Why "Do No Harn" Should Be Fiscal Policy Rule No. 1

 

The 35-day government shutdown that kicked-off 2019 is only the latest indicator of the fiscal chaos that reigns in Washington. The chaos is reflected both in the failure of Congress to follow the procedural rules it has set for itself, and in a failure to provide a degree of fiscal stimulus or restraint that is appropriate to the state of the business cycle. Without better fiscal policy rules, the chaos will continue

Procedural rules are not enough

Congress does have rules to guide fiscal policy. The 1974 Budget Act specified a set of procedural rules that Congress is supposed to follow each year in passing a budget. However, Congress has passed the full set of appropriations bills on schedule only three times in the past 40 years.

Even more problematic is the failure to align annual tax and spending decisions, whether made on time or not, with long-run goals of stability and economic growth. Attempts to address that problem have proved inadequate.

Consider the debt ceiling, first enacted more than 100 years ago. Even if we could accurately determine the point beyond which debt becomes excessive, the ceiling in its current form is unworkable. Since it is set in nominal terms, with no allowance for inflation or growth of the economy, Congress must vote periodically to raise it. That creates opportunities for various factions to disrupt the budgeting process with brinkmanship over extraneous issues, even though everyone knows that the consequence of not raising the ceiling — default on the debt — would be so dire as to make the whole process a charade.

A more recent type of rule, known as pay-as-you-go, or PAYGO, has fared little better. PAYGO has taken several forms since it was first established in 1990, but the underlying idea is to require that tax cuts or new spending be offset by tax increases or spending cuts elsewhere in the budget. In case the necessary offsets are not made, sequestration — mandatory cuts to already authorized programs — can be invoked to prevent an increase in the deficit. In practice, however, Congress can, and does, waive PAYGO rules whenever it wants to. For example, it used a waiver to allow the 2017 tax cut to go into effect despite the resulting increase in the deficit.

Long-term rules for fiscal policy

If procedural rules are not enough, what would work better? The answer is that if we want a more responsible fiscal policy, we will need to rely less on the short-term impulses of politicians and more on policy rules that target stable, sustainable growth. Here are three suggestions.

Rule 1: First, do no harm. The economic equivalent of this maxim is to aim for cyclical neutrality, that is, one that that manages taxes and spending in a way that avoids prolonging expansions or deepening recessions.

At first glance, it might seem that the ideal neutral policy would be to keep the budget in balance at all times, as would be required by that perennial favorite of congressional conservatives, a balanced budget amendment. In reality, nothing could be worse. As I explained in an earlier post, a balanced budget amendment would be profoundly pro-cyclical. To keep the budget in absolute balance year-in and year-out would require tax increases or spending cuts during downturns and spending increases or tax cuts when the economy was at or above full employment. That would be the exact opposite of “do no harm.”

In contrast, a cyclically neutral rule would take full advantage of automatic stabilizers to moderate the business cycle. One form of such a rule would be to hold the primary structural balance of the budget at a constant target value over time. The primary structural balance differs from the ordinary way of measuring the federal deficit or surplus in two ways:

• The “structural” part means that the actual surplus in any year is adjusted to reflect the levels of tax receipts and spending that would prevail, under current law, if the economy were at full employment. During a recession, the actual balance is below the structural balance (that is, further toward deficit) because of low tax revenue and high spending on income transfers. When the economy is running hot, the actual balance is above the structural balance (that is, further toward surplus).
• The “primary” part of the term means that interest payments on the national debt are disregarded. Although interest payments are a form of government outlay, in the short run, they are not under the control of policymakers. Instead, for any given level of debt, federal interest expenditures are largely determined by market interest rates.

