Committee for a Responsible Federal Budget

OECD on the Fiscal Outlook: The Way Forward

May 27, 2010 | Economics

The OECD (the Organization for Economic Cooperation and Development, the Paris-based think tank for the 31 richest countries) released its twice-a-year economic outlook yesterday. It presented a bleak fiscal picture for many of the member countries (including the United States) unless governments make policy changes, but, constructively, it also presented possible ways forward for countries to get their fiscal house in order. 

The bleak fiscal picture reflects the past (expansionary fiscal policies followed by most of the countries over the past decade; the kick-in of automatic stabilizers such as unemployment insurance when the great recession began; and measures to stimulate the economy taken by governments to head off a downward spiral as the economic and financial crisis took hold), the present (the result of emergency stimulus measures, general government debt will have increased by 30 percentage points from 2007-2011) and the future (the fiscal impact of aging will start to have a bite in the next 10 years).

For countries to get their fiscal houses in order, the OECD suggested a package of measures--coming no later than next year--featuring fiscal consolidation and structural reforms to boost overall future economic output. These reforms are very important to counteract the effects of the fiscal contraction as the economy adjusts to a new fiscal path and will in the longer run make things better by boosting the economy's efficiency.

Generally speaking, the OECD suggested that the make-up of the fiscal package be mostly spending cuts since historical OECD country experience has shown that efforts focused on spending cuts were more successful.

What does the OECD say about the way forward for the United States? In addition to the well-recognized principle that the Fed and administration "should gradually withdraw policy stimulus as economic growth becomes self sustaining" (which, it recognized, will not be easy to gauge), the OECD recommended:

"The Administration needs to develop sustainable medium term consolidation plans setting out in detail how improvements in public finances are to be achieved."

The OECD presents some illustrative fiscal paths for the United States and other OECD members in this context that are useful to study, as we think about our fiscal way forward.

What structural reforms does the OECD discuss for the US? It  focuses on the importance of financial sector reform and key tax reforms:

"[T]he improvement of financial sector regulation should foster household deleveraging over the medium term and could narrow the current-account deficit by further increasing the private savings rate. Also a tax reform including the elimination of distortionary tax incentives could support household saving (OECD, 2005). In particular, the mortgage interest deduction could be reduced and a value-added tax (VAT) introduced. The pricing of environmental externalities of fossil fuel use will also reduce the fuel intensity of the US economy and possibly fuel imports and the overall external deficit."

We have suggested possible areas for tax reforms, as well. A few days ago, we touched on the Wyden-Gregg proposal, which would eliminate some distortionary tax incentives, but leave many of the biggest offenders in place, including the mortgage interest deduction. Additionally, in the past we have looked at the potential for a carbon tax/cap-and-trade system or a value-added tax in our "Countdown to Tax Day" series; both could raise a significant chunk of change while promoting economically productive initiatives (reducing fossil fuel use and encouraging household savings, respectively.)

Finally, the OECD has a message that readers of this blog should be very familiar with:

The effects on GDP would depend on the timing of consolidation measures. If financial markets were convinced about governments' fiscal consolidation plans, then measures might be back-loaded with the most severe tightening delayed until the recovery had gathered momentum. Alternatively, and especially for those countries with the largest fiscal imbalances, it is likely that an early demonstration of intent would be required to establish credibility.

Sound familiar? The OECD message: if a country (including the U.S.) can announce a multi-year fiscal consolidation plan that is credible to financial markets, then it can phase-in adjustment measures so that the toughest are applied later on, when the economic recovery is on firmer footing. Credibility with the financial markets is critical and real, whether we all like it or not. This is particularly important for the United States, which relies on these markets, instead of domestic savings, to finance its fiscal needs.

We have in fact written extensively along the same lines. See for example "Time To Develop a Fiscal Recovery Plan".