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Advanced economies must face fiscal reality

Oct 18,2023 - Last updated at Oct 18,2023

STANFORD — Around the world, advanced economies are facing heightened fiscal challenges, owing to the simple fact that most have bloated, financially unsustainable welfare states. As Mario Draghi said over a decade ago, when he was serving as the president of the European Central Bank, “The European social model is already gone.” Equally, America risks falling into the same trap if it doesn’t control spending and rein in public debt.

The math is straightforward. Consider the case of welfare-type social benefits that are financed by payroll taxes. The average payroll-tax rate needed to cover such spending (now or later with interest, if financed with government debt) is equal to the dependency rate times the replacement rate, that is, the ratio of benefit recipients to taxpaying workers multiplied by the ratio of average benefits to average wages being taxed.

This equation does not even include the taxes needed to pay for other government-funded programmes, from defence and policing to roads and schools. Yes, other kinds of taxes can be used to cover these costs, and various changes can be made to the benefit formulas and tax schedules. Ultimately, though, if you have many people receiving considerable benefits, you will (eventually) have very high tax rates. As Shakespeare’s Hamlet mused, “aye, there’s the rub”.

Make no mistake: high tax rates are not desirable, regardless of the social benefits they support. They can be extraordinarily harmful, because they reduce incentives and thereby damage the economy, starving the proverbial goose that lays the golden eggs. By some estimates, Europe’s tax rates are already close to the peak of the Laffer curve, where additional tax hikes no longer increase revenue, and may even cause it to fall.

Moreover, some economists believe that higher taxes are the reason that European economies’ real (inflation-adjusted) per capita GDP is lower than in the United States. Even if that is an overstatement of the causality, taxes are almost certainly an important factor. Most European countries collect revenues equal to well over 40 per cent of their GDP, whereas the US ratio is about one-quarter (Canada and the United Kingdom are in between, at around one-third).

For example, America’s after-tax real GDP per capita (in terms of purchasing power parity) is about significantly higher than that of Sweden and Denmark, two countries that American progressives eagerly want to emulate. Of course, Swedes and Danes get more publicly provided services, spend less on defense (though they are now committed to raising their meager defense budgets), and work less. But even after accounting for such adjustments, Americans on average are considerably richer.

With populations aging rapidly across advanced economies, the concomitant fiscal pressure on health and public-pension benefits (such as Medicare and Social Security in the US) will only increase. Over the next dozen years, the ratio of people aged 25-64 to those 65 and older is projected to plummet in the US, the UK, and Canada, from roughly 3:1 to 2:1. That follows the trend already seen in Germany, France, and Italy, where the ratio is projected to be well below 2:1 by 2035. In these economies, the fastest-growing demographic group comprises those aged 85 and up. While we should welcome longer lifespans, we also must recognise the associated costs for public budgets.

Worse, with the exception of northern European countries, advanced economies have accumulated much larger public debts over the last decade and a half. For a while, this additional fiscal pressure was masked by extremely low interest rates; but now, interest costs are ballooning everywhere (though they are somewhat more manageable in inflation-adjusted terms). As central banks continue to unwind their huge holdings of government debt (equal to around 20 per cent of GDP in the US Federal Reserve’s case), they will be competing with governments’ efforts to finance large new deficits and roll over maturing debt.

While some of the debt-financed spending in response to the 2008 financial crisis and the COVID-19 pandemic was justified, the subsequent failure to consolidate budgets was extremely irresponsible, leaving many economies highly vulnerable to another shock. It is now more urgent than ever for governments to reform their welfare states, including by targeting benefits more narrowly to the needy and introducing stronger work incentives. The best approach is to allow for a gradual slowing of spending to avoid the economically disruptive forced changes that Draghi and others (including me) have long predicted.

Back when advanced economies were growing rapidly, leaving greater debt burdens to future generations arguably was not a problem, because it was assumed that our children and grandchildren would be much richer and thus capable of affording higher taxes. But with productivity growth having long since slowed, the intergenerational inequity we have created is indefensible.

Viewed in this light, the policies favoured by the political left are a recipe for making a bad situation worse. If we want to support stronger economic growth and intergenerational equity, we should reject proposals for higher tax rates on businesses and personal capital income, as these will reduce incentives to save and invest.

Looking ahead, the renewed risk of war, terrorism and other security threats means that defense spending will have to increase substantially. Economists have long agreed that investments in the military can justifiably be financed by debt, on both efficiency and intergenerational-equity grounds. But to support these necessary outlays, we must get serious about today’s growing fiscal pressures. The sooner policies to address them are implemented, the better. Sadly, few political leaders have been willing to confront reality and propose solutions. Those who do deserve voters’ support.

 

Michael J. Boskin, professor of Economics at Stanford University and Senior Fellow at the Hoover Institution, was chairman of George H.W. Bush’s Council of Economic Advisers from 1989 to 1993. Copyright: Project Syndicate, 2023. www.project-syndicate.org

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