The Campaign’s Hidden Issue


When they mention economics, both of this year’s candidates have concentrated, predictably, on prosperity: How successful has the Reagan administration been in creating jobs, boosting incomes, and containing inflation since the current business expansion began at the end of 1982? What can be done about those Americans who remain poor? Is a recession imminent? What is the risk of higher inflation?

These questions are important, but they miss the point. By fixing our attention on the details of today’s economy, we are allowing Vice-President Bush and Governor Dukakis to avoid addressing the difficult choices that the next president will have to make.

Those choices will be difficult because the prosperity about which the candidates are debating is a false prosperity, built on borrowing from the future. When President Reagan took office our federal debt (not counting what various government agencies owe each other) was $738 billion, or twenty-six cents for every dollar that the country produced and earned. The United States was also the world’s leading creditor nation, with the power and influence that so privileged a position has historically carried with it. But seven years of a radical new fiscal policy—all years of peacetime—have nearly tripled federal indebtedness, while the national income increased by only half. When either Mr. Bush or Mr. Dukakis takes office, therefore, the net federal debt will be approximately $2.1 trillion, or forty-three cents for every dollar of our income.

Worse yet, after seven years of reckless borrowing the United States is now the world’s largest debtor nation, dependent on the good will of the countries that lend the money to keep the party going. The nation is surrendering the ownership of its productive assets, not in exchange for assets it will own abroad, or to build new plants and other facilities at home, but merely to finance higher and higher personal consumption. Having stunted its investment at home and dissipated its assets abroad, the nation now faces difficult choices because, unless it acts quickly to reverse these forces, today’s voters and their children will pay the consequences in the form of a diminished standard of living and a far different role for America in world affairs.

In the meanwhile, jobs are plentiful and profits are high because Americans are spending amply. But more than ever before, they are spending both their own money and what they can borrow not to make the productive investments the economy needs—renovated equipment in basic industries like steel, expanded capacity for producing semiconductors and other high-tech devices, airports and ocean ports and highways that are not in disrepair—but merely to consume more. Prices have remained stable in part because business was depressed at the beginning of the decade, and also because, until recently, consumers could use overpriced dollars to buy foreign-made cars and clothes and computers at prices cheaper than what it cost to produce the same goods in America. After-tax incomes are rising because Americans are continuing to receive the usual variety of services and benefits from the government, but nobody is paying the taxes to cover the cost. In short, the sense of economic well-being that is so widespread today is an illusion, an illusion based on borrowed time and borrowed money.

President Reagan blames Congress for the deficits that have totaled more than $1.1 trillion during 1982–1987 (the 1981 budget was still Jimmy Carter’s). But the difference between the spending that Congress voted and what he proposed—including defense and nondefense programs—added up to only $90 billion for these six years. Even if Congress had adopted each of the Reagan budgets down to the last dollar item, the deficits and the economic corrosion that they have caused would have been only slightly smaller. The real cause of the deficits the government has run during these years was that Congress, in 1981, approved the deep, across-the-board Kemp-Roth tax cut, which Mr. Reagan strongly supported, without matching spending cuts that neither Congress nor the President was willing to propose.

Both candidates, when they discuss economics, limit themselves to meaningless generalities and unworkable promises such as balancing the budget through as-yet-unspecified spending cuts, or more efficient management of government programs, or better enforcement of the tax laws. Then, in other parts of their speeches, they appeal to moral values such as respect for family and the obligation to America’s children, as if economics and morality were unrelated. But at the deepest level, an economic policy that artificially boosts consumption at the expense of investment, dissipates assets, and runs up debt contradicts the essential moral values that underlie each generation’s sense of obligation to those that follow. We are enjoying what appears to be a higher and more stable standard of living by selling our and our children’s economic birthright. The interest on the sums the government is now borrowing will—without common agreement on the matter or even much public discussion—burden generations of Americans to come.

What ought to make these issues all the more important to the current campaign is that the decision to mortgage America’s economic future has not been a matter of personal choice by American families but one of legislated public policy. Popular talk of the “me generation” to the contrary, most Americans are working just as hard, and saving nearly as much, as their parents and grandparents did. What is different is economic policy. The tax and spending policies that the US government has pursued throughout Ronald Reagan’s presidency have, in effect, rendered every citizen a borrower, and every industry a liquidator of assets. The average American has enjoyed such a high standard of living lately because since January 1981 our government has simply borrowed more than $20,000 on behalf of each family of four.

Moreover, we owe nearly half of this new debt to foreign lenders. At the beginning of the 1980s, the balance of what foreigners owed Americans beyond what Americans owed foreigners amounted to some $2,500 per family. Today the balance against us amounts to more than $7,000 per family, and it is continuing to grow rapidly. Foreigners have already begun to settle these debts by acquiring office buildings in American cities, houses in American suburbs, farmland in the heartland, and even whole companies. We are selling off America, and living on the proceeds.

The unprecedented splurge of consumption financed by borrowing in the 1980s is eroding America’s future prospects in two ways, each of which carries deep implications not just for our standard of living but for the character of our society more generally. The more straightforward cost of our current economic policy is no more, and no less, than what any society pays for eating its seed corn rather than planting it. The federal deficit has averaged 4.2 percent of US national income since the beginning of the decade. This amount is nearly three-fourths of the 5.7 percent of national income that individuals and businesses together manage to save after spending for consumption and for replacing physical assets (such as houses or machines) that wear out.

As a result, US investment in new business plant and equipment has fallen to a smaller share of national income than in any previous sustained period since World War II. So has investment in roads, bridges, airports, harbors, and other kinds of government-owned infrastructure. So has investment in education (even including spending by state and local governments), despite the urgent need to train a work force whose opportunities will more than ever before arise in technologically advanced industries.

