Glenn’s Opinion Column on the Economics of an Increase in Defense Spending

Graphic from the Wall Street Journal.

Glenn published the following opinion column in the Wall Street Journal. Link here and full text below.

NATO Needs More Guns and Less Butter

Russia’s unprovoked invasion of Ukraine has challenged Western assumptions about security, economics and the postwar world order. In Europe and the U.S., public finances have long favored social spending over public goods such as defense. While President Biden doubled down on his proposal to increase social spending during his State of the Union address, Russia’s aggression highlights the shortcomings of this model. Western democracies now face a more uncertain and dangerous world than they did two weeks ago. Navigating it will require significantly higher levels of defense and security spending.

But change will be difficult, and the magnitude of what needs to be done is sobering. The U.S. currently spends 3.2% of gross domestic product on defense—roughly half of Cold War spending levels relative to GDP. An increase in spending of even 1% of GDP would amount to about $210 billion. That’s about 5% of the total federal spending level using a 2019 pre-Covid baseline. While Covid spending was large, it was transitory. Defense outlays would be much longer-lasting, an insurance premium or transaction cost for dealing with a more dangerous world.

The U.S. is not alone. Germany’s announcement of €100 billion in additional defense spending this year represents an increase of just over 0.25% of GDP, leaving Berlin still under the 2% commitment agreed to by North Atlantic Treaty Organization allies. Increasing Europe’s defense spending merely to the agreed-on level would require significant outlays. Such spending increases would occur against the backdrop of elevated public debt relative to GDP, brought on in part by heightened borrowing during the Covid pandemic and the earlier global financial crisis. High levels of public debt make it unlikely that countries will want to pay to increase their defense spending with new borrowing.

Paying for higher levels of defense spending will force most governments either to raise taxes or cut spending. Tax increases raise risks to growth. The larger non-U.S. NATO economies are already taxed to the hilt. Tax revenue relative to the size of the economy in France (45%), Germany (38%), Canada (34%) and the U.K. (32%) doesn’t leave much room to tax more without depressing economic activity. The U.S. has a lower tax share of GDP—about 17.5% at the federal level and 25.5% in total—but its patchwork quilt of income and payroll taxes makes tax increases more costly by distorting household and business decisions about consumption and investment.

A significant tax increase in the U.S. would need to be accompanied by fundamental tax reform, dialing back income taxes (as with the 2017 reduction in corporate tax rates) and increasing reliance on consumption taxes. A broad-based consumption tax could be implemented by imposing a tax at the business level on revenue minus purchases from other firms (a “subtraction method” value-added tax). Alternatively, the tax system could impose a broad-based wage and business cash-flow tax, with a progressive wage surtax on high earners. These consumption-tax alternatives would be efficient and equitable in a revenue-neutral tax reform. And they are crucial in avoiding decreases in savings, investment and entrepreneurship that accompany a tax increase.

Since the 1960s, spending on Social Security, Medicare and Medicaid has come to dominate the federal budget. Outlays for these programs have almost doubled since then as a share of GDP to 10.2% today, and the Congressional Budget Office projects they will consume about another 5% of GDP annually by 2040. Spending offsets to accommodate higher defense spending would surely require slowing the growth in social-insurance spending. As with tax increases, there are trade-offs. It is possible to slow the growth of this spending while preserving access to such support for lower-income Americans. Accomplishing that will require focusing net taxpayer subsidies on lower-income Americans, along with undertaking market-oriented health reforms. Such changes require serious attention.

The U.S. and its NATO allies will face a challenging set of economic trade-offs and political realities in achieving higher defense spending. The challenge will be exacerbated by additional private investment needs in a more dangerous world of investment risks, skepticism about globalization, and cybersecurity threats. 

In the U.S., the failure of the 2010 Simpson-Bowles Commission’s proposed spending and tax reforms to spark a serious discussion is a warning sign. So, too, is the antipathy of Democratic and Republican officials alike toward creating the fiscal space necessary to accommodate greater defense spending. Such challenges don’t cause threats to vanish. They require leadership—now.

Would Cutting the Federal Excise Tax on Gasoline Lower the Price that Consumers Pay?

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The federal government levies an excise tax of 18.4 cents per gallon of gasoline. (An excise tax is a tax that a government imposes on a particular product. In addition to the tax on gasoline, the federal government imposes excise taxes on tobacco, alcohol, airline tickets, and a few other products.) In February 2022, inflation was running at the highest level in several decades. The average retail price of gasoline across the country had risen to $3.50 per gallon from $2.60 per gallon a year earlier. The following figure shows fluctuations in the retail price of gasoline since January 2000. 

