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Wake Up, America: Spending and Tax Cuts Won't Save the Economy

According to a recent Bloomberg poll, 55 percent of Americans think cutting taxes and spending will help revive the economy by giving businesses more confidence to hire. So will it?

Not likely. Let's take the tax part first. Federal taxes on companies and individuals are already at the lowest level they've been in more than 40 years. As rates have declined (and corporate loopholes proliferated), so have government tax receipts. Federal revenue plunged after George W. Bush cut taxes and rose after hikes under both his father, George H.W. Bush, and Bill Clinton. Less revenue means less investment in the kind of federal programs that stimulate growth, such as on education, public infrastructure and drug research.

As tax rates fell during the last decade, the U.S. economy experienced its slowest growth since World War II. By contrast, after taxes increased in the 1990s the economy boomed. Other factors of course played a part. But this notion that tax cuts will somehow magically unlock growth is misguided. And lest we forget, reducing taxes also boosts government debt. As Republicans correctly keep telling us, that eventually leads to higher interest rates, further stifling growth.

Bad time for austerity
On spending, there's little evidence that cuts promote growth. On the contrary, in a 2010 historical analysis of "fiscal consolidation" in advanced economies, the International Monetary Fund found that cuts equal to 1 percent of GDP reduced annual growth by about 0.5 percent within two years. It also raised the unemployment rate by 0.3 percent. As a result, the IMF concluded:

The idea that fiscal austerity triggers faster growth in the short term finds little support in the data.
Although such measures can benefit the economy when it is strong, they almost always hurt in a downturn. When an economy is producing more than it can consume, interest rates are low and unemployment is high, tax and spending cuts fail to boost growth almost 90 percent of the time, according to the nonpartisan Congressional Research Service. Not a very good batting average, is it?

What's driving the deficit
It's no surprise people are confused about how to get the economy back on track. We've been subjected to a steady barrage of disinformation about the supposed merits of spending cuts, ranging from simple misunderstandings to outright propaganda. But the reason such tactics work is largely because of lingering misconceptions about what's driving the federal deficit and debt.

We actually have two fiscal challenges in this country -- one short term, one long. As economist Chad Stone of the Center on Budget and Policy Priorities recently told lawmakers, the recent spike in the deficit is a direct result of the financial crisis and ensuing recession, along with the public policies aimed at keeping the economy from sinking into depression. Yet most of that spending, which includes things like TARP and the bailout of Fannie Mae and Freddie Mac, is scheduled to switch off by year-end.

The longer term, and more serious, problem has to do with mounting health care costs -- and that's in both the public and private sector, it's worth noting. Phase out Medicare, as Republicans have proposed, and health care costs would still spiral out of control.

The other big drivers of the federal debt are the Bush II-era tax cuts and the wars in Iraq and Afghanistan (click on adjoining chart to expand). Those two factors account for nearly half of the projected public debt through the rest of the decade.

The imaginary problem

Ditching those tax breaks and ending the wars wouldn't solve our fiscal woes. But it would result in the debt growing no faster than the economy, Stone notes. In other words, the kind of spending cuts now being discussed in Washington and that much of the public seems to favor target a problem that doesn't exist. Or as the NYT's David Leonhardt says, turning things around will require dealing with the deficit we have "rather than the deficit we imagine":

The one we imagine is a deficit caused by waste, fraud, abuse, foreign aid, oil industry subsidies and vague out-of-control spending. The one we have is caused by the world's highest health costs (by far), the world's largest military (by far), a Social Security program built when most people died by 70 -- and to pay for it all, the lowest tax rates in decades.
The idea that cutting taxes and spending will unleash a jobs boom is fanciful at best, and simply insane at worst. The sooner we realize that, the better.

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