With so little investment in the basic structure of a strong economy, it is not surprising that America’s ability to produce goods and services has been disappointing in the 1980s. Worse still, US productivity has flagged despite the fact that some of the other forces that typically affect business performance have improved. Today workers, on average, are older and more experienced than they were in the 1970s. Business has spent more on research and development. Most of the investment needed to meet environmental regulations is already in place, and energy prices have fallen.

But the weakness of business investment has overwhelmed these favorable developments. There has been no significant increase during the 1980s in the amount of capital at the disposal of the average American worker. Since 1979, the last year of full employment before the two business recessions that began this decade, our overall growth in productivity has therefore averaged only 1.1 percent per year. (In July the Commerce Department reported that US business productivity declined in the most recent quarter.) If productivity continues to grow at this pace, America will, at best, be able to do no more than pay the interest on its mounting foreign debt, leaving no margin to provide for increases in the standard of living. The further need to devote some 3 percent of national income merely to balance US export-import accounts will therefore have to come out of incomes that are already stagnating.

The spreading awareness that our current prosperity is hollow, and that we will have to accept a lower standard of living in the future than what we otherwise could have expected, is probably one cause of heightened fears of recession. But while a recession is certainly one way for an economy to adjust to a lower standard of living, it is not the only way. A decline in economic well-being can also take place more gradually, and, in a relative sense, that is what has already begun to happen. The current business expansion is the first since the 1930s in which the average working American has not enjoyed a sustained increase in earnings, after taking account of inflation. In 1983, the average worker in American business earned $281 a week. The average weekly paycheck this year, in 1983 dollars, is just $276. Nations can lose economic ground abruptly, as happens in a recession, but they can also decline over much longer periods of time merely by achieving less growth than they might otherwise have achieved. For this reason, the current intense concern with a possible recession in 1989 is misplaced.

Indeed, the political campaign would be far more likely to address the real issues at stake if an impending economic cataclysm really did seem likely. The American political system has always been best at responding to crises. During the weeks when it looked as if last October’s stock market crash might be just such a crisis, prospects that the government might actually do something about the policies promoting systematic over-consumption temporarily brightened—only to fade as the fears themselves faded. Defenders of these policies have argued that overconsumption in the US has had no serious implications, and will have none in the future, precisely on the grounds that there are no tangible, readily visible, adverse consequences to which one can point.

This argument is wrong, because it ignores the devastation of our agricultural sector and the failure of many of our key manufacturing industries—autos, steel, electric machinery—to compete internationally in the years when the US government’s borrowing drove interest rates here above those abroad, and therefore made dollar investments so attractive that the dollar became heavily overvalued. It also ignores the continuing loss of sales by other US industries to countries whose production costs are low. But in fact the more important costs of our current policy are not dramatic and obvious, but subtle and gradually corrosive.

To persist in our present economic policy is to risk the material basis for the progress that has marked Americans’ perceptions of themselves and their society since its very beginnings. What will America be like—what will Americans be like—without the fact, and consequently the idea, of progress? How long will it take before the rigidity, complacency, and mediocrity characteristic of economically stagnant societies set in? We simply do not know. But although it is hard to believe that anyone wants to stay on our current course in order to find out, neither Mr. Bush nor Mr. Dukakis has pointed a clear alternative. What Americans should have learned since 1980—but neither Mr. Bush nor Mr. Dukakis is willing to acknowledge—is that being in favor of saving and investment, or more effort at work, or competitiveness, is not the same as actually advancing these objectives. What is necessary is new policies.


The second and even more worrisome cost of our current economic policy is that it has sacrificed part of America’s sovereignty. The great sums we have borrowed to finance our overconsumption have included large amounts borrowed from abroad. With government borrowing absorbing nearly three fourths of our private saving since 1980, heightened competition among business and individual borrowers for the remainder has raised our interest rates, compared to inflation, to record levels, well above what investors could get in other countries. From 1981 to 1984, interest rates in the US averaged more than 2 percent above what they were abroad, after allowing for different countries’ inflation rates. For nearly half a decade, therefore, the dollar became more and more expensive in relation to other countries’ currencies, as foreign investors competed among themselves to acquire dollars with which to buy high-interest US bonds and other dollar IOUs. As the dollar rose, the ability of our industries to compete with foreign producers all but collapsed, not only in world markets but here in America too.

With the dollar so overvalued, we therefore increased what we consumed faster than what we produced, not only because we failed to invest adequately in new productive capacity at home but because we increasingly used our over-valued dollars to import more than we exported. The $25 billion gap in merchandise trade between US exports and US imports in 1980, considered a major problem at the end of the Carter administration, grew to $161 billion in 1987. As we paid for this growing excess of imports over exports, we sent more and more dollars abroad. Foreigners then invested these funds in our financial markets. Indeed, because so little of what Americans save is left over after the government has financed its deficit, this reinvestment of our own dollars by foreign lenders now accounts for most of the inadequate supply of capital that American business has available for investment. In 1987 the total amount that American businesses invested in new plant and equipment, beyond the mere replacement of worn-out facilities, was $75 billion. The net flow of funds into the US from abroad, available for business investment and other purposes, was more than $160 billion.

Failure to understand the direct correspondence between the dollars we send abroad to pay for each year’s excess of imports over exports and the dollars that foreigners accumulate each year has frequently led to discussion of these issues as if they were separate. In fact, they are the same. Most recently, for example, there has been much ill-founded talk about what would happen if foreign investors decided to “pull out” of our financial markets. But as long as we continue to import more than we export, all foreign investors together will necessarily increase still further the amount of dollars they own, as they receive additional dollars in payment for what we buy from them.

