Building Back Better—Economically

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Democrats and Republicans are even more divided over President Biden’s “Build Back Better” bill than they were over the infrastructure bill. When BBB passed the House last week, all Democrats except one supported it, while every Republican opposed it. House Speaker Nancy Pelosi called it “historic, transformative and larger than anything we have ever done before.” Minority Leader Kevin McCarthy called it “the single most reckless and irresponsible spending bill in our nation’s history.” The bill now goes to the Senate, where it will need the support of every Democratic senator to pass.

The benefits

Of the concerns about the bill I have heard, far more raise doubts about whether the country can afford it than about the substance of the proposals. Most of the specific provisions are popular with the general public, although we do hear some of the usual complaints about Big Government “taking over” health care or child care or whatever. Here are the bill’s main components:

Universal preschool: The bill would subsidize preschool and child care programs for three- and four-year-old children. Any public or private program could qualify if it met federal standards. The cost to families earning less than 2.5 times a state’s median income would be no more than 7% of their personal income, much less than many families are paying today.

Child tax credit: The bill extends the child tax credit for another year. It also makes it permanently refundable for low-income families, which means that they can continue receiving it even if they have no tax liability.

Family and medical leave: The bill would provide four weeks of paid leave to be used for caregiving or personal illness. The pay would be up to 90% of regular pay, with higher percentages for lower earners than higher earners.

Expanded ACA funding: The bill increases the subsidies for those who obtain health insurance through the Affordable Care Act. It also provides coverage for the low-income people who were previously excluded by their state’s refusal to participate in the expansion of Medicaid.

Expanded home care: The bill provides additional funding for Medicaid’s home health care program, in order to alleviate a backlog of applicants who qualify but are on waiting lists.

Drug price control: The bill would allow Medicare to negotiate lower prescription drug prices, but only for drugs that have been on the market for at least nine years. It also sets a new $2,000 limit for out-of-pocket expenses under Medicare Part D and caps the price of insulin at $35 a month.

Affordable housing: The bill will contribute to the construction and preservation of low-cost housing units, and also provide assistance with down payments and rent.

Clean energy: The bill authorizes grants, loans and tax credits to encourage businesses and consumers to develop and use clean energy, such as wind turbines, solar panels and electric vehicles. It also funds a Civilian Climate Corps to create 300,000 jobs in environmental protection and restoration.

Costs and revenues

The Build Back Better bill would pay for these new or expanded programs mainly by imposing new taxes and improving the enforcement of existing tax law. For personal income taxes, it would place a 5% tax surcharge on income above $10 million, as well as an additional 3% surcharge on income above $25 million. For corporate taxes, it would set a minimum tax of 15% on companies with over $1 billion in profits, aimed especially at corporations that have been managing to avoid paying any taxes at all. It would also place a 1% tax on corporate stock buybacks, a response to concerns that companies were using their 2017 tax cut to boost stock prices for shareholders instead of investing in economic growth.

The bill provides funding for stricter tax enforcement, to recover hundreds of billions of taxes lost to tax evasion. IRS audits have dropped substantially due to Republican budget cuts, a “penny-wise and pound-foolish” exercise if there ever was one.

A “scoring” of the bill by the Congressional Budget Office concluded that tax revenue would pay for about 85% of the bill’s $1.75 trillion cost over ten years. The White House was aiming for 100%, with the discrepancy due mainly to uncertainty about the increased revenue from stricter tax enforcement. Any shortfall would add to the annual budget deficits.

Although the CBO evaluated the budgetary impact over a ten-year period, as is customary, many parts of the bill call only for temporary funding for proposed programs. Universal preschool is funded only for six years, and increased ACA subsidies only for four years. If Congress were to continue these programs through the full ten years, it would either have to impose new taxes or accept larger deficits than currently projected.

Concerns about the bill focus mainly on the question of fiscal responsibility. Conservative politicians and some economists worry that it calls for too much taxing, too much borrowing, and/or too much spending. Let’s consider each of these in turn.

Too much taxing?

Most voters support raising taxes on the rich. Americans with the highest incomes and accumulated wealth have been the main beneficiaries of economic trends and public policies over the past 40 years. Corporate profits and executive compensation have risen faster than general wages. Top-bracket income tax rates have been cut, along with estate taxes and capital gains taxes. Corporate tax cuts have mainly benefited corporate shareholders, and the richest 10% of households hold about 90% of the corporate stock. Since 1990, the share of the national wealth held by the richest 10% has increased from 60% to 70%, as the U.S. has become one of most unequal countries in the developed world.

The tax code is mildly progressive, in that the wealthy pay a somewhat higher rate of tax when all taxes are considered. But the superrich pay a lower-than-average rate because they are very good at taking advantage of loopholes (which is legal) and opportunities for tax evasion (which is not). One study found that the 400 richest families paid only 8.2% in income taxes from 2010 to 2018. That’s a lower rate than a person earning only $10,000 a year has to pay.

