Government Debt, Taxes, and the Weakness of the Global Recovery


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A recent presentation about why economic growth in the US is slow and how budget deficits retard growth. Presented by Carlos Zarazaga, senior research economist of the Dallas Federal Reserve Bank. Part of DCFR's Series "M" on money issues, September 25th, 2012..

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Government Debt, Taxes, and the Weakness of the Global Recovery

  1. 1. Government Debt, Taxes, and the Weakness of the Global Recovery Carlos E. J. M. Zarazaga Federal Reserve Bank of Dallas Research Economist and Policy AdvisorThe views expressed herein are those of the author and do not necessarily reflect those of the Federal ReserveBank of Dallas or the Federal Reserve System.
  2. 2. By contrast, real GDP is back on its pre-recession trend in Germany...Index, 2001Q1=100 130125120115110 Germany105100 95 01 02 03 04 05 06 07 08 09 10 11 12
  3. 3. ... and whose Net General Government Debt has NOT risen muchPercent of GDP 6055 Germany5045 2005 2006 2007 2008 2009 2010 2011
  4. 4. Large government debts seemingly associated with slow recoveries• Comparison with Germany suggests the hypothesis that the burden of large government debts is impairing economic recovery everywhere else.• Hypothesis consistent with historical evidence examined by Reinhart and Rogoff in recent controversial paper “Growth in a Time of Debt” (American Economic Review Papers and Proceedings, 2010.)
  5. 5. Why large government debts can induce anemic recoveries• Large government debts raise specter fiscal imbalances will be addressed with tax hikes, rather than spending cuts.• Prospect of tax hikes discourages investment and employment.• Economy grows at same historical rate as before, but along a trajectory significantly below the one that it was following before the recession.
  6. 6. U.S. economy traveling at historical average speed, but now along the lower deck of the highwayIndexIndex, logarithmic scale 1.4 1.2 1 U.S. real GDP 2011 0.8 0.6 0.4 0.2 0 1980 1985 1990 1995 2000 2005 2010 2015 2020
  7. 7. Higher taxes and the weakness of the U.S. economic recovery• Can fear of higher taxes account quantitatively for the downward shift in the trajectory of U.S. real GDP?• Yes, according to economic model designed to answer the question. – Technical details in “Fiscal Sentiment and the Weak Recovery from the Great Recession: A Quantitative Exploration,” by Finn Kydland and myself. Forthcoming in Dallas Fed Working Paper.• Model incorporates Congressional Budget Office—a non- partisan agency—assessment of U.S. fiscal situation: – To bring back Debt-GDP ratio to 50% levels recorded in mid 1990s, fiscal deficits must be reduced by about $3.8 trillion over the next decade (CBO’s Director Testimony Before the Joint Select Committee on Deficit Reduction on 9/12/2011).
  8. 8. Tax policy assumed in the model• Economic agents in model assumed to expect a switch to a higher tax rates on capital income regime, with the following features: – Between 2013 and 2022: • capital income tax rates go up above current ones by as much as necessary to reduce fiscal deficits in amounts suggested by CBO: – $3.8 trillion over ten years, or – 2.5% of GDP per year, on average. – From 2023 on: • capital income tax rates go up above current ones by as much as necessary to generate additional revenues of “only” 0.3% of GDP per year (to cover permanent increase in Social Security payments induced by demographics.)
  9. 9. Are tax rate hikes of the implied magnitude plausible?• Yes.• Some capital income tax rates will jump as much as 20 percentage points in 2013 under current law: – top dividend tax rate from 15% to 43.4%. – estate tax rate from 35% to 55%
  10. 10. Conclusions• Recovery from Great Recession particularly weak in countries with high and growing levels of government debt.• Fears that fiscal imbalances will be resolved with higher taxes one of the potential causes.• A model calibrated to the U.S. economy suggests dangerous to summarily dismiss the hypothesis: – Choosing higher taxes on capital income as the best solution to fiscal imbalances might also mean keeping many world economies traveling along the lower deck of the highway for many years to come.