Some foreigners may sell their holdings and, in so doing, drive dollar exchange rates lower, as they did during 1986 and 1987. This possibility is hardly a matter of indifference. A cheaper dollar boosts the competitiveness of American industry, yet, at the same time, risks our hard-won but fragile victory over inflation. But when foreigners do sell their dollar holdings, it is only to other foreigners (unless Americans are, just then, selling some of the foreign currencies that they hold). Foreigners in the aggregate can reduce their holdings of dollars only if the United States runs an overall export-import surplus—not just in goods but also in services and earnings on foreign assets.

As our trade deficit continued to grow throughout the 1980s, the great accumulation of dollars in foreign hands increasingly saturated the foreign appetite for dollar-denominated assets. The waves of selling that drove the dollar down in 1986 and 1987 had to come sooner or later. By now, after its most recent rise, which began in April, the dollar is about back to where it was in 1981.

With the dollar cheap again, our trade deficit has already begun to shrink. But the improvement so far has been modest, and there is no assurance that the dollar has yet reached a level low enough to balance our export-import account. Even if it has, a significant change will take time, in large part because we have underinvested in our economy as a whole and especially in industries like manufacturing that compete against foreign producers. As recently as 1986, total US investment in manufacturing was only 1 percent above what it had been in recession-depressed 1982. A cheaper dollar by itself is not enough. Our industries must also have the capacity to produce enough of what people here and abroad want to buy.

Even more important, as a result of our excessive borrowing we have, within less than a decade, dissipated our net international holdings and run up the world’s largest net debt to foreign creditors—$368 billion as of the end of 1987, and probably more like half a trillion dollars by next inauguration day. Now, therefore, we have not one debt problem but two: the debt that our government owes as a result of borrowing to finance its string of record budget deficits, and the debt that we as a nation owe as a result of borrowing from abroad to finance our string of record trade deficits. Even on the most optimistic projections, our debt owed abroad (over and above what foreigners owe us) will continue to grow in relation to our income for several more years. We will reach a ratio of net foreign debt to national income of about 15 percent, a ratio comparable to that of many of today’s hard-pressed developing countries. If instead we allow our net foreign debt to continue to grow at this rate until the mid-1990s, our net debt to income ratio then will be more like 25 percent, roughly equal to what Brazil’s is today.

One grave implication of America’s becoming a debtor nation is simply our loss of control over our own economic policies. Losing control over one’s affairs is, after all, what being in debt is all about—no less for a nation than for an individual or a business. Foreign investors who may become nervous about holding US bank deposits and US Treasury securities are free to buy up US businesses and US real estate instead. They are already doing so in increasing volume, and, given the vast amounts of dollars held abroad, it is clear that the process has only begun.

World power and influence have historically accrued to creditor countries. It is not coincidental that America emerged as a world power simultaneously with its transition from a debtor nation, dependent on foreign capital for its initial industrialization, to a creditor supplying investment capital to the rest of the world. But we are now a debtor again, and our future role in world affairs is in question. That role will gradually shift to Japan and Germany, or still other new creditor countries that are able to supply resources where we cannot, and America’s influence over nations and events will ebb. Watching US economic power shift to these new creditors as they begin to deal with the developing world’s debt, for example, or step in to prevent a “dollar crisis”—in both cases presumably in ways that promote their own commercial or diplomatic advantage—is merely the price America will have to pay for the fiscal policy we have pursued throughout the 1980s.

Most Americans continue to think of themselves as creditors, and they readily offer unsolicited advice to other debtor countries, as if these countries had fallen into a trap that the US had successfully avoided. Meanwhile, the Japanese and Germans still appear to think of themselves as debtors. But attitudes toward world leadership will change soon enough, as America’s financial problems circumscribe its scope for maneuver in world affairs while the new creditors’ financial strength does the opposite. Just how large a departure from recent history the resulting new international arrangements will represent depends in part on whether, and how, we change our economic policy.


What should Mr. Bush and Mr. Dukakis be saying about all this? What would amount to a responsible approach to these pressing problems if either of them were bold and open enough to propose it?

No change of policy, economic or other, can now neatly restore the damage already done by the policy we have pursued in the 1980s. The assets we have dissipated are gone. The debts we have incurred are real. The full impact of these new economic facts has not yet reduced our living standards, because the excess of US consumption over US income that this policy has fostered is still underway. But this cannot go on forever, because the burdens of both domestic and foreign debts will continue to mount until, as many developing countries have found, no one is willing to hold either.

To limit the damage means, in the first place, not committing so much of US private saving, and foreign borrowing, to finance the federal deficit. Even so, there is nothing magic about balancing the budget. There are times when a deficit is more appropriate to the nation’s economic needs, especially when those needs may be central to developing productive capacity. Moreover, simply matching government income and expenditure makes even less sense when accounts are as crudely and arbitrarily measured as the US government’s.1

The best measure of a government’s fiscal position, over long periods, is the rise or fall of its debt compared to national income—that is, the total value of all the goods and services that the country produces. The amount of government debt outstanding at any time is the accumulation of all budget deficits the government has run over its entire history, reduced by all of its surpluses. There is no reason that any government would ever need, or even want, to repay its entire outstanding debt in a single year, and no government of any major country has ever done so. But the size of government debt in relation to the national income—how much of that income it would take to pay off the debt if the government ever chose to do so—is the surest gauge of how indebted a government has become. More important, changes in government debt in relation to the country’s income from year to year or even from decade to decade—in other words, movements of the government debt ratio over time—give the best single measure of how its fiscal situation is evolving.