Defenders of low taxes on the rich argue that they help the economy by leaving the rich with more money to invest. In Arguing with Zombies, Paul Krugman makes a case that tax cuts for the wealthy have been a “fizzle” because too much of the money has gone to boost the price of existing assets instead of financing new investment. The Keynesian view is that investment is driven more by aggregate demand, and that government spending stimulates the economy more than tax cuts. In any case, economic and public opinion seems to be turning against the Republican policy of generosity toward the rich and austerity for the rest of us.

Too much borrowing?

Whenever the government spends more than it collects in taxes, it runs a budget deficit. Stephanie Kelton’s The Deficit Myth is a good source for correcting common misconceptions about deficits, and it has informed my recent thinking on this topic.

When the government runs a deficit, it normally raises money by selling government obligations like treasury bonds. Although people often think of the resulting public debt as analogous to private debt, there are important differences. A private household or business that accumulates debt runs the risk of default—or even bankruptcy—should its income fall below expectations. A government with monetary sovereignty like the U.S. government need never default on an obligation or go bankrupt, since it has the authority to issue currency and collect it in taxes. Also, U.S. bonds are in great demand because of their security, and people will buy them even when they pay low rates of interest. The government does not have to pay off its debt, but can continue rolling it over from lender to lender indefinitely if it chooses to. The national debt is a public sector liability on which the government pays interest, but it is also a private sector asset on which bondholders earn interest.

According to neoclassical thinking, government borrowing can “crowd out” private investment by competing with businesses for a limited supply of savings. Government borrowing adds to the demand for “loanable funds,” pushing up interest rates (the price of money) and making it more costly for businesses to finance investment. Keynesians counter this argument mainly by focusing on the situation where the economy is running below full capacity. Then deficit spending can boost national output and income, which also increases the savings from which government can borrow. As Krugman and Wells explain:

When the economy is at far less than full employment, a fiscal expansion will lead to higher incomes, which in turn leads to increased savings at any given interest rate. This larger pool of savings allows the government to borrow without driving up interest rates. The Recovery Act of 2009 was a case in point: despite high levels of government borrowing, U.S. interest rates stayed near historic lows.

Modern Monetary Theory adds the argument that any increase in the public-sector deficit must be balanced by an increase in the private-sector surplus, other things being equal. (The relevant other thing held constant here is the current account balance with our trading partners.) As the gap between government spending and tax revenue widens, so does the excess of private-sector income over spending, and that’s where the money to buy treasury bonds comes from. What makes that hard to see is that the connection is indirect, since the immediate recipients of the government spending are not usually the ones buying the bonds. A long chain of financial links may intervene, such as that government spending increases employment, which increases consumer income, which increases consumer spending, which increases business revenue, which increases business profit, which increases investor income, which provides extra savings with which to buy treasury bonds.

In this scenario, the government’s demand for loanable funds does not have to crowd out private investment. Instead, government spending increases the loanable funds. And interest rates do not have to rise, unless the Federal Reserve chooses to raise them in order to fight inflation.

Too much spending?

What keeps this constructive use of government borrowing and spending from becoming a definitive solution to economic problems is the threat of inflation. Economists generally agree that additional government spending becomes inflationary when the economy reaches its potential output, the point where it is producing as much as possible with the available resources and technologies. Then spending more than taxing drives up prices by creating too much demand for too few goods and services. Taxing the rich to spend on the nonrich—which is Biden’s main way of financing his plan—could have a similar effect, since it takes from those more likely to save in order to spend on those more likely to consume.

Although the idea of stimulating the economy with government spending has come back into fashion since the global financial crisis of 2007, economists still debate how often and how much to use it. Many accept a cyclical Keynesianism that supports a stimulus only when the economy is very weak and inflation is under control. From this perspective, the government may want to cycle between stimulus and austerity, engaging in more deficit spending in a contracting economy, but running a surplus and paying down debt to slow an “overheated” economy. (These fiscal fluctuations would be in addition to the Fed’s monetary policy of manipulating interest rates, which has become the most common way of influencing the economy.) But how does one tell whether an economy has reached its potential output? “Full employment” is a common answer, but how exactly is that defined?

Mainstream economists associate potential output not with zero unemployment, but with a “natural rate of unemployment” that includes some frictional and structural unemployment. Workers who are currently between jobs are classified as frictionally unemployed, while those who live in the wrong place or lack the skills employers want are classified as structurally unemployed. The argument is that during an economic expansion, the economy can reach a limit on real growth in output even when unemployment remains as high as 5 or 6 percent. Then further stimulus is inflationary, since it just increases what employers have to pay for qualified labor or what consumers have to pay for goods and services.

This line of reasoning is not without its critics. One problem is that potential output is a moving target, since it changes with increases in productivity. Estimates of the rate of natural unemployment also vary, and some economists reject the concept altogether. Modern Monetary Theory argues that we can employ as many workers as we are willing to train to do something useful, so the level of unemployment is mainly a matter of social policy.

Although Paul Krugman accepts the idea that stimulating the economy when it has reached potential output creates inflation, he warns against turning to austerity prematurely when the economy still has room for growth. This is the mistake many countries made in the aftermath of the global financial crisis, which made the recovery longer and harder that it needed to be. While the threat of inflation is always a concern, cutting government spending and raising interest rates at the first sign of inflation is a formula for subpar economic performance or even recession.

