Monday, November 16, 2009

Increase taxes or reduce spending 4%, lose GDP 

Assuming no major changes in federal government tax and spending policies, the federal deficit and debt picture looks bleak. The picture is similar to that of the CBO (2009b) and Auerbach and Gale (2009), although in the present case all the macroeconomic endogeneity has been accounted for.

...Personal income tax increases and transfer payment decreases have similar effects on the economy. A tax increase or spending decrease of 4 percent of nominal GDP is enough to solve the debt problem. The real output cost is about $300 billion per year.

A national sales tax is more contractionary in the model than are personal tax increases and transfer decreases, due in large part to decreases in real wealth and real wages. A national sales tax thus does not look like a good idea, although there is more uncertainty here regarding the ability of the model to deal with this case.
From a new paper by Ray Fair, of FAIRMODEL fame. I use FAIRMODEL in some of my teaching in forecasting. His latest iteration is a little higher in terms of debt-to-GDP than in the paper but not appreciably so. The emphasis is mine. Both those runs of his model show negative GDP growth in Q4 of 2011, which would appear to suggest that fixing the debt problem means a W recession pattern. Fair assumes the tax increase or transfer payment reduction to fix the recession begins in the first quarter of 2011.

Would the federal elected officials risk the W to get the debt issue off the 2012 agenda? It depends on whether they can impose the taxes fast enough and get the pain out of the way before the summer of 2012 when voter decisions for November are being made. Losing $300 billion a year means losing 1-2% of GDP per year, which will cost many jobs.

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