Throughout two centuries of America’s peacetime experience—until the 1980s—our federal debt was almost always declining in relation to our national income. The ratio of federal debt to income rose, sometimes sharply, in each of the wars we have fought. But once each war ended, the nation returned to repaying that debt, if not through outright budget surpluses then at least in the economic sense that if the debt rose at all, it rose less rapidly than income. The only exception was in the early 1930s, at the bottom of the Depression.

The entire federal debt outstanding as of December 1980, accumulated since the founding of the Republic, was not quite three quarters of a trillion dollars. In an economy that was then producing nearly $3 trillion each year, it would have taken twenty-six cents out of each dollar of income to pay that debt off completely—exactly the same share as in 1920, or, for that matter, in the 1870s. That the United States entered the 1980s with precisely the same ratio of government debt to national income that it had at the beginning of the 1920s, despite the Great Depression and the cost of World War II along the way, testifies to the remarkable steadiness of the traditional American commitment to making each generation pay its own way. From $1.14 per dollar of national income in 1946, the federal debt fell to eighty-two cents per dollar in 1950, forty-seven cents in 1960, and twenty-nine cents in 1970. By 1980 it went down to twenty-six cents. But by the end of 1987 the debt rose to forty-two cents for every dollar of US income, and by January 1989 it will probably be forty-three cents per dollar.

The guiding aim of American fiscal policy in the aftermath of the Reagan years should be to reverse the direction of the federal debt so that it is declining compared to the nation’s income—and to do so without inflation. A declining ratio of debt to income will mark a return to the traditional US fiscal position. The 1980s will then have been a highly costly, one-time aberration. The nation will no longer be following a policy that is obviously unstable in the long run, and that is currently imposing a growing mortgage against future American living standards.

A sensible and cautious strategy for the next eight years should aim to reduce the debt ratio at about half the pace at which it has risen between 1980 and 1988, so that by 1996 the federal debt will be no more than thirty-four cents for every dollar of national income. Because incomes will continue to grow in real terms, and because there will inevitably be some modest inflation, meeting this target does not mean eliminating budget deficits altogether. But it does mean bringing federal revenues and expenditures closer into line—much closer into line—than under President Reagan. If growth of national income during this period continues to average 2.4 percent per year after inflation (as during 1980–1987), while inflation runs at 3.3 percent per year (the average since our unacceptably high inflation ended in 1982), total annual income will reach approximately $7.6 trillion by 1996. Debt equal to thirty-four cents per dollar of income would amount to approximately $2.6 trillion at the end of 1996—compared to a likely debt outstanding (not counting what the government owes to itself) of some $2.1 trillion at the end of 1988. To reach a debt ratio of thirty-four cents to the dollar by 1996 therefore means limiting the growth of the federal debt to $500 billion over eight years, and the average annual budget deficit in those years to approximately $60 billion. Moreover, in estimating these amounts, we should not take into account the surpluses—almost $40 billion this year, more like $50 billion next year, and still larger in the 1990s—currently accruing in the Social Security trust fund.2

We must therefore narrow the deficit by about $125 billion from its current level of approximately $190 billion, excluding the Social Security surplus. Not by 1996, nor at some unspecified date to be determined, but now, beginning in fiscal year 1989. And we must achieve this goal not by accounting illusions, or by measures like sales of government-owned assets (which absorb saving just as if they were sales of Treasury bonds), but by deficit reduction measures that are both genuine and lasting. The sticking point for both Mr. Bush and Mr. Dukakis is that this means spending less or taxing more.

At the same time, it would make no sense to adopt a new policy that would achieve fiscal stability but would drive business into recession along the way. Too much has been made of the specter of recession, but it is not irrelevant either. Reduced spending and higher taxes will serve no purpose if they induce a slump that lowers revenues and raises expenditures by so much that the deficit instead actually widens. The point of correcting our fiscal trajectory in the first place is to achieve a satisfactory and rising standard of living, now and in the future. Though sacrifices are inevitable, they should be kept to a minimum.

Despite the generally loose historical connection between fiscal policy and recessions, there are good reasons to be cautious about carrying out a new fiscal policy now. One is simply the size of the adjustment required. Since World War II we have experienced only two fiscal swings on a scale comparable to reducing today’s deficit by as much as $125 billion, in 1960 and 1969, and both were followed by mild business downturns. In addition, the international economic environment is now unusually precarious. Many developing countries are already at the brink of economic collapse, and it remains to be seen how the world’s major exporters will act to protect their industries now that the dollar, despite its recent strength, is nearly 40 percent cheaper than it was three years ago.

Moreover, because in America not just government but businesses and individuals as well have borrowed at an extraordinary pace during the 1980s, our economy’s financial structure is now more fragile than at any time since World War II. The problem is most acute in the corporate business sector, where throughout the 1980s firms have borrowed in record volume, not for the most part to build new assets but merely to substitute debt for equity in their capital structures. As a result, servicing debt is now a major burden for many corporations. On average during the 1950s and 1960s, interest payments took only 16 percent of total corporate earnings. On average during the 1970s, interest claimed 33 percent of earnings. But in each year during the 1980s, American business corporations have needed more than 50 percent of available earnings just to pay the interest they owe to banks, holders of their corporate bonds, and other creditors. If a recession were now to shrink earnings, many firms would be unable to meet their obligations.

The US should therefore change its fiscal policy only in conjunction with a significant shift in its monetary policy that would lower interest rates, making it cheaper to borrow money for investment. After all, our problem since the end of the 1981–1982 recession is not that the overall level of economic stimulus from fiscal and monetary policies together has been inappropriate. Business recovered sharply after the recession, and then settled into a modest expansion that by the end of 1987 had continued longer than any other cyclical upswing since the Vietnam War. The problem is that the composition of our economic activity has been wrong, with too much consumption and too little investment, too many imports and too few exports. The United States has urgent need to correct these imbalances, but there is no reason to slow the pace at which our economy is growing overall.