In the present situation, we can hardly say that the economy is already running at full capacity. Unemployment is below 5 percent, but that number leaves out many people who have yet to return to the labor force since the pandemic. Much of the current inflation seems to be due to temporary shortages of supply, not overstimulation of demand. Krugman compares the situation to 1947, when the postwar demand for consumer goods temporarily got out ahead of producers’ capacity to convert to peacetime production. Producers abhor empty shelves as much as nature abhors a vacuum (which is why the makers of Beanie Babies are chartering airplanes to bring them in from China, avoiding the bottleneck in container shipping). Inflation is not always a result of government spending, as critics of Big Government would like us to believe. Time will tell, but we can hope that inflation will subside even as government spending increases, if we spend wisely.

A deeper issue

A more fundamental question than where we are in the current business cycle is what we should be doing to address our structural problems, which I would describe more generally as mismatches between what markets supply and what today’s society actually needs.

Consider structural unemployment, when the labor market isn’t supplying enough workers with the qualifications that employers need. The orthodox perspective sees it as a pricing problem that arises because the supply of unskilled or poorly located workers exceeds the demand. The orthodox solution is to lower the price of such labor, on the assumption that anyone can get hired if they will work cheaply enough. Krugman and Wells’ macroeconomics text reflects that thinking when they say, “Until the mismatch is resolved through a big enough fall in wages of the surplus workers that induces retraining or relocation, there will be structural unemployment.” Trouble is, price rigidities in the labor market like minimum wage laws, unemployment compensation, and union contracts—and maybe just plain refusal of workers to work for peanuts—keep surplus workers from being hired. So we can’t really have full employment without inflation, and must settle for a “natural rate” of unemployment. But this argument assumes that if we removed the price rigidities, the unemployed could get what they needed to qualify themselves for today’s jobs.

A less orthodox macroeconomics text, by Mitchell, Wray and Watts, puts the responsibility for the mismatch on employers, saying that “the notion of structural unemployment arising from ‘skills mismatch’ can be understood as implying an unwillingness of firms to offer jobs, with attached training opportunities, to unemployed workers whom they deem to fall short of their ideal profile.” Employers prefer to “externalize” the costs of human capital development, expecting society to send them qualified workers from whom they can profit at low cost. But from the workers’ perspective, the goods and services market isn’t supplying enough education and training (and other human development services like affordable health care, drug treatment programs and mental health services) to enable them to become the kinds of workers employers want. The market is also failing to provide enough affordable child care and affordable housing in the cities where the jobs are. Under these market conditions, the idea that we must lower wages to force devalued workers to improve themselves is a cruel joke. Government, however, can use its spending power to increase economic demand for what society really needs.

The challenge of transitioning to cleaner energy is also a structural problem, a mismatch between what we produce and what we need. The current spike in energy prices is partly a result of temporary shortages, as energy producers resume production in the aftermath of the COVID recession. But it’s also a sign that the transition to cleaner energy is not going very well. Investments in fossil fuel production are falling faster than investments in renewable energy are rising. If the resulting inflation becomes an excuse not to spend on the transition, that would be seriously counterproductive. As The Economist editorialized recently:

The panic has…exposed deeper problems as the world shifts to a cleaner energy system, including inadequate investment in renewables and some transition fossil fuels, rising geopolitical risks [especially global dependency on energy-producing countries with autocratic regimes] and flimsy safety buffers in power markets. Without rapid reforms there will be more energy crises and, perhaps, a popular revolt against climate policies.”

Government spending doesn’t just have cyclical consequences—a stimulus when an economy is slumping and possible over-stimulus and inflation when it reaches potential output. It also has structural consequences, since it can create more potential by developing human and natural resources. This is consistent with Stephanie Kelton’s conception of Modern Monetary Theory: “MMT is about identifying the untapped potential in our economy, what we call our fiscal space.” Think of the fiscal space as the room to grow before we reach the limit of our economic potential. If we can produce more with a well qualified labor force and new forms of energy, we can also spend more without inflation. We practice a false economy if we refuse to consider the spending that would develop the potential.

When the House Budget Committee passed the Biden plan, it issued a statement, “The Build Back Better Act: Transformative Investments in America’s Families & Economy.” The statement included these claims about the economics of the plan:

The Build Back Better Act makes essential investments in family care, health care, and combatting climate crisis. It will overhaul and reimagine sectors of our economy and society so that everyone – not just those at the top – benefit from a growing economy. The Build Back Better Act will implement key reforms to make our tax system more equitable. This plan is prudently paid for by ensuring the wealthiest Americans and most profitable corporations pay their fair share of taxes. Americans making less than $400,000 a year will not see their taxes increase by a penny. Additionally, it is estimated that the Build Back Better Act will ease longer-term inflationary pressures and stimulate future economic growth, further offsetting the cost of the plan.

Building Back Better is not just about getting back to the phase of the business cycle that preceded the COVID recession. It’s about using the democratic process—what’s left of it—to assert what people need, and using government spending to help make it happen. If that entails a wiser use of our human and natural resources, it can be economical in the best sense of the term.

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