The target for the primary structural balance could be set at zero, at a small surplus, or at a moderate deficit. The choice depends in part on variables like the economy’s long-run rate of growth relative to market interest rates, and also on whether policymakers want to hold total debt steady as a share of GDP, to allow it to grow gradually, or to decrease it (for details of the math behind the choice of targets, see this slideshow). Under conditions that currently prevail in the U.S. economy, a zero primary structural balance, or even a small deficit, equal, say, to half a percent of GDP, would be sufficient to achieve cyclical neutrality while ensuring that the debt ratio would gradually decrease.

“Do no harm,” of course, is a pretty low bar. In theory, a rule that held the primary structural deficit at the desired level over the business cycle but allowed temporary countercyclical tax and spending measures on a discretionary basis would be even better. However, practical considerations of lags and forecasting errors, not to mention political temptations to do the wrong thing at the wrong time, provide grounds for caution. The PAYGO waiver for the pro-cyclical 2017 tax cut, passed as the economy was well on its way to full employment, is a case in point.

However, there is one important exception to the “no exceptions” rule. A “do not harm” rule should allow for extra fiscal stimulus, beyond the amount needed to hold the primary structural balance constant, during periods when interest rates fall to the zero bound, rendering conventional monetary stimulus ineffective. The 2009 American Recovery and Reinvestment Act of 2009 would fit that specification (see here and here for analysis of the ARRA and its effects).

Rule 2: Tax and spending reforms should be consistent with macro targets. Fiscal policy has both a macroeconomic and a microeconomic side. Rule 1, which calls for cyclical neutrality, serves the macroeconomic goals of stability and growth. Microeconomic issues concerning the structure of taxes and the composition of spending are also important, but they should be approached in a manner that does no macroeconomic harm.

In particular, tax reform, whether aimed at removing perverse incentives or improving distributional equity, should be carried out in a way that is revenue-neutral over the business cycle. For example, cuts in distortionary payroll or corporate-profits taxes could be offset by increases in taxes thought to be less distortionary, such as consumption or carbon taxes. Similarly, spending increases — even putatively growth-enhancing ones such as infrastructure spending — should be accompanied by cuts to lower-priority spending programs or appropriate tax increases.

Like its distant cousin PAYGO, this rule would require Congress to consider impacts on the deficit when passing tax or spending legislation. However, it differs from PAYGO in two important ways. First, it would be symmetrical, in that it would not only bar inappropriate fiscal stimulus when the economy is near full employment, but also inappropriate austerity during a recession or the early stages of a recovery. Second, the degree of offset for tax cuts and spending increases would vary with the business cycle. The required offset would be less than 100 percent near the bottom of the cycle and greater than 100 percent at or near the peak.

Rule 3: Fiscal rules should be neutral with respect to the size of government. Conservatives often propose that any fiscal rule should place a constraint on the overall size of government. For example, a 2011 version of a balanced budget amendment proposed capping federal expenditures at 18 percent of GDP. Such a constraint would be a mistake. Instead, any rule governing the path of the deficit or surplus over the business cycle should be neutral as to the size of government as well as neutral with regard to the cycle itself.

In reality, there is little evidence to support the idea that small government is necessarily good government. On the contrary, as I have discussed previously (see here and here), the available evidence shows a negative correlation between the size of government relative to GDP and broad measures of prosperity, personal freedom, and economic freedom. Overall, quality of government, as measured by such things as the rule of law, protection of property rights, and government integrity, is more important for freedom and prosperity than the size of government. Yet even if one believes a smaller government is better, such rules inject a contentious ideological motive into the debate over how best to reduce the debt level. A rule that is neutral to government size leaves the question up to democratic debate, with the proviso that new structural spending must be paid for. 

The bottom line

It is not likely that the White House or Congress will agree anytime soon to putting fiscal policy on autopilot, nor should they. Overly rigid rules would do more harm than good if strictly enforced (as a balanced budget amendment would be), or would invite so many waivers as to make them meaningless (as in the case of debt ceilings and PAYGO). Yet between rules that are too rigid and no effective rules at all, there is a golden mean.

