Today sees the rise of two key studies that reveal some fundamental truths about how an economy works, which are best looked at together. First, the CBO studied the question of how full employment would reduce the deficit. “Full employment” is defined here as a projection of what would happen if there wasn’t an “underutilization of capital and labor resources in the economy.” That’s pretty bloodless wonk-speak, but it means that the economy would be working to produce maximum output without idle labor sitting around collecting unemployment check. The unemployment rate they cite as the “full employment” rate is 5.2%. CBO estimates that the deficit would be 1/3 lower in 2012 as a result. This would result from an increase in tax revenue from higher employment, as well as a reduction in those qualifying for unemployment insurance and other social services. The report was requested by Rep. Chris Van Hollen, a member of the Super Committee.
CBO calculated its estimate of the portion of the deficit attributable to those “cyclical” factors, about $340 billion, using the same methodology that the agency uses to estimate the so-called automatic stabilizers—the automatic responses of revenues and outlays to changes in real (inflation-adjusted) output and unemployment. Specifically, CBO estimated what taxable income would be if output equaled its potential; under those circumstances, taxable income (as measured in the national income and product accounts maintained by the Department of Commerce’s Bureau of Economic Analysis) would exceed the taxable income currently projected by about $850 billion (or by about 7½ percent). CBO translated that difference into an estimate of how much higher revenues would be in the absence of cyclical factors.
I think it’s almost certainly true that CBO is under-representing this, and the evidence can be seen from when we had a full-employment economy, or nearly so, in the late 1990s. Deficits turned into large surpluses well beyond CBO’s projections as a result. CBO was quick to highlight that it didn’t take into account inflation and interest rate increases that could come from full employment, both things that could expand the deficit. But it did not highlight this evidence from the late 1990s.
A good companion to this is a study on income inequality, showing it to be a major drain on economic growth.
“Countries where income was more equally distributed tended to have longer growth spells,” says economist Andrew Berg, whose study appears in the current issue of Finance & Development, the quarterly magazine of the International Monetary Fund. Comparing six major economic variables across the world’s economies, Berg found that equality of incomes was the most important factor in preventing a major downturn.
In their study, Berg and coauthor Jonathan Ostry were less interested in looking at how to spark economic growth than how to sustain it. “Getting growth going is not that difficult; it’s keeping it going that is hard,” Berg explains. For example, the bailouts and stimulus pulled the US economy out of recession but haven’t been enough to fuel a steady recovery. Berg’s research suggests that sky-high income inequality in the United States could be partly to blame.
In other words, we’re not going to lower the unemployment rate – and subsequently reduce out deficit – until we end this extreme income inequality that has grown to stratospheric rates over time. Rich people wanting to keep their tax cuts is impoverishing the rest of the country. It’s no accident that the highest two points of stratification of the distribution of wealth in America can be seen in 1928 and 2007, one year before both the Great Depression and the Great Recession.