Economic outlook: A healthy economy if policymakers let the engine go

When it comes to the economic outlook for 2007, Nobel Laureate and W. P. Carey School professor of economics Edward Prescott is optimistic. "The economy will be healthy," Prescott says, "unless Congress implements policies that would impede economic growth — such as policies that would increase tax rates or regulations that would adversely affect productivity growth."

When it comes to the economic outlook for 2007, Nobel Laureate and W. P. Carey School professor of economics Edward Prescott is optimistic. "The economy will be healthy," Prescott says, "unless Congress implements policies that would impede economic growth — such as policies that would increase tax rates or regulations that would adversely affect productivity growth."

A trade-off

Prescott is well known for his work demonstrating how overly high tax rates (such as those in many European countries) cause people to work less — and the economy to slow. "Taxes provide a disincentive to work," Prescott says. "And the fact is that people respond to disincentives."

What is the optimal tax rate for the U.S.? Prescott — who is also a senior monetary policy advisor at the Federal Reserve Bank of Minneapolis — says it depends. "We do need some tax revenue to finance some expenditures — including welfare payments, public goods such as national defense, and interest on government debt," Prescott says.

He says the tax rate could be decreased from its current rate of about 40 percent to 20 percent. Per capita GDP would then increase by about 25 percent and welfare by 10 percent where welfare takes into consideration the value of non-market time. "Basically, it's a trade-off," says Prescott.

Fostering economic growth

While increasing tax rates would impede economic growth, are there measures policymakers could take to foster economic growth — to give the economy a boost? Prescott says no. "You can't make the economy grow," he says. "That just happens on its own. You have to let the economic engine go." What policymakers sometimes do is impede that economic engine.

"Policies that impede economic growth are like something that prevents a plant from soaking up water — an impediment that prevents the plant from getting what it needs to grow," Prescott says. Change is needed for progress and policies that preserve the status quo impede growth, he adds. So policymaking isn't about helping the economy but about not hurting it.

And that can often involve removing policies that impede economic growth (recent examples include tort reform, relaxing financial regulations, and having a better contract law). Japan knows better than any other country the dangers of policies that impede economic growth. "Japan lost a decade of growth between 1992 and 2002 because of policies that subsidized inefficient businesses," Prescott says.

Tax and transfer

One impediment to economic growth in the U.S., according to Prescott, is the nation's large tax and transfer system. (A tax and transfer system collects tax revenue based upon how much people earn and distributes it back to them in equal shares.) By far the largest tax and transfer programs in the U.S. are Social Security and Medicare. These are not welfare programs designed to help the unfortunate.

"At lower tax rates, the welfare loss from tax and transfer programs is not very large," Prescott says. "But at a 40 percent tax rate, the welfare loss is enormous." That welfare loss is called a deadweight loss — the social cost of economic inefficiency. Prescott's solution? "Retirement should be handled by individuals' savings," he says. One problem with Social Security, Prescott says, is that people don't save as much when they have a tax and transfer system to rely on.

"The solution — a mandatory savings system — is not complex," Prescott says.

"And there are no costs associated with a transition from the current system to a mandatory savings system. People say that there's a generational conflict with the Social Security issue — that one generation inevitably loses no matter what's done with that program. I don't agree. With a mandatory savings program, everyone will be at least as well off as they are under Social Security. And, anyone who's not yet retired will be better off." Prescott says.

To fix the system, he says, the government should make retirement payments explicit liabilities. Currently, Social Security payments are implicit liabilities and not counted as government debt as the government is not legally obligated to pay out to those who have paid in. "Making retirement savings an explicit liability means that the government is legally obligated to pay," Prescott says.

Prescott says that he would structure the mandatory savings system like an annuity — with people paying into their fund a percentage of their incomes until retirement, then receiving monthly payments upon retirement for the rest of their life. Prescott sees the funds earning a real rate of return of about 4 percent — much better than the 2 percent average return on the Social Security Trust Fund.

"Simply put, Social Security is a bad deal," Prescott says. The biggest waste, he says, comes from the fact that Social Security taxes — just like other taxes — incentivize people to work less. "With a mandatory savings system, there would be no incentive to work less — and removing that incentive to work less would be good for people," Prescott says.

And average wage-earners would get more when they retire under a mandatory savings system than under the current system. "Transitioning from Social Security to a mandatory savings system would reduce poverty and make everyone better off," says Prescott.

Medicare is another tax and transfer system that generates large deadweight losses, Prescott says. But he sees policymakers taking steps in the right direction toward reforming the healthcare system. "Healthcare spending accounts, for example, were a small step in the right direction," he says. In terms of larger Medicare reforms, Prescott doesn't see why medical expenses should be any different than retirement.

"People should have major medical insurance, but most medical expenses should be paid out of current income or savings," he says. But while losses associated with the tax and transfer aspect of Medicare are huge, Prescott says that even larger deadweight losses are generated by our third-party payment healthcare system. The problem is called moral hazard.

"People who have insurance don't take proper care of themselves, so they end up needing more medical care, which costs the insurance companies more money, which in turn drives up the costs of health insurance. There is duplication and excessive testing. Expensive drugs are used when the added benefits, if any, are not commensurate with extra cost." On top of those deadweight losses, Prescott says that the overhead associated with the administrative aspect of health insurance is large.

Optimistic outlook

Nevertheless, Prescott says that overall he's optimistic about the economy's future. His optimism comes, in part, from the fact that we're "moving in a positive direction saving for retirement. As people continue to live longer, people are going to accumulate more savings to finance their retirement." Total savings, he says, is equal to the stock of productive assets (assets used by firms to make money, including machinery, workers, and processes) plus the amount of government debt.

"The problem," Prescott says, "is that if productive assets get too big because we're putting all our savings into them, then the rate return on these assets becomes low. So we also need to put savings into government debt." For now, Prescott says, the amount of government debt — if Social Security and Medicare promises are included — is about right.

Prescott is also optimistic about the stock market. "The expected real rate of return is around 5 percent," he says. "The stock market is healthier now than it has been because of relatively low tax rates on corporate distributions. In the 1950s and 1960s, the tax rate on corporate distributions was almost 50 percent," he says. "Now the tax rate is about 10 percent, and the value of the stock market relative to GDP is almost twice as high now."

And while new policies that impede economic growth are always a possibility, Prescott predicts that Congress won't take any major actions that would depress growth. "If they impede growth they will be voted out office and they don't want to be voted out of office," he says.

Bottom line

• Taxes provide a disincentive to work. Reducing the U.S. tax rate from 40 percent to 20 percent would increase per capita GDP by 25 percent.
• Policymakers cannot create economic growth, but can promote it by removing policies that impede growth.
• Deadweight losses from Social Security and Medicare are huge.
• Transitioning from Social Security to a mandatory savings system would reduce poverty and make everyone better off (or at least equally well off).
• Retirement savings — including investments in productive assets and government debt — will increase as people continue to live longer.
• The stock market will remain strong, with an expected real rate of return around 5 percent.
• Policymakers aren't likely to make new policies that impede economic growth.