The Congressional Progressive Caucus has published The People’s Budget for Fiscal Year 2012 (and beyond) that achieves balance in the primary federal deficit by 2014 and overall balance by 2021…much faster than any other plan we’ve seen. [1] It does so by raising taxes aggressively, cutting defense spending by $2.3 trillion over the next decade, but then shifting $1.7 trillion of those savings into nondefense outlays. - An analysis of the People’s Budget prepared by the Economic Policy Institute suggests the $1.7 trillion of new “investments” could boost growth of potential GDP by 0.3 percentage point per year over the next decade.[2]
- This result implies that the proposed federal spending is three times more productive than a similar investment in private nonresidential capital.
- We are aware of the literature on the return to public investments, and believe many such investments are worthwhile. However, we find this estimated impact on long-term growth to be implausibly high.
The analysis ignores near-term fiscal drag sure to arise if the plan is implemented when the Federal Open Market Committee has little room to accommodate a strong fiscal contraction. Nor does it even mention the potential deleterious supply-side effects of raising marginal tax rates.[3] Still, the contrast between the People’s Budget and the earlier “Ryan Plan” sharply defines the boundaries of the coming budget debate. Let the compromising begin.
THE PEOPLE’S BUDGETPure and simple, this is a gauntlet. While the Ryan Plan balances the federal budget in thirty years mainly by cutting spending on the middle class, the People’s Budget does so in ten years mainly with tax increases on the wealthy. There’s much to say about this new entry into the sweepstakes for fiscal sustainability, but here our main focus is on one claim regarding the possible growth effects of the plan.
The People’s Budget was accompanied by an analysis prepared by the left-leaning Economic Policy Institute (EPI). It does not include the kind of detailed simulation that the right-leaning Heritage Foundation prepared on the Ryan Plan and which landed that think tank in hot water. Nor has EPI attempted to “dynamically” score the plan. In our view, these were wise decisions, even if we’re left with little to pick on from our macroeconomic viewpoint! Still, EPI does suggest that over the next decade the $1.7 trillion on new nondefense spending will boost GDP growth by 0.3 percentage point per year from the supply side of the economy because all of these new outlays are productive public investments.
A THOUGHT EXPERIMENTHow sensible is this claim? As a point of reference, consider that over the next decade such incremental growth would accumulate to a level of real GDP roughly 3% higher than in the baseline. This is almost a third more than the 2.2% rise in the level of GDP shown in Heritage’s much-maligned analysis of the Ryan Plan, even though that analysis shows a far larger effect on private fixed investment than the extra $1.7 trillion for public investments proposed in the People’s Budget.[4] Color us curious.
So, as a thought experiment, suppose the private nonfarm business sector spent $1.7 trillion over the next decade on nonresidential fixed investment. All else equal, what would be the impact on potential GDP? Let’s step through a simple growth-accounting calculation.
(1) The $1.7 trillion is
nominal, not real, spending. Furthermore, in the CBO baseline inflation averages 2% per year. Adjusting for inflation reduces the $1.7 trillion in current dollars to $1.5 trillion in 2005 dollars.
(2) This is
gross investment, some of which depreciates away over time.[5] The average or effective depreciation rate on private nonresidential fixed capital is about 7.5% per year. Assuming this rate of depreciation, and then accumulating the real gross investment flows by perpetual inventory into a net stock leads to an increase of roughly $0.7 trillion in the level of the real capital stock over the coming decade.
(3) In our own long-run forecast, the real private nonresidential capital stock is roughly $21 trillion at the end of 2021, of which $0.7 trillion would represent an increase of about 3%.
(4) If the underlying production function is Cobb-Douglas with capital assigned a weight of a third, the implied increase in the level of potential output at the end of the decade is 0.33 times 3% = 1%.
(5) This is for the private nonfarm business sector, which accounts for only three-fourths of total GDP. Hence the impact on the level of GDP at the end of ten years would be 0.75 times 1%, or 0.75%.
(6) When this increase is spread over ten years, the average impact on growth is less than 0.1 percentage point per year, or only about a third of the impact the EPI analysis suggests would result from the federal government spending the same amount of money on nondefense activities.
