Obamanomics arrives: policy priorities for the new President

President Barack Obama faces a long economic "to-do" list in his first term. The first 100 days must focus on stabilizing the economy by fixing the financial sector and passing a well-crafted stimulus bill. These policies will set the tone for the longer-term reforms required to address budget deficits, regulatory reform, and waning U.S. competitiveness.

President Barack Obama faces a long economic "to-do" list in his first term. The first 100 days must focus on stabilizing the economy by fixing the financial sector and passing a well-crafted stimulus bill. These policies will set the tone for the longer-term reforms required to address budget deficits, regulatory reform, and waning U.S. competitiveness.

1. Fix the Banks
Obama must first fix the nation's banks if he hopes to fix the American economy. Wall Street is directly linked to Main Street: businesses unable to obtain credit cannot make payroll, service debts, or invest in new job creation. President Obama must recapitalize the banking sector, clearly articulating principles for when and how the government would intervene. Bailouts should be used only when market-failure could trigger a contagious downward spiral, and should be structured to prioritize limiting economic damage first, safeguarding taxpayer investments second and minimizing inefficiencies and distortions third. With this commitment to stability and Federal Reserve liquidity flooding into banks, lending and job creation will return as the economy stabilizes. Public opposition to the first bank bailout program may make President Obama hesitant to act, but failing to do so is a recipe for failure.

2. Craft a smart stimulus bill
If the President's first economic challenge is courage in the face of opposition, the second will be to seize the opportunity - and avoid the pitfalls - that his stimulus plan presents. How the $825 billion of proposed funds are spent - on tax cuts, transfer payments, local government grants, or investments - must balance boosting employment with investing in future growth prospects, while easing the burden on those most impacted by the recession. Numerous interest groups, some of which expect payback for votes delivered in November, will seek to push their constituents' interests over these national priorities. Succumbing to these interests or trying to make the recession painless is the fastest way to ensure that government inefficiency and the rejection of free markets stain Obamanomics with the mark of failure. The President proposed significant accountability to minimize these failures in implementing the policy but first must determine the optimal mix of tax cuts, transfers, grants and spending.

Taxes
Tax cuts that incentivize investments in future GDP growth deliver tremendous value. They act quickly, align the nation for the future, and prioritize free-market efficiency. Obama's earned income, college tuition, and first-time homebuyer credits for individuals and his business tax credits all meet these criteria. These should be retained and expanded. Conversely, Obama's plan to provide lump-sum tax cuts unrelated to GDP boosting investments - similar in nature to the failed 2008 rebate check strategy - is $140 billion better used to bolster government investments in infrastructure and education.

Spending
The $550 billion of spending outlined by President Obama includes transfer payments, grants to local governments, and investments. Transfer payments (largely extended unemployment insurance, food stamps, and college aid exceeding $100 billion) provide an immediate boost to growth and a cushion to those most impacted by the recession. Obama should extend these transfers, but must ensure that individuals have a clear path back to fruitful employment by creating jobs and providing education and job retraining programs.

The $200-plus billion in grants to local governments to maintain healthcare, education, and public safety service levels shield governments from recession much as transfers shield individuals. These grants advance worthy goals, but they allow government officials to avoid reducing costs or increasing efficiency as recessions normally force officials to do. Obama should only deliver grants to local governments that are willing to improve efficiency and cut costs before turning to grant money.

The remaining $200-plus billion is allocated to a laundry list of investment projects. Projects should be reprioritized using an investor's mindset, calculating the amount and timing of future benefits produced relative to the cost of the project. High return-on-investment projects should be prioritized, whether the return comes as GDP growth, better healthcare outcomes, or a cleaner environment.

Implementing this approach will require political courage, for some projects may be politically unpopular. To cite but one example, the plan devotes $650 million to subsidizing TV converter boxes, generating minimal economic benefits but politically popular amongst recipients. Those funds would be better spent boosting the measly $25 million allocated to charter schools - a move that benefits predominately inner-city students but might anger teacher unions who strongly supported Obama. President Obama must muster the courage to demand sacrifices from close supporters as well as those with different ideological views to pass the most effective stimulus bill.

3. Start planning to fix the deficit -- including entitlements
President Obama's short-term economic challenges seem formidable until confronted with the long-term problem of balancing the government's budget deficits - including the rapidly growing entitlement programs. President Obama rightfully notes that the issue has been ignored for too long. With near-record high popularity - and hopefully a track record of competence, cooperation, and fairness gained from his stimulus bill - the President has a strong position to negotiate long-term solutions for the consolidated Federal budget. While the President's chances for re-election may hinge on the success of his stimulus plan in diverting economic decline, the history books will focus on his resolution - or lack thereof - of this critical issue.

4. Get the regulation right
History is less likely to remember the President for regulatory reform, but the economy will certainly notice. The financial sector regulatory failure of the past two years exemplifies the need for reform. Institutions overseen by numerous different agencies failed, and the response from the Federal Reserve, Treasury Department, FDIC, and various smaller agencies seemed muddled at best. Instinctively, politicians called for more regulation. But it is not more regulation that is necessary but better regulation. Consolidating regulators, assigning exclusive jurisdiction, and focusing on fewer but more important rules lowers costs and increases effectiveness. The potential for dramatic (if underappreciated) impact on the economy earns regulatory reform a place on the President's to-do list.

5. Put government on business's side
That to-do list has so far focused on government bailouts, stimulus, and regulation. However, business, not government, drives long-term economic prosperity, and America's business environment has deteriorated relative to other nations. American businesses seem constrained by the government instead of supported by it. This must change; supporting business competitiveness should be an explicit government goal. The Obama Administration should enlist the private sector in developing a strategy to address American competitiveness. Whether investing in education and infrastructure, reforming regulatory, administrative, and judicial processes, or tailoring tax laws, government support of business is critical to growth. Encouraging businesses to invest and innovate is the only way to ensure long-term economic success. The new Administration must find ways to encourage private investment and innovation to sustain the recovery the stimulus