Economics as public policy

EFFECTIVE ECONOMIC POLICY must go beyond conventional monetary and fiscal measures, important though they are. We need to eliminate the structural defects that depress productive capacity and productivity. These structural barriers interfere with maintaining a pace of economic expansion that is more rapid and durable than today's experience. Many of these defects arise from the operation of Federal government policies and programs. Let us focus initially on two major categories: the composition of government spending and the structure of taxation. Reforms in these groupings can further more fundamental economic objectives.

Five guidelines can be helpful for changing the composition of government spending: focus budget cuts on reducing the large consumption part of the budget rather than on the small investment portion; target subsidy programs that benefit limited groups; avoid spending programs that merely offset problems caused by regulation (reform regulation directly); privatize activities that are properly the responsibility of the private sector; and use economic efficiency considerations more widely.

The array of government programs that affect the economy is staggering--and a basis for serious budget cutting. Concerning privately produced goods and services, the government is a major buyer, significant seller, and potential competitor. Literally, the Feds giveth and the Feds taketh away. Government is a powerful regulator, but it also subsidizes private business in a great variety of ways--making direct expenditures, providing credit, furnishing facilities, and offering numerous tax loopholes.

Moreover, government can encourage technical programs and innovation in numerous ways. Most Federal expenditures for research and development are not motivated by the desire to promote R&D per se. Rather, they are designed to support a specific program objective, which may or may not have a high technology content--national defense, space exploration, health, agriculture, etc. All of the expenditure approaches possess a basic shortcoming: the government selects the firms to do the R&D and the specific fields to which the funds are to be devoted. In contrast, a tax incentive for business firms to finance and perform R&D represents a private sector approach to fostering innovation. Unlike direct government expenditures, the tax credit puts the major responsibility for selecting the area of R&D on the private sector, which also bears the major risk for success or failure. The existing tax credit for R&D should be made permanent.

The most fundamental--and desirable--reform of the present tax structure is to shift the base of Federal taxation from income to consumption. This would encourage saving in an economy extremely short in that area. Thus, a consumption-based tax, by generating more funds to finance investment, ultimately would result in a more rapid rate of economic growth and, hence, a larger income pie to distribute.

The most practical way of shifting from income to consumption taxation is to modify the existing personal income tax form to allow the taxpayer to deduct savings from reported income. Unlike a conventional sales tax, this method avoids the need to tax individual purchases. Unlike a regressive sales tax, it retains the opportunity for maintaining a progressive tax schedule.

Perhaps the least understood mechanism of government activity is the use of the government's credit power. By charging interest rates well below the social cost of capital, the provision of Federal credit shifts investment funds to lower-yield uses. Thus, these government programs just reallocate investment funds rather than increasing society's pool of investment capital. The risk to the taxpayer is greatly underestimated as well. It is important to illuminate the hidden--but substantial--costs of this politically attractive and mainly off-budget type of program. From time to time, the Federal government is called upon to bail out a large credit program with the burden shifted to the general taxpayer. Clearly, Federal credit is not a free lunch.

Looking ahead, the major challenge to the Federal budget will be financing Medicare. Every recent study shows that the Medicare trust fund is likely to run out of money long before Social Security--and that the cumulative deficit will be much larger. What is required is not tinkering with the existing program, but a basic overhaul of the way that health care is financed. The most effective way to do so is to increase the scope for the operation of market forces.

This approach requires reducing the dependence on third-party reimbursements. For the typical middle class patient/consumer, it makes no sense to go through an expensive insurance/reimbursement system for routine office and out-patient hospital visits and procedures (e.g., flu shots). Health insurance should be seen as a form of insurance protecting people from chance--but devastating--illnesses. As long as patients view health care as a "free" entitlement, the prospects for effective cost control remain dim.

By no means does this exhaust the serious economic issues facing the Federal government. Social Security, for example, is a program where Congress has promised more benefits than the Social Security taxes it has levied to finance the program. The real culprit is demographic rather than political. Americans are living longer and retiring earlier. Once the public comes to accept these economic facts of life, then people may be more receptive to considering specific reforms.

Murray Weidenbaum, Economics Editor of USA Today, is Mallinckrodt Distinguished University Professor and honorary chairman of the Weidenbaum Center on the Economy, Government, and Public Policy, Washington University, St. Louis, Mo.

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