Those who are in charge of fiscal policy could learn a lot about the proper balance between rules and discretion by heeding the example of the Fed. For years, there have been economists who have urged the Fed to follow a more rules-based policy and others who resisted those urgings. Speaking at a 2017 conference where both sides of the debate were thoroughly aired, Frederic Mishkin, a former member of the Fed’s Board of Governors, argued that rules vs. discretion is not an either-or choice. Instead, Mishkin sees the Fed as moving toward a regime of “constrained discretion” — one that pays attention to rules but permits departures from the rules in response to unexpected economic shocks. He argues that as long as such a regime is backed by transparent communication of policy goals and actions, it can avoid the disadvantages both of pure discretion and of overly rigid rules. In fact, thisstatement on the Board of Governors website amounts to an assertion that constrained discretion is already the Fed’s official policy.

Other countries, such as Sweden and Chile, have successfully applied constrained discretion to the management of government deficits and debts over the business cycle. We could do so, too, if we could find the political will. Let’s hope that it does not take another recession or self-inflicted fiscal crisis to provide the impulse.

Based on a version posted earlier at NiskanenCenter.com

How to Slow Climate Change Without Hurting the Poor

"Energy is the lifeblood of any economy,” writes H. Sterling Burnett, a fellow at the Heartland Institute. “A carbon tax would increase energy prices and thus cost jobs, making it difficult U.S. companies to compete with foreign rivals and punishing the poor.”

The Manhattan Institute’s Robert Bryce agrees. In an article for the National Review, he tells us that a carbon tax would “disproportionately hurt low-income consumers,” especially those who “live in rural areas and must drive long distances to get to and from their job sites.”

The American Energy Alliance echoes that sentiment, placing the “it will hurt the poor” argument in the third spot on a list of 10 reasons to oppose carbon taxes:

The carbon tax is by nature regressive, because it will raise the prices of gasoline, electricity, and other goods by the same dollar amount for all consumers, regardless of their incomes. This disproportionately affects the poor, because energy costs are a bigger portion of their overall budgets. A carbon tax will therefore hurt low-income families and seniors more than it will hurt middle- and upper-class households.

It is true, as we will see, that poor households do devote larger shares of their incomes to energy than do those with higher incomes, but there is more to the story than that. If we properly measure the impacts of carbon pricing and look at the full range of policy alternatives, there is no reason why concern for the poor should block policies to protect the environment.

The wrong way to help the poor

Let’s begin with the conventional wisdom, which holds that low-income households would be disproportionately impacted by a carbon tax since they devote a relatively high share of their incomes to energy. For example, a 2009 study by Corbett A. Grainger and Charles D. Kolstad found such a pattern, as shown by the blue bars in the following chart:

The population is divided into five income quintiles, from lowest to highest. The blue bars show how many kilograms of carbon each quintile emits per dollar of income; this proportion is much higher for the lowest quintile than the highest, indicating that the poor do spend more of their budgets on energy. But the red diamonds indicate the proportion of national carbon emissions emitted by each quintile, and they move in the opposite direction. In other words, as you move up the income ladder, a smaller portion of your budget goes to energy, but you still emit more. As a result, the top income quintile is responsible for almost 35 percent of total emissions, compared to just under 10 percent for the lowest quintile.

Even if we take these numbers at face value, it is clear that forgoing a carbon tax in order to keep energy prices low is an absurdly inefficient way to help the poor. Based on their share of national emissions, the top two income quintiles would capture 58 percent of the benefits of such a policy, compared to just 24 percent for the bottom two quintiles. The very richest households would gain three-and-a-half times more than the very poorest.

Furthermore, looking only at incomes and energy use gives a misleading picture of the degree to which the effects of a carbon tax would be concentrated on the poor. A more recent study by Julie Anne Cronin, Don Fullerton, and Steven E. Sexton took a different approach. Cronin et al. considered not only the direct impact of a carbon tax on household energy prices, but also indirect impacts on the prices of goods like housing, food, and clothing. In addition to income, they also looked at the impact of carbon taxes in proportion to household consumption expenditures, which are more stable from year to year than incomes. They also accounted for the fact that transfer payments to low-income households are indexed to rise automatically when prices increase, whether because of general inflation or due to a policy change like a carbon tax.