An easier monetary policy is therefore a necessary counterpart to our return to a responsible fiscal policy. Just as it is wrong to think that the business expansion since 1982 could not have happened without the huge federal deficit to fuel it, it is also wrong to think that even a large deficit reduction program enacted now will necessarily throw that expansion into reverse. If federal spending and revenues had been more nearly in balance as we neared full employment of our resources in the mid 1980s, the Federal Reserve System could have—and, to judge from Paul Volcker’s repeated comments, would have—run an easier monetary policy, so as to lower interest rates. And we could make just such a change in monetary policy now, as we shift to a new fiscal policy. Indeed, because monetary policy influences economic activity mostly in ways that are less direct than changes in taxes and government spending, it would be prudent to adopt an easier monetary policy in advance of the transition to a new fiscal policy.

But to ease monetary policy first, in order to reduce the risk of an economic downturn, obviously risks overstimulating the economy, and hence increasing inflation, if fiscal policy is in fact going to remain on the highly expansionary course that has characterized the Reagan years. The way to avoid that risk is for Congress to legislate a new fiscal policy promptly and at least partly in advance of its becoming effective. Here the Kemp-Roth tax cut—the real root of so much of our present difficulty—provides a useful model in reverse, both for cutting spending and for raising taxes. Enacted in August 1981, the Economic Recovery Tax Act lowered personal tax rates by 5 percent in September 1981, then by another 10 percent in July 1982, and finally by yet another 10 percent in July 1983. If the new administration spreads the fiscal changes that we now need over two years—by having spending cuts partly take effect during the 1989 fiscal year and partly during fiscal 1990, and having tax increases take effect partly in the 1989 calendar year and partly in 1990—it would give the Federal Reserve the assurance it needs to ease monetary policy ahead of time.

What is essential in such an undertaking, however, is that the shift to a new fiscal policy, on whatever schedule it is carried out, should be visibly firm and therefore credible. Legislated promises to find spending cuts or perhaps even tax increases in the future—the stuff of this year’s campaign—will not do.


To nobody’s surprise, both parties’ platforms give the impression of calling for just such a rebalancing of our fiscal and monetary policies. But on closer examination, these statements consist mostly of empty rhetoric, devoid of actual plans. The Republican platform, noting “the relentless spending of congressional Democrats,” says that “with the help of the Gramm-Rudman Law and a flexible budget freeze, a balanced budget can be expected by 1993.” The lack of specifics echoes Mr. Reagan’s initial promise to balance the budget by 1983.

The Democratic platform, reacting to “seven years” of “fiscal irresponsibility,” says that “reducing the deficit requires that the wealthy and corporations pay their fair share and that we restrain Pentagon spending.” But this platform gives no hint of what that fair share is, and the further discussion of defense also lacks specific recommendations that can be translated into budget savings.

At the same time, both Mr. Bush and Mr. Dukakis have presented their respective lists of new government initiatives for the 1990s—investment in our long-neglected infrastructure, including roads and water supplies, improved education and training, expanded research, a better system of child care to help working mothers, a more comprehensive campaign against drugs, and a more energetic attack on AIDS—all worthy proposals. But they will all cost money, and make it even more difficult to trim as much as $125 billion from the government’s annual deficit. Nor will continuing economic growth provide the tax revenues to do the job, any more than it has under Mr. Reagan.

The new president will therefore have to continue the search for ways to cut government spending, which has now dominated our fiscal agenda for the better part of a decade. The government undoubtedly provides many services that are not worth what they cost, and perhaps even some that benefit no one other than the employees paid to provide them. There are serious questions about how much defense is enough, how generously to support our retirees, and what responsibilities families ought to shoulder on their own when someone becomes ill. Just last March, for example, the Congressional Budget Office filed a 374-page report describing over a hundred possible cuts in federal spending, ranging from such small items as saving $50 million per year by reducing the student loan interest subsidy to saving $10 billion per year by limiting each year’s cost-of-living increase in Social Security to two thirds of the percentage rise in consumer prices, instead of the entire rise. To whatever extent it is politically possible—and here leadership by whoever becomes president will be crucial—cuts in spending should make up part of the necessary reduction of the annual deficit by as much as $125 billion.

It is highly doubtful, however, that such cuts will actually amount to all, or even half, of what is needed. In fiscal 1987, the federal government spent $1,005 billion. Of that, 73 percent went for defense, Social Security, Medicare and Medicaid, and interest on the national debt. The remaining 27 percent paid for everything else—federal law enforcement, the courts, our embassies abroad, the immigration authority, tax collection, highway construction, the space program, the national parks, disaster relief, public health, public housing, veterans’ benefits, federal civilian and military retirement pensions, child nutrition, all aid to education, all farm supports, all welfare payments, all aid to state and local governments, all foreign aid, the entire cost of paying federal employees’ salaries, and administering all federal programs.

The relevant question is not whether it is possible to identify further potential reductions in non-defense spending, or economies in providing for our defense. There is no lack of possibilities. The real question, which should be under debate in the presidential election, is whether Americans actually want to make these potential cuts. The standard political rhetoric of the 1980s, including this year’s campaign, repeatedly asserts that a consensus for such cuts exists. But the experience of the 1980s—including the actions both of President Reagan and of the Congress, and within Congress of both Democrats and Republicans—suggests that it does not. We can all identify plenty of government programs that are of no interest to us individually. But most of government spending pays for activities, like defense and Social Security, that are supported by a large percentage of Americans. The makings of a consensus for major reductions simply are not there. And neither candidate seems interested in creating one.

