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Economic Outlook (Part 3) -- Fiscal Policy

Part 1 (overview) of this 7-part series, which is taken from a recent presentation I made at UCLA, can be found here. Part 2 (monetary policy) can be found here.

Federal tax receipts are now rising at double-digit rates, which is typical following a recession, as incomes and profits rise and more people go back to work. The federal budget could be balanced in 5 years if spending just stops growing.

Deficits of 9% or more of GDP are a serious drag on the economy. Government spending is the problem, more so than the deficit. When government spends money it does so much less efficiently than the private sector, thus squandering the economy's scarce resources. Contrary to popular (Keynesian) thinking, large deficits are not stimulative, they are contractionary. Reducing government spending would likely provide a big boost to the economy, since it would reduce the future expected burden of taxation and it would make the economy more efficient and productive.

There is no necessary connection between tax rates and tax revenues. In this chart, we see that a huge reduction in top tax rates (from 90% prior to 1955, to 28% in the late 1980s) did not reduce tax revenues as a % of GDP at all. Lower rates coupled with fewer deductions and a broader tax base are far more efficient ways of collecting taxes. Reducing the top marginal rate for as many people as possible is the best way to use the tax code to encourage work, investment, and risk-taking.

The level of federal debt has correlated negatively to interest rates for most of post-war history. Interest rates are primarily determined by the rate of inflation, which is the purview of the Fed. Only recently has the Fed been engaged in monetizing the federal deficit, and not coincidentally, there are signs that the level of debt and interest rates are more positively correlated now than at any time in the past. Should inflation rise, interest rates will likely follow, and the combination would make the debt burden much more serious than it already is.

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