Tradeoffs Between Social Policy and Growth

Mark Thoma's recent Fiscal Times column seems to me to be heavy on politics and light on economic analysis. He sets out to convince the reader that there is no tradeoff between social insurance provided by the federal government and economic growth, but I think there are good reasons to doubt this notion.


Taken to the extreme, his point is totally senseless. A quick look at the "success" of communist regimes of the 20 century built around economic equality shows that, at least at some point, there is a tradeoff between social safety nets and growth. My guess is that Thoma would agree and that he believes the tradeoff only becomes binding when we reach a certain level of intervention.

Thoma claims that "the evidence" supports his thesis, yet he provides no sources for us to examine. He instead offers four arguments, each of which I'll discuss in turn. (Thoma in block quotes, I'm not.)

First, on the source of fluctuations, does anyone seriously believe that events such as the Great Depression and Great Recession can be explained by productivity shocks? I don’t, and there is plenty of evidence to support the idea that demand side fluctuations are the predominant source of output and employment variability.

This is a a false dichotomy. There are more than two possible explanations for the recent boom and bust. The Austrian Business Cycle Theory has been used in many papers to explain many of the primary drivers of the financial crisis and ensuing recession. Thoma's focus on demand as a causal factor is likely what drives his perception that it is, in fact, a causal factor. It's true that people have to deleverage after a credit-fueled boom-bust cycle, but the root of the problem is the distortionary policies that created the artificial boom. A drop in demand is one of many consequences.

Second, on the benefits of long-run supply-side growth policy, there is little evidence to suggest that tax cuts do, in fact, raise economic growth. And even if they do, will tax cuts “lift all boats” as advocates of these policies claim, or will most of the gains go to the yacht owners? The evidence in recent years is clear. If tax cuts for the wealthy do spur growth, and that is doubtful, most of the gains flow to the top (not to mention the increase in inequality from the tax cuts themselves).

The graph below shows tax receipts and budget outlays as a percentage of GDP. Top marginal tax rates ranged from just under 30% to over 90% over this period, yet receipts didn't change nearly as much and are projected to get close to the highest ever in the next 5 years. So, what tax cut is Thoma talking about?

Source

What's important is spending, since that is what ultimately determines the extent to which resources are diverted from the private sector to the government sector. For all but a few years since 1970, outlays have exceeded tax receipts. Most of the political conversations I'm familiar with wouldn't change budget outlays all that dramatically. Most of the federal budget consists of the military and Social Security, two things that are not typically on the table when cuts are discussed.

Third, on the costs of pursuing a more equitable distribution of income and providing social programs that help the unfortunate, recent evidence suggests that lowering inequality can actually raise economic growth. There was considerable resistance to this idea at first, but it is finding acceptance. If this research is correct, there is no equity-efficiency tradeoff to worry about, and reducing inequality may actually promote economic growth. 

An example of policy designed to reduce the ability of corporations owned and run by the rich to harm consumers is regulation. However, Dawson and Seater (2013) find that growth in regulation since the late 1940s has had a dramatically negative impact on growth. Specifically, they find that "[f]ederal regulations added over the past fifty years have reduced real output growth by about two percentage points on average over the period 1949-2005. That reduction in the growth rate has led to an accumulated reduction in GDP of about $38.8 trillion as of the end of 2011. That is, GDP at the end of 2011 would have been $53.9 trillion instead of $15.1 trillion if regulation had remained at its 1949 level." I'd wager that $38.8 trillion of GDP would go a long way to alleviating the financial hardship of many of the poor in the US.

Another example of a policy explicitly designed to help the poor is the minimum wage. Unfortunately, this policy likely harms those who are trying to enter the job market and likely reduces employment growth. Not good things for the short or long term.

There is one way in which inequality and growth are related, though not in the manner in which Thoma suggests. Improvements in the material well-being of everyone, especially the poor, are the result of private sector innovation and growth. More and better products have enriched even the poorest among us well beyond what we could have imagined just a few decades ago. Tables 4, 5, and 6 in this paper (or 3, 4, and 5 in the ungated version) are helpful.

Finally, on the effectiveness of short-run stabilization, the ability of monetary and fiscal policy to offset economic fluctuations appears to be much greater than many people realized prior to the Great Recession. For most economists, monetary policy has always been an effective tool for offsetting mild fluctuations, but it was thought to lose effectiveness in severe recessions. In addition, many economists had little faith in fiscal policy as a replacement for monetary policy in deep downturns. 

But the Fed surprised us with its creativeness during the Great Recession, and while it was far from a cure-all, monetary policy had more impact than many would have predicted. In addition, the evidence from the Great Recession indicates that fiscal policy is a much more effective tool in deep recessions than many economists understood. There is still resistance to this evidence, but a fair examination of recent research leads to the conclusion that the benefits of stabilization policy are large and worth pursuing.

See my previous post on the labor force participation rate. It's far too early to declare victory for monetary and fiscal policy since people are still leaving the labor force in droves (a process that started during the recession).

I don't think Thoma makes a particularly strong case for the idea that social insurance and pro-growth policy can coexist nearly costlessly. Moreover, there's evidence that policies which ostensibly help the poor don't actually do so.