Policymakers were looking for ways to lessen the effects of inflation on consumers. An article in the Wall Street Journalreported that several Democratic members of the U.S. Senate, including Mark Kelly of Arizona, Maggie Hassan of New Hampshire, and Raphael Warnock of Georgia proposed that the federal excise tax on gasoline be suspended for the remainder of 2022. The sponsors of the proposal believed that cutting the tax would reduce the price of gasoline that consumers pay at the pump. Other members of the Senate weren’t so sure, with one quoted as saying that cutting the tax was “not going to change anything” and another arguing that oil companies would receive most of the benefit of the tax cut.

Some members of Congress were opposed to suspending the gasoline tax because the revenue raised from the tax is placed in the highway trust fund, which helps to pay for federal contributions to highway building and repair and for mass transit. In that sense, the gasoline tax follows the benefits-received principle, under which people who receive benefits from a government program—in this case, highway maintenance—should help pay for the program. (We discuss the principles for evaluating taxes in Microeconomics, Chapter 17, Section 17.2 and in Economics, Chapter 17, Section 17.2) Other members of Congress were opposed to suspending the tax because they believe that the tax helps to reduce the quantity of gasoline consumed, thereby helping to slow climate change. 

Focusing just on the question of the effect of suspending the tax on the retail price of gasoline, what can we conclude? The question is one of tax incidence, which looks at the actual division of the burden of a tax between buyers and sellers in a market. In other words, tax incidence looks beyond the fact that gasoline stations collect the tax and send the revenue to federal government to the issue of who actually pays the tax. As we note in Chapter 17, Section 17.3:

When the demand for a product is less elastic than supply, consumers pay the majority of the tax on the product. When the demand for a product is more elastic than supply, firms pay the majority of the tax on the product. 

Consumers would receive all of the tax cut—that is, the retail price of gasoline would fall by 18.4 cents—only in the polar case where the demand for gasoline were perfectly price inelastic. Similarly, consumers would receive none of the tax cut and the price of gasoline would remain unchanged—so oil companies would receive all of the tax cut—only in the polar case where the demand for gasoline is perfectly price inelastic. (It’s a worthwhile exercise to show these two cases using demand and supply graphs.)

In the real world, we would expect to be somewhere in between these two cases, with consumers receiving some of the benefit of suspending the tax and producers receiving the remainder of the benefit. The short-run price elasticity of demand for gasoline is quite small; according to one estimate it is only −.06.  The short-run price elasticity of supply of gasoline is likely to be somewhat larger than that in absolute value, which means that we would expect that consumers would receive the majority of the tax cut. (Note that we would expect the long-run price elasticities of demand and supply to both be larger for reasons we discuss in Chapter 6, Section 6.2 and 6.6.) In other words, the retail price of gasoline would fall, holding all other factors constant, but not by the full tax cut of 18.4 cents.

Joseph Doyle of MIT and Krislert Samphantharak of the University of California, San Diego studied the effect of suspension in the state excise tax on gasoline in Indiana and Illinois in 2000. In that year, Indiana suspended collecting its gasoline excise tax for 120 days and Illinois suspended its tax for 184 days. The authors estimate that consumers received about 70 percent of the tax cut in the form of lower gasoline prices. If we apply that estimate to the federal gasoline tax, then suspending the tax would lower the price of gasoline by about 12.9 cents per gallon, holding all other factors that affect the price of gasoline constant. As the above figure shows, the retail price of gasoline frequently fluctuates up and down by more than 12.9 cents, even over fairly brief periods of time. In that sense, the effect on the gasoline market of suspending the federal excise tax on gasoline would be relatively small.  

Sources: Andrew Duehren and Richard Rubin, “Some Lawmakers Want to Halt Gas Tax Amid High Inflation. Others See a Gimmick,” Wall Street Journal, February 16, 2022; Tony Romm and Jeff Stein, “White House, Congressional Democrats Eye Pause of Federal Gas Tax as Prices Remain High, Election Looms,” Washington Post, February 15, 2022; Joseph J. Doyle, Jr., Krislert Samphantharak, “$2.00 Gas! Studying the Effects of a Gas Tax Moratorium,” Journal of Public Economics, Vol. 92, No.s 3-4, April 2008, pp. 869-884; and Federal Reserve Bank of St. Louis.