When all of those factors are considered, Cronin et al. found that the impact of a carbon tax is more equally distributed in proportion to household income and consumption than the conventional wisdom assumes. As the next chart shows, the burden of a carbon tax as a percentage of household income varies only slightly, from 0.54 percent of income for the poorest income decile to 0.46 percent of income for the wealthiest decile. If the calculation is done as a percentage of consumption rather than a percentage of income, the impact of a carbon tax on wealthy households is actually proportionally greater than on poor households.

If we judge by the Cronin method rather than the earlier Grainger method, the idea of helping the poor by keeping carbon prices low is even more suspect. According to the Cronin data, the top two income quintiles would capture 77 percent of the benefit of forgoing a carbon tax, rather than the 58 percent they would capture based on the older data. Meanwhile, the poorest two income quintiles would receive only 10 percent of the benefit of a low-price policy, rather than the 24 percent they would get based on the older data.

Still, though, a carbon tax would have some adverse effect on the poor, even if its impact would not be as regressive as the conventional wisdom suggests. If forgoing a carbon tax is the wrong way to help the poor, what is the right way?

How to help the poor and the planet

The right way to assist low-income families would be to give them extra income to pay the higher prices that a carbon tax would bring. Every serious carbon pricing proposal that I have seen includes some such compensation scheme.

For example, the Citizens’ Climate Lobby, one of the leading backers of a carbon tax, proposes distributing the tax revenue equally among the entire population as a “citizen’s dividend.” A group of 45 prominent economists recently wrote an open letter in support of a carbon tax that would take the same approach.

Alternatively, some favor a revenue-neutral tax swap that would offset carbon tax revenues by reducing the rates of other taxes. If enough of the rate reductions were focused on payroll taxes or other taxes that are disproportionately burdensome for low-wage households, the net impacts of a revenue-neutral tax swap could be made neutral with respect to income, or even moderately progressive. Still other carbon tax backers propose distributing all or part of the compensation in the form of increased benefits for existing income-support programs, such as food stamps, Social Security, and the earned income tax credit.

Finally, some backers favor spending carbon tax revenues to address climate change directly, for example, by investing in clean-energy infrastructure or adaptation. If the benefits of slowing climate change are enjoyed equally by everyone, regardless of income, the distributional effects of such a policy would be similar to those of a tax-and-dividend scheme. If, as is sometimes claimed, climate change hurts the poor disproportionately, using carbon tax revenue for climate mitigation would could be even more progressive than a citizens’ dividend.

These are not either-or options. Carbon tax revenue could be divided in some way among all of them. In a report for the Brookings Institution, Aparna Mathur and Adele Morris calculate that compensating low-income households for the impact of a carbon tax could take as little as 11 percent of the tax revenues. In an analysis of the 2018 Market Choice Act, researchers from Columbia University and Rice University found that allocating 10 percent of carbon tax revenue to transfers to the lowest 20 percent of income earners increased household wealth and especially benefited younger workers.

However, Cronin et al. add a big caveat. They point out that not all families in a given income bracket are equally affected. Those who live in temperate climates use less energy for heating and cooling than do those in more severe climates. People who commute to jobs use more energy than retirees with equal incomes, and so on. The impacts from family to family within an income bracket can vary more than the average effect of the tax across income brackets. The implication is that to be sure that most in the poorest quintile were not hurt, it would be necessary to spend more on compensation than Mathur and Morris’s 11 percent, or to target compensation to regions or activities with high carbon consumption.