This failure of leadership is not new. It would be foolish to pretend that further cuts in federal spending are impossible, but it would be even more foolish to pretend that there has been any major disagreement between President Reagan and Congress over the total amount, in contrast to the composition, of federal spending in the 1980s. On average, between 1982 and 1987, the savings made by Congress on the defense spending Mr. Reagan had proposed came fairly close to offsetting the excess it voted for in non-defense programs. The result was that total government outlays for all purposes other than interest on the national debt were only $15 billion per year more than what Mr. Reagan requested. But the deficit during those six years averaged $184 billion anyway, mostly as a result of sharply reduced government revenues produced by the Kemp-Roth tax cut. The search for spending cuts, ever since 1981, has amounted to an experiment to learn whether Americans want to reduce government activity to a level consistent with post–Kemp-Roth revenues. Thus far they do not.

There is nothing inherently “wrong” with this answer. The United States is surely rich enough to devote 6 percent of its national income to defense, and another 3 percent to other services provided directly by the federal government, if its citizens want. It can also afford to redistribute 11 percent of its national income through Social Security, Medicare and Medicaid, and other transfer programs. America remains a strong and well-to-do country, able to afford its current level of government if that is what its citizens choose. When we compare America to other major industrialized countries, what stands out is not how large US government expenditures are but how small.

The Reagan administration’s rhetoric demanding a consensus for sharply lower spending in relation to national income has been based largely on myths. When most of the budget pays for defense and the livelihood of retired people, it is pointless to pretend that public spending is an embarrassment consisting only of welfare and waste. Nor is it constructive to talk about “spending,” as President Reagan often does, as if military hardware were donated free of charge and Defense Department employees served as unpaid volunteers. It makes no sense to pursue a policy that expands the national debt and also raises real interest rates, and then complain, as several speakers at both parties’ conventions did, that government spending including interest is higher compared to national income than it used to be.

To seek a consensus in favor of significantly lower spending, on the deceptive claim that much of current spending pays for activities that nobody wants, is bound to be futile. If we continue to delude ourselves in this way, searching for a consensus that is not there while ignoring the real source of our fiscal imbalance and excluding other ways to address it, the damage from current national economic policy will only worsen. But neither Bush nor Dukakis has shown much interest in stopping it.

It is easy to see the political reasons. Ronald Reagan’s big victories in 1980 and 1984 dramatically demonstrated the appeal of the attractive but faulty logic underlying this policy. After all, no one asked Americans to vote for tripling the national debt, or diverting their savings away from productive investment, or turning the United States into the world’s largest debtor, all within less than a decade. Instead, Reagan was explicit and emphatic, both as a candidate and then as president, that his policy would balance the budget.

The essence of the “supply-side” argument that Reagan advanced is that the incentive effects of across-the-board cuts in personal tax rates would so stimulate individuals’ desire to work, and so sharply increase the amount of after-tax earnings available for business investment, and the rewards for investing, that lower tax rates would lead to a permanently higher level of economic activity and therefore produce higher tax revenues. Lower tax rates, according to this notion, would help balance the federal budget despite sharp increases in military spending, and without requiring cuts in the non-defense programs that people genuinely valued. Americans could therefore enjoy both continued government spending and lower tax rates too—a combination most Americans once regarded as irresponsible.

But is it realistic to suppose that American voters really believed this fairy tale just because Ronald Reagan asked them to? Few who examined the available evidence in 1980 would have made or accepted such a claim, and there was surely no lack of opponents—including Mr. Bush, who proclaimed it “voodoo economics”—who bluntly said Mr. Reagan’s promises made no sense.

One possibility is that the architects of the new fiscal policy genuinely believed the claims they made for it, and that widespread economic frustration on the part of the public—tapped by Reagan’s startling question of 1980, “Are you better off than you were four years ago?,” which neither Bush nor Dukakis has been able to match—was sufficient to induce many voters, if not entirely to believe, then at least to suspend their disbelief. But if the ready acceptance by the voters of the supply-side promise contained at least some element of self-deception, it is also possible that the claims offered on behalf of the new fiscal policy were disingenuous in the first place. The most charitable defense of the policy is that it vastly overestimated the incentive effects of lower tax rates while vastly underestimating Americans’ commitment to the activities government undertakes. A darker assessment is that its hidden purpose was, as David Stockman suggested, for example, to mortgage the nation’s future as a means of forcing Americans to give up government activities that they would otherwise have been able to afford.

In other words, the policy of running up ever larger deficits and government debt, with whatever costs have occurred and are still to follow, may not have been simply a failure of economic thinking but a way to force a reduction of the government’s role in American life. And, further, the economic costs of this subterfuge may not have been a surprise, but the inevitable and foreseen byproducts of a more important campaign in which the issue at stake was not economic well-being as much as the future character of American life, and in which our economic prospects (not to mention the government’s fiscal position) were merely a hostage to the larger purpose of permanently reducing the capacity of government to intervene in American life.

It would be sad—far worse than sad—if that were so. A policy that intentionally and deceitfully provides too little tax revenues to pay for the costs of government, as determined by the voters, while accumulating ever greater debt both at home and abroad, would amount to willful bankruptcy: the deliberate curtailment of the nation’s economic growth in order to preclude the next generation of Americans from using government for social purposes.