The Effect of the Covid-19 Pandemic on Income Inequality

During 2020, Congress and President Donald Trump responded to the Covid-19 pandemic with very aggressive fiscal policy initiatives. First, in March 2020, Congress enacted the Coronavirus Aid, Relief, and Economic Security (CARES) Act. The CARES Act increased the federal government’s expenditures by $1.9 trillion. Then, in December 2020, in response to the continuing effects of the pandemic, Congress and President Trump included an additional $915 billion in expenditures related to Covid-19 in the Consolidated Appropriations Act.  These two fiscal policy actions included payments directly to households and supplemental unemployment insurance payments. Higher income households were not eligible for the direct payments (often referred to as “stimulus payments”). Higher income households were also less likely to be unemployed and so were less likely to receive the supplemental unemployment insurance payments.

In Chapter 17, Section 17.4, we discuss the unequal distribution of income in the United States. Because the federal payments were targeted toward lower and middle income households, did the payments result in a decline in income inequality? Table 17.6 in Chapter 17, shows a common measure of the distribution of income: Households in the United States are divided into five income quintiles, from the 20 percent with the lowest incomes to the 20 percent with the highest incomes, along with the fraction of total income received by each of the five groups. The following table displays the distribution of income using this measure for 2019 and 2020. (We also include the data for the share of income received by the 5 percent of households with the highest incomes.) Note that the definition of income used in the table includes tax payments households make in that year in addition to payments—including the stimulus payments—received from the government. The income is also “equivalence adjusted,” which means that income is adjusted to account for how many adults and children are in a household.

YearLowest 20%Second 20%Middle 20%Fourth 20% Highest 20%Highest 5%
Percentage change in income share8.7%4.8%2.1%0.8%−3.0%−5.1%

The table shows that the distribution of income in the United States became somewhat more equal during 2020, with the share of income going to each of the first four quintiles increasing, while the income of the highest quintile declined.  The income share of the lowest quintile increased the most—by 8.7 percent—while the income share of the top 5 percent of households decreased by 5.1%. In that section of Chapter 17, we discuss the Gini coefficient, which is a measure of how unequal the distribution of income is. The Gini coefficient ranges between 0 and 1 with higher values indicating a more unequal distribution. Between 2019 and 2020, the Gini coefficient decline from 0.416 to 0.399, or by 4.1 percent, which measure the extent to which the income distribution became more equal. 

Will the reduction in income inequality the United States experienced during 2020 persist? It seems likely to, at least through 2021, given that in March 2021, Congress and President Joe Biden enacted the American Rescue Plan, which included payments to households of up to $1,400 per eligible household member. As with the payments to households made during 2020, high-income households were not eligible. Congress also extended supplemental unemployment insurance payments through early September 2021 in states that were willing to accept the payments. 

What about after federal stimulus payments to households end? (As of late 2021, it appeared unlikely that Congress and President Biden planned on enacting any further payments.) One indication that some of the reduction in inequality might be sustained comes from the sharp increases in the wages of many low-skilled workers. For instance, in October 2021, the wages (as measured by their average hourly earnings) of workers in the leisure and hospitality industry, which includes workers in restaurants and hotels, increased by nearly 12 percent over the previous year. For all workers in the private sector, wages increased by about 5 percent over the same period. Many of the workers in this industry have low incomes. So, the fact that their wages were increasing more than twice as fast as wages in the overall economy indicates that at least some low-income workers were closing the earnings gap with other workers.

Sources: Emily A. Shrider, Melissa Kollar, Frances Chen, and Jessica Semega, U.S. Census Bureau, Current Population Reports, P60-270, Income and Poverty in the United States: 2020, Washington, DC, U.S. Government Printing Office, September 2021, Table C-3; and U.S. Bureau of Labor Statistics.

Glenn’s Take on the Proposal at the G7 Meeting to Impose a Minimum Tax on Corporate Profits

   The G7 (or Group of 7) is an organization of seven large economies: Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States. Only democratic countries are included, so China is not a member. At a recent meeting attended by U.S. Treasury Secretary Janet Yellen, the group agreed to adopt a uniform corporate tax rate of at least 15 percent.

Glenn discusses this decision in the following opinion column published in the Financial Times.

U.S. Treasury Secretary Janet Yellen and Paolo Gentiloni, European Commissioner for Economy, at a recent meeting of the G7.

Governments Should Tax Cash Flow, Not Global Corporate Income

From the Biden administration’s inception, US Treasury Secretary Janet Yellen has championed a global minimum tax for corporations. While the US walked back from a request for a 21 per cent rate (which was linked to an objective of raising the current US corporate tax of 21 per cent to between 25 and 28 per cent), it did lock in with G7 finance ministers a rate of at least 15 per cent. Secretary Yellen praised the move: “That global minimum tax would end the race to the bottom in corporate taxation, and ensure fairness for the middle class and working people in the US and around the world.”