One final point regarding compensation: The basic point of carbon pricing is to incentivize conservation of energy, investments in low-carbon technology, and other behaviors that reduce emissions. There is a trade-off between compensation and incentives. On the one hand, to make compensation more effective, it makes sense to tailor it to the specific circumstances of beneficiaries, so that fewer are undercompensated or overcompensated. On the other hand, it is important not to allow the compensation plan itself to undermine incentives.

For example, low-wage workers who have to drive a long way to their jobs will be more severely impacted by a carbon tax than those who have access to public transportation or can work from home. It would be a mistake, though, to automatically offer extra compensation in proportion to miles driven, or to provide vouchers to allow purchase of gasoline at pretax prices. Any such forms of compensation would remove incentives to move closer to work, use public transportation, or buy a more efficient car. Similarly, fully compensating people who live in hot or cold climates for their extra home heating costs could erode incentives to make their homes more energy efficient or even to move to more temperate areas.

The Bottom Line

When considerations both of efficiency and fairness are taken into account, “It will hurt the poor” does not ever have to override “It’s good for the environment.” In any democratic political system, there are going to be differences of opinion on the relative priorities of distributional equity and environmental protection, but to say we must abandon one goal to pursue the other is simply false. It is perfectly possible to protect the environment and, at the same time, to protect low-income consumers from any undue effects of doing so.

Based on a version published previously by NiskanenCenter.com

How Universal Catastrophic Coverage Could Ease the Transition to Health Care for All

The vision of universal access to health care that lies behind Medicare for All has wide appeal. However, as David Brooks noted in a recent column for the New York Times, the problem is less the vision than the transition. Medicare for All, in both its Senate (Sanders) and House (Jayapal) versions seems designed without a thought to the problem of transition. If we can’t get there from here, what is the use of a glittering vision of health care reform?

Fortunately, Medicare for All is not the only path to affordable access to health care for all Americans. Our team at the Niskanen Center has been working on an alternative health care reform known as universal catastrophic coverage (UCC). UCC would cover the needs of the very poor and the very sick in full, as does Medicare for All. At the same time, it would also require those who can afford to do so to pay a fair share of their routine medical expenses through income-based deductibles, coinsurance, and copays. That gives UCC a greater flexibility that would ease many of the transition problems that Brooks lists.

Sticker Shock

The sheer cost of Medicare for All is one of the biggest obstacles to its adoption. As measured by the Kaiser Family Foundation, Public support for comprehensive national health care drops from 56 percent to 37 percent when people are told that it would require higher taxes.

Backers of Medicare for All point out, correctly, that most people would get those taxes back through lower premiums and out-of-pocket costs. But taxation is a leaky bucket. Taxes distort financial decisions made by families and businesses. There are administrative costs of collecting taxes and disbursing benefits. As a result, it takes more than one dollar in tax burden to support each dollar of benefits.

Because of the leaky bucket effect, it makes no sense to impose heavy new taxes on upper-income households and then give that money right back as health care benefits. That is all the more true since the benefit in Medicare for All are more generous than in other countries. Highly regarded health care systems, such as those in Australia, Singapore, and France, require at least modest deductibles or copayments. What is more, they do not cover as wide a range of services as Medicare for All would do.

By comparison, universal catastrophic coverage would cost at least 30 percent less than Medicare for All. Based on reasonable assumptions, the government could finance UCC entirely from funds it now spends directly on health care, plus funds that now go to mandated and tax-advantaged employer plans. The lower cost of UCC would greatly reduce the problem of sticker shock.

What Role for the Insurance Industry?

Observers like Brooks rightly worry about the impact of health care reform on the half-million-odd people who work in health insurance. The fragmented and adversarial nature of our health care payment system is a big part of the reason for its high costs relative to those our high-income peers. Any serious reform will, and should, have a big impact on the insurance industry.
Still, it would be possible to implement UCC in a way that would be less disruptive to the insurance sector and its employees than Medicare for All, under which the entire industry would effectively disappear.

