Reserve’s aggressive unconventional expansion, the secular stagnation story is hard to square with the evidence. Today’s employment report revealed continued strengthening of the labour market. And consensus estimates for output growth predict an acceleration to underlying growth rates above the growth rate of potential gross domestic product.
In addition, the Taylor rule – the simple monetary policy guide suggested by Stanford economist John Taylor – would today suggest a positive federal funds rate (of just over 1.5 per cent) based on inflation and the unemployment rate. Monetary policy is not so constrained now as to consign the economy to inevitably slower growth. And monetary policy is a poor tool for dealing with structural factors that may slow growth.
This observation tees up the second and larger policy concern: tax reform. This offers the key to increasing the number of hours worked, and productivity. Recent research by Federal Reserve Board economists suggests that structural factors account for most of the decline in labour force participation in the aftermath of the financial crisis. While that conclusion indicates strong limits to the effectiveness of additional monetary accommodation – as there is not much slack remaining in the labour market that the Fed’s actions can remove – tax policy can still be quite potent.
For one thing, tax reform offers the best route to encouraging work by low-wage workers and removing barriers to their participation in the labour force. The Earned Income Tax Credit, which supplements the income of low-wage workers as they earn more, has bipartisan support. Expanding this programme’s payments for single workers would create a more powerful work incentive. Federal disability insurance reform is also important for bringing low-wage workers back in to the labour force. For some, disability insurance has become an incentive to quit work, but it does not have to be that way. As part of business tax reform, employers of disabled workers could receive tax advantages for retraining them to remain on the job.
The Affordable Care Act also creates disincentives for work, since generous subsidies phase out as income rises. John Cogan, Dan Kessler, and I estimate that this implicit tax, coming on top of existing income and payroll taxes, raises the effective marginal tax rate on earnings to as much as 80 to 100 per cent for some middle-income families. A broader tax reform that gives a more uniform subsidy for health insurance and health spending would reduce this problem.
In addition, in response to demographic shifts in today’s workforce, tax reform can lean against tax penalties on work by older Americans. Eliminating the Social Security payroll tax on older workers and disposing of the retirement earning test would promote work and can be implemented with a modest budget cost in the context of tax reform.
Finally, the boldest contribution of tax reform to bolstering structural barriers to growth is through strengthening productivity growth. Fundamental tax reform – lowering marginal tax rates, broadening the tax base, and reducing or eliminating double taxation of investment – can increase GDP growth by 0.5 to 1 per centage point a year for a decade, according to research by Alan Auerbach and Kevin Hassett. Much of this gain would come from improvements in business taxation to enhance competitiveness and innovation. Business tax reform at its best would be part of a shift toward a broad-based consumption tax, but large gains are possible by reforming the income tax. By raising productivity, reducing business tax rates would also boost wages, as labour bears much of the burden of high business taxes.
The policy debate itself is entering a kind of secular stagnation, with excessive focus on monetary policy and inadequate consideration of pro-growth fiscal policy. Tax reform is our most powerful weapon to limit the likelihood of a slow-growth future and, properly executed, should gather support on both sides of the political aisle. If the president will not lead with this growth agenda, perhaps a new Congress can place it on his desk.
This op-ed appeared on FT.com on October 3, 2014.