It is tough to argue that corporate income shouldn’t pay its “fair share”. But the global minimum tax raises both political and economic questions.

Politics first. Approval in the US is likely to be tough. The minimum tax is estimated by the OECD to raise as much as $50bn-$80bn per year, much of it from successful American firms. Revenue to the US Treasury would be part of this amount, but small relative to the substantial expansion in spending proposed by the Biden administration. Will other governments engage their own political costs to achieve a deal that may be ephemeral if it fails to get US legislative approval? Even if the deal succeeds, might it hand a competitive victory to China? As a non-party to G7 or OECD proposals, could it not use both tax rates and subsidies to draw more investment to China?

But it is on economics that the global minimum tax draws more sensitive questions in two areas. The first is the design of the tax base. The second addresses the foundational question of the problem policymakers are trying to solve and whether the new minimum tax is the best way to do so.

A 15 per cent rate is not particularly useful without an agreement on what the tax base is. Particularly for the US, home to many very profitable technology companies, the concern should arise that countries will use special taxes and subsidies that effectively target certain industries. The US has had a version of a minimum tax of foreign earnings since the Tax Cuts and Jobs Act of 2017 enshrined GILTI (Global Intangible Low-Taxed Income) provision into law. The Biden administration wants to use the new global minimum tax to raise the GILTI rate and expand the tax base by eliminating a GILTI deduction for overseas plant and equipment investments.

For a 15 per cent minimum rate to make sense, countries would need a uniform tax base. Presumably, the goal of the new minimum tax is to limit the benefits to companies of shifting profits to low-tax jurisdictions, not to distort where those firms invest. The combination of a global minimum tax with the broad base advocated by the Biden administration could reduce cross-border investments and reduce the profitability of large multinational firms.

A still deeper economic issue is that of who bears the tax burden. I noted above that projected revenue increases are small compared to G7 government spending levels. It is not corporations who would pay more, but capital owners generally and workers, according to contemporary economic views of who bears the burden of the tax.

There is a better way to achieve what Yellen and her finance minister colleagues are trying to accomplish. To begin with, countries could allow full expensing of investment. That approach would move the tax system away from a corporate income tax toward a cash flow tax, long favoured by economists. In this revision, the minimum tax would not distort new investment decisions. It would also push the tax burden on to economic rents—profits in excess of the normal return to capital—better satisfying the apparent G7 goal of garnering more revenue from the most profitable large companies. And such a system would be simpler to administer, as multinationals would not need to set up different ways to track deductible investment costs over time in different countries.

In the debate leading up to the 2017 US tax law changes, Congress considered a version of this idea in a destination-based cash flow tax. Like a value added tax, this would tax corporate profits based on cash flows in a given country. The reform, which foundered on the political desirability of border adjustments, limits tax biases against investment and boosts tax fairness.

Returning to the numbers: countries with large levels of public spending relative to gross domestic product, as the Biden administration proposes, fund it mainly with value added taxes, not traditional corporate income taxes. A better global tax system is possible, but it starts with a verdict of “not GILTI.”

NEW! – 04/09/21 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss the longer-term impact of several post-pandemic fiscal policy efforts and the new Biden administration infrastructure investment proposal.

Authors Glenn Hubbard and Tony O’Brien discuss the long-term impacts of recent fiscal policy decisions as well as the proposed infrastructure investment by the Biden administration. The most recent round of fiscal stimulus means that we’re spending almost 4.5 Trillion which is a high percentage of what we recently spent in an entire fiscal year. They deal with the question of if the infrastructure spending will increase future productivity or will just be spent on the social programs. Also, Glenn deals with the proposed corporate tax increase to 28% which has been designated to fund these programs but does have an impact on stock market values held by millions through 401K’s and IRA’s.

Just search Hubbard O’Brien Economics on Apple iTunes or any other Podcast provider and subscribe!

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NEW! – 02/19/21 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss early thoughts on the Biden Administration’s economic plan.

Authors Glenn Hubbard and Tony O’Brien discuss early thoughts on the Biden Administration’s economic plan. They consider criticisms of the most recent stimulus packages price tag of $1.9B that it may spur inflation in future quarters. They offer thoughts on how this may become the primary legislative initiative of Biden’s first term as it crowds out other potential policy initiatives. Questions are asked about what bounce we may see for the economy and comparisons are made to the Post World War II era. Please listen and share with students!

The following editorials are mentioned in the podcast:

Glenn Hubbard’s Washington Post Editorial with Alan Blinder

Olivier Blanchard’s comments on the Stimulus in a Peterson Institute for International Economics post

Larry Summer’s WaPo editorial about the risks of the stimulus:

Just search Hubbard O’Brien Economics on Apple iTunes or any other Podcast provider and subscribe!