We shall probably never know which of these alternative accounts of the origins of the Reagan fiscal policy better describes what really happened. Was it an intellectual error of the first magnitude or deliberate moral irresponsibility? From the perspective of where to go from here, however, just what combination of forces was at work nearly a decade ago hardly matters. The eight-year experiment to find out whether Americans want significantly less of what their government spends money to provide has gone on long enough, and it has already been far too costly. Americans want a level of government activity much like what they now have, and they can afford it. The question is how to pay for it.


In the face of President Reagan’s opposition to outright tax increases, Congress for the last half-decade has limited itself to what it calls “revenue enhancement.” The Deficit Reduction Act of 1984 increased revenues by an average of $15 billion per year in the 1985 and 1986 fiscal years, through mostly trivial measures such as delaying the scheduled elimination of the 3 percent telephone excise tax, canceling the $100 per person net interest exclusion from individual income tax liability, and increasing from 15 to 18 years the time over which businesses could depreciate real property. The bi-partisan budget compromise reached after the October 1987 stock market crash raised revenues for the 1988 fiscal year by $9 billion through such measures as accelerated corporate tax payments and yet another delay in eliminating the telephone excise tax. These actions have hardly exhausted the possible ways to obtain small-scale increases in revenues, as the renewed discussion of such familiar potential targets as whiskey, cigarettes, and oil imports demonstrates.

But pretending that such measures, or spending cuts, or even both together, can go far toward cutting the deficit by as much as $125 billion is a sure way to repeat the costly errors of the past seven years. Unless Bush or Dukakis can promote a consensus for a significant reduction in spending, something that neither of them has yet begun to do, we will need a tax increase—not a miscellaneous collection of small nuisance taxes, or a series of increases disguised so that the average citizen never quite knows what he is paying. And we certainly do not want an increase in taxation through inflation, which would erode the value of the government’s debt but at the cost of eroding the wealth of those citizens who live on fixed incomes, thereby making it the must subtle hidden tax of all. The United States will need a tax increase that is plainly in view and comprehensible to everyone.

A tax increase of, say, $50 billion or more per year will have major economic consequences, even in a $5 trillion economy. This is why a significant easing of monetary policy by the Federal Reserve is needed in advance of a tax increase, to prevent a recession. Beyond that, some taxes are better than others. Just as it will be counterproductive to cut spending by reducing still further our already shrunken investment in our basic infrastructure, or by failing to educate tomorrow’s labor force, to raise taxes in ways that discourage investment in new plant and equipment will also miss the point. So will raising taxes that discourage exports. So will raising taxes that discourage saving, and encourage Americans to consume still more of their incomes or go further into debt. For the size tax increase that the country needs, the kind of tax increase we choose is not trivial.

From a purely economic perspective, the best choice would probably be an entirely new tax: on spending for personal consumption. By redesigning the tax form so that the bottom line figure on which tax is paid is what people spend, not what they earn, a consumption tax would avoid even the small negative effect that an increase in income taxes could have on people’s desire to work. And because it would shield from taxes the part of their incomes that people save, a consumption tax would also not discourage saving. Although many people fear a consumption tax on the grounds that it might fall disproportionately on low- and middle-income families (which typically spend most of what they make), a consumption tax need not be regressive in this way. A well-designed combination of tax rates and family exemptions can easily make a consumption tax as progressive as an income tax. If spending of $2,500 per person is made exempt from the tax altogether, the remaining amount of consumption would be so large that with a 2.25 percent tax rate a consumption tax would raise approximately $75 billion per year in additional revenue, on average, during 1989–1996—more than half of the deficit reduction we need. With the same $2,500 per person exemption, a progressive rate structure, ranging from 1 percent for people who consume very little to 4 percent for those at the top, would do the same.

Closely related to the consumption tax, and sharing most of its virtues and perhaps more acceptable politically, is the value added tax (in different variants sometimes called a business transfer tax, or even a national sales tax). Unlike a consumption tax, which people would calculate and pay as they now do their income tax, a VAT is paid by purchasers every time a good or service is sold. Because purchases of inputs used in production are exempted, as are purchases for export, in the end the VAT amounts to a form of consumption tax. Like a consumption tax, therefore, it would not discourage the desire to work, invest, or save, nor need it fall disproportionately on low-income families. With exemptions or refundable credits, or both, a VAT can also be as progressive as desired. And because it is collected as if it were a sales tax, a VAT would be easier to administer than a consumption tax. A 6 percent VAT, with all food, housing, and medical care specifically exempted, would raise approximately $75 billion per year. Without the exemptions, a 3 percent VAT would do the same.

Unfortunately, the lengthy debate that culminated in passage of the so-called Tax Reform Act of 1986 promoted the illusion that such different approaches to taxation had been seriously considered, and so Americans may now be unwilling to accept an entirely new tax: a pity since most of the “reforms” adopted in the 1986 law will impede rather than promote our efforts to invest and become competitive. More important, the entire effort missed the chance to shift more of the burden of the tax system from income toward consumption. Introducing a consumption tax or even a VAT would still be economically sensible. But by now many Americans consider the structure of the tax system a settled issue. Where, then, can we raise another $50 billion per year or more to pay for what we expect our government to provide?

President Reagan’s new fiscal policy began with the Kemp-Roth tax cut of 1981, which reduced rates for all tax-payers in three stages. Personal income tax payments were reduced by $387 billion from 1982 through 1986 (by $110 billion in 1986 alone) compared to what the government would otherwise have received at prevailing income levels. Other provisions of the 1981 tax bill, including especially the indexing of tax brackets for inflation beginning in 1985, reduced individuals’ income tax payments by another $110 billion during 1982–1986 ($44 billion in 1986). The economic stimulus that these huge tax cuts provided presumably made up for part of the revenue loss—but surely no more than one third of it, and far less by 1986, when the economy had fully recovered from the 1981–1982 recession.