Under UCC, many higher-income households would have deductibles and coinsurance of thousands or even tens of thousands of dollars. Many of them would probably choose to buy some form of supplemental insurance. Private companies would serve that market, much as they serve today’s market for Medigap coverage.

UCC could also create a role for private insurers as payment agents for the federal catastrophic program. For example, they could offer a private option, similar to Medicare Advantage, even if the Centers for Medicare and Medicaid Services administered the basic UCC program.

Instead, UCC could contract out all coverage to competing private insurers, as the highly-rated Dutch and Swiss systems do. Those countries regulate insurance companies much more tightly than the U.S. system currently does. The regulations ensure that companies compete by offering lower costs and better customer service, rather than boosting profits by denying as many claims as possible. But even with its much tighter regulation, the transition to a Dutch or Swiss model would be far less disruptive for insurance companies and their employees than Medicare for All.

If You Like Your Plan . . .

The failure of the Affordable Care Act to deliver on President Obama’s incautious promise, “If you like your health care plan, you can keep it,” helped spark a widespread backlash against that program. No such promise should ever have been made. There are too many health care plans in today’s system that make no sense even to try to keep.

Employer-sponsored health insurance (ESHI) is Exhibit A in that regard. ESHI, which covers about half of all households, came into being in the 1940s as a wartime accident. It has been nothing but trouble ever since. It is a source of job lock that ties millions of Americans, terrified of losing coverage, to unsuitable careers. What is more, it contributes to fragmentation and raises administrative costs.

Above all, ESHI is appallingly inequitable. Economists Robert Kaestner and Darren Lubotsky  estimate that workers in the bottom fifth of the family income distribution get annual tax benefits of less than $500 from ESHI, while those in the top fifth get benefits averaging $4,500. What is more, their data show that inequity to have become worse over time.

Still, surveys have repeatedly shown that more than two-thirds of people on ESHI like their plans. Presumably, many of those are people who have little chance of getting other coverage. Others have no interest in changing jobs, or are on the favored end of the unequal distribution of tax benefits. Whatever the reason, Medicare for All’s determination to throw millions who like what they have into an unfamiliar new system is a major barrier to its adoption.

UCC, in contrast, could be phased in more gradually than Medicare for All, especially for employer-provided plans. One possibility would be to lift the employer mandate, phase out the tax deductibility of ESHI, and allow employees to opt into UCC if they chose. Most lower-paid workers would probably take that option. Employers who wanted to use health care benefits to retain higher-paid employees could offer them supplemental policies. That way many fewer people would have to make a change of plans against their will.

Cost Controls

Any successful health care reform will have to deal with the high prices charged by American doctors, hospitals, and pharmaceutical companies.  Medicare for All takes a risky and simplistic approach to cost control through across the board cuts in of as much as 40 percent in reimbursement rates for doctors and hospitals. That could be very disruptive to the many communities where hospitals are among the biggest employers.

UCC, too, would need to put downward pressure on excessive prices, but it could do so in a more nuanced way. Like Medicare for All, UCC would empower government administrators to bargain for favorable prices with hospitals, doctors, and drug companies. However, direct bargaining would be only one of several cost-control mechanisms. Market-based cost controls would back up administrative actions for consumers who have not reached their oout-of-pocket limits. Measures to promote competition and transparency, and to reward those providers who offer the best value for money, would make it easier than it is today for such consumers to shop wisely for health care services.

Transition Will Never be Easy

No matter what the final design, comprehensive health care reform will encounter problems of transition. Our existing system is not a product of rational design. It performs so far from optimally that there will be no way to fix it without big changes, necessarily disruptive. Providers and consumers who exploit imperfections in the system to their own advantage will resist change.
Transition will never be easy, but there is no reason to make it harder than it needs to be. The versions of Medicare for All now on the table in the House and Senate face obstacles that are likely to prove insurmountable. The greater pragmatism and flexibility of universal catastrophic coverage offers a less hazardous path forward.

Based on a version previously published at NiskanenCenter.com