Economic Growth and Budget Deficits

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Wednesday, 17 November 2010 05:28

David Leonhardt has a good piece pointing out the simple fact that more rapid economic growth will substantially reduce the budget deficit. However he overlooks an important part of the story.

More rapid growth makes the country richer. In his hypothesized growth speed-up, the country grows 0.5 percentage points more rapidly on average over the next two decades. If this happened, then people would be roughly 10 percent better off on average in 2030 than under current projections. 

If people are wealthier, then the cost of sustaining the government would be less of a burden. For example, in this fast growth scenario if we had a tax increase equal to 1 percentage point of GDP in 2030 (a large tax increase), it would still leave people with roughly 9.0 percent more after-tax income than in the baseline scenario even without a tax increase.

In other words, if before tax income grows more rapidly, then after-tax income can increase rapidly even if a somewhat greater portion is diverted to the government in tax revenue. Since the deficit is often put as a generational issue, if workers 20 years from now enjoy much higher after-tax incomes than workers today (which they will in every plausible scenario), it is difficult to understand why anyone today should be troubled if workers in future decades will pay a higher tax rate.