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Census Bureau Releases Results from the American Community Survey

Each year the U.S. Census Bureau conducts the American Community Survey (ACS) by surveying 3.5 million households on a wide range of questions including their income, their employment, their ethnicity, their marital status, how large their house or apartment is, and how many cars they own. The ACS is the most reliable source of data on these issues and is widely used by economists, business managers, and government policy makers. The data for 2019 and for the five-year period 2015-2019 were released on December 10. You can learn more about the survey and explore the data on the ACS website.

The ACS provides data on increases in income over time by different ethnic groups. This news article discusses the result that between 2005 and 2019, the incomes of Asian American grew the fastest, followed by the incomes of Hispanics, the incomes of non-Hispanic whites, and the incomes of African Americans.

Measuring Changes in Income Inequality

As we discuss in Chapter 17, there are several complications in accurately measuring changes in the distribution of income over time. First, people will not typically remain in the same place in the income distribution their whole lives. Instead, their incomes are likely to fluctuate, moving them up and down the income distribution. So comparing the distribution of income for the whole population at two points in time can give a misleading idea of how the incomes of particular individuals changed. Measuring income mobility can be difficult, however, because it entails tracking the incomes of individuals over time. Doing that requires specialized studies rather than relying on the more readily available government data we can use to track changes in the incomes of the whole population. 

Second, we are more interested in the income people have available to spend rather than the income they earn. Because people pay taxes on the incomes they receive and because many people receive transfer payments from the government, including unemployment insurance payments and Social Security payments, the income distribution is more equal if we measure it after taking into account the taxes people pay and the transfer payments they receive.

Finally, people earn income from a variety of sources in addition to wages and salaries, including dividends they receive from owning stock, capital gains they earn from selling a financial or other asset, and income they earn from owning a business such as a restaurant or dry cleaners. The income people at the top of the income distribution earn from owning a business can be particularly hard to measure because it depends on how the income is reported to the Internal Revenue Service, which depends in turn on changes in laws affecting how businesses are organized and how they pay taxes. Dealing with these measurement issues is particular important in determining how much the share of income earned by the top 1% of the income distribution has changed over time—an issue that has been the subject of much political debate.

Wojciech Kopczuk of Columbia University and Eric Zwick of the University of Chicago address these measurement issues in a new article in the Journal of Economic Perspectives. Even skimming the article makes clear just how difficult the measurement issues are. Click HERE to read the article.

Note that the article is part of a symposium on income and wealth inequality that appears in that issue of the journal. The other articles in the symposium are also worth reading. Articles that appear in the Journal of Economic Perspectives are frequently (but not always!) nontechnical summaries of research that can be read without knowledge of economics beyond the principles course. 

10/24/20 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss the economics of issues raised during the Final 2020 Presidential Debate.

Authors Glenn Hubbard and Tony O’Brien discuss the economic impacts of what was discussed in the final Presidental debate on 10/22/20. They discuss wide-ranging topics that were raised in the debate from reopening the economy & schools, decreasing participation of women in the workforce due to COVID, healthcare, environment, and general tax policy. Listen to gain economic context on these important items. Click HERE for the New York Times article discussed during the Podcast:

Just search Hubbard O’Brien Economics on Apple iTunes and subscribe!

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5/15/20 Podcast – Glenn Hubbard & Tony O’Brien Welcome Guest – Texas A&M Economics Professor, Jonathan Meer

Glenn Hubbard and Tony O’Brien continue their podcast series hosting guest – Jonathan Meer, Professor of Economics from Texas A&M University as well as the Director of the Private Enterprise Research Center at Texas A&M. During the conversation, we learn about Jonathan’s teaching over 3,500 students annually in a large online Principles of Microeconomics lecture course. He discusses how his usual online teaching absolutely helped his transition when Texas A&M closed for the semester. He also talks about the state of Higher Education, non-profit giving, as well as some challenges nonprofits face in these uncertain times.

Some notes from this Podcast if you’d like more information:

1. Link to Jonathan Meer’s Youtube video on setting up an online course:

Jonathan Meer of Texas A&M University shares his best practices for teaching economics online.

2. Link to Jonathan’s website page providing links to his research papers on altruism and charitable giving:

3. Nontechnical summary of Jonathan’s research with Harvey Rosen on charitable giving:

4. Please refer to the Apply the Concept feature from Chapter 2 of Hubbard and O’Brien Economics, 7/E, on the use of market mechanisms to allocate food at the Feeding America charity (for your convenience, we hope to post this shortly so check back).

Please listen & share!