Don’t get us wrong: we are aware of the literature on the rate of return to public investments, and believe that many such investments are worthwhile. However, the proposition that every dollar of nondefense spending is three times more productive than a dollar invested in private nonresidential capital seems far-fetched.[6]
WHAT’S AN INVESTMENT?There are additional reasons to be suspicious. Much of the literature estimating the return to public investments focuses on the productivity of tangible investment like infrastructure, in part because there are data on the tangible public capital stock that facilitate such research. However, of the $1.7 trillion of new nondefense spending proposed in the People’s Budget, only $0.2 billion is specifically earmarked for physical infrastructure that would be included in official estimates of the public capital stock. The remaining $1.5 trillion is for “job creation, education, clean energy and broadband infrastructure, housing, and R&D.” Our National Accounts would count almost all of this either as current consumption or current transfers, not gross investment, and certainly there must be some consumption element in such spending. Do we really think that an increase in “foreign assistance” delivers the same productivity gain as expanding or repairing the inter-state highway system?
In addition, the analysis doesn’t argue that the $2.3 trillion of cuts in defense spending are a reduction in public investment that reduces economic growth. In essence, the EPI analysis implies that, at the margin, nondefense spending is all investment but that defense spending is all consumption. Both sides of this proposition might be closer to the truth than not, but if some nondefense spending is consumption and some defense spending is investment, the EPI calculus on the growth effects of the People’s Budget can be quickly undermined.[7] Suppose, for example, that 75% of the extra nondefense outlays really are new investments, but that 25% of the proposed savings in the defense budget actually reflects cuts in public investment. Then, the net change in public investment is reduced from the $1.7 trillion advanced in the People’s Budget to just $0.7 trillion (=.75*$1.7 trillion - .25*$2.3 trillion).
CONCLUDING COMMENTSWhatever the supply-side ramifications of the People’s Budget over the next decade, it cuts net spending and raises taxes both sharply and quickly. The EPI analysis makes no mention of the potential near-term drag on aggregate demand. We believe that drag would be large and, given the front-loaded timing of deficit reduction shown in the People’s Budget, would occur when the Federal Open Market Committee is not well positioned to accommodate a strong fiscal contraction. And while the emphasis of the People’s Budget is on the Caucus’s view of fairness, if one is to make supply-side arguments in favor of the plan, then it seems only fair that one should at least mention the likely adverse impacts of the proposed increases in marginal tax rates on incentives to work, save, and invest.
Still, we like that this plan is out there. The contrast between the People’s Budget and the Ryan Plan sharply defines the boundaries of the coming budget debate. And ultimately we expect it will be one of the competing social visions that determine the outcome of that debate, not the projected macroeconomic effects.
[1] http://grijalva.house.gov/uploads/The%20CPC%20FY2012%20Budget.pdf
[2] http://cpc.grijalva.house.gov/files/The%20People's%20Budget%20-%20A%20Technical%20Analysis.pdf
[3] The People’s Budget would rescind the Bush tax cuts while also adding new tax brackets with marginal rates of 45%, 46%, 47%, 48%, and 49%.
[4] The Heritage analysis of the Ryan Plan showed an extra $3.6 trillion of private fixed investment over the next ten years—in real terms. This is more than double the new public investments sought in the People’s Budget.
[5] The pattern of the new gross outlays is as follows: $350 billion in 2012, $300 billion in 2013, $250 billion in 2014, $150 billion in 2015, $125 billion in 2016, $100 billion in both 2017 and 2018, $50 billion in both 2019 and 2020, and $25 billion in 2021.
[6] Here’s another (and perhaps much simpler) way to think about this. In the CBO baseline, nominal GDP reaches roughly $24 trillion by 2021. A 3% increase in this is $720 billion. Even assuming no depreciation, the implication is that in 2021 the $1.7 trillion of proposed public investments shows a gross rate of return of 42%!
[7] Certainly there are private sector spin-offs from defense R&D. In addition, military training partially substitutes for traditional education by endowing military personnel with some skills (and maturity) that carry over later into civilian life.This is from a commentary that was published on May 6, 2011.
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