If such measures as a consumption tax or a VAT prove politically unacceptable, then the way to change US fiscal policy that is most likely to promote public understanding and thereby command public support is to admit that the Reagan administration cut taxes too much and fix its mistake. In contrast to the supply-side argument, a realistic assessment is that the across-the-board cuts in individual income tax rates enacted in 1981 have had an almost negligible effect on how hard people work, and none at all on saving. Investment and productivity growth have suffered already and will continue to do so without adequate revenues to pay the government’s bills. When there is no evidence that even large across-the-board cuts in personal tax rates have done anything more than finance high consumption, it is foolish to go on pretending that a small increase in tax rates would only stifle incentives.

After subtracting all exemptions and deductions, personal incomes are now taxed at 15 percent for the first $17,850 ($29,750 for joint returns), and 28 percent above that level. Simply raising the new system’s two basic rates from 15 percent to 18 percent, and from 28 percent to 31 percent, while maintaining all other features of the new tax code as they are now, would raise approximately $75 billion per year in additional revenues. Although this three-percentage-point increase would raise a large amount of additional revenue, its effects on most individuals and families would be modest. Nor is there evidence to suggest that a difference of three percentage points in tax rates would noticeably affect economic incentives. A family of four, earning the nationwide average income of $28,000 and claiming only its four personal exemptions and the standard deduction, would end up paying $2,700 in federal tax instead of $2,250. A comparable family earning only half the average income would pay $180 instead of $150. A family earning twice the average income would pay $9,462 instead of $8,172. More complicated schemes could, of course, make the tax increase more progressive (or less) by revising the new rate structure instead of simply changing by equal amounts the two key rates put in place under the 1986 tax reform.

Nobody enjoys paying more taxes, but once we accept the sorry fact that Mr. Reagan’s promise in 1980 of tax cuts without matching spending cuts was empty, an extra $450 for the average family—or $1,290 for families with twice the average income and only $30 for those with only half the average—is the price that must be paid if we want to continue to receive what our government now provides. It is certainly not excessive compared to the consequences—economic, social, political, and international—of continuing indefinitely along our currently unbalanced fiscal path.

America faces difficult economic choices. We may have to cancel some domestic programs, make Social Security or Medicare less generous, spend less on defense, pay higher taxes. Whichever we choose, we will have to make real sacrifices.

If the public is to accept this, citizens must not only understand why such steps are necessary but also see that they are fair in how they affect different groups. Whether we cut spending by shutting down military bases, or letting inflation erode retirees’ incomes, or paying government employees lower salaries, or by eliminating food stamps or farm price supports altogether, will make little difference so far as the functioning of the economy is concerned. But it will powerfully affect the people who make the sacrifices. How to raise taxes is less important for the economy as a whole than whether to raise taxes at all. But because there will be no public support for a tax increase that Americans think is unfair, in the end the form a proposed tax increase takes will determine whether we increase taxes at all. That is why we need the leadership and direction from Mr. Bush or Mr. Dukakis that they have so far failed to provide.

In his first budget address to Congress, as America’s new president in February 1981, Ronald Reagan asked of those whom he identified with the tax-and-spend strategy of the past, “Are they suggesting that we can continue on the present course without coming to a day of reckoning?” The irony is that the right answer would have been “yes” in 1981 but it is surely “no” seven years later. The old policy of tax-and-spend, as the President derisively labeled it, resulted in budgets that were nearly balanced by today’s standards. More important, apart from the expense of wars, the policies of all presidents since the founding of the Republic always reduced federal debt in relation to America’s growing income. The Reagan policy of large tax cuts not matched by spending cuts has instead produced record deficits, and debt that is rising compared to national income. As a result, our investment in domestic capital has been eroded, and for a while our international competitiveness all but collapsed.

Without economic growth, American society will ultimately lose its dynamic sense of progress, its capacity to accommodate the aims of diverse groups within the population, its ability to offer its citizens remarkable social mobility and individual opportunity. Without a strong and competitive economy, America as a nation will watch others take its place in the world order. These are the real costs of our current fiscal policy, though for the most part they will not even be perceptible from one year to the next.

This is why it is wrong for Mr. Bush and Mr. Dukakis to think that they can genuinely address issues of moral values while they duck the hard economic choices. If we do not correct America’s fiscal course, our children and our children’s children will have the right to hold us responsible. The saddest outcome of all would be for America’s decline to go on, but to go on so gradually that, by the time the members of the next generation are old enough to begin asking who was responsible for their diminished circumstances, they will not even know what they have lost.

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    For example, the budget systematically understates costs by failing to acknowledge the government’s growing liabilities for future payments of pensions to federal civilian employees and military personnel. At the same time, the budget systematically overstates costs by including all interest that the Treasury pays on its outstanding securities while failing to allow for the fact that, with inflation, part of the interest payment is really a repayment of the lender’s principal. There is no reason to think that these omissions—and many more besides—simply offset one another.

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    To do so would defeat the purpose for which Social Security contribution rates were raised in 1983, namely to enable the Social Security system to deal with the burdens it will face early in the next century. The aging of the postwar baby boom generation will sharply raise the number of retirees receiving benefits compared to the number of workers making contributions. Without these surpluses now, there will be no choice but to raise payroll taxes for that era’s workers to unacceptably high levels, or reduce benefits sharply—just the outcomes that the 1983 legislation was intended to avoid. The target of $2.6 trillion of federal debt outstanding as of the end of 1996 should therefore include whatever amount of federal debt the Social Security fund may accumulate, and the target $60 billion average annual deficit during 1989–1996 should include whatever part of each year’s deficit the Social Security surplus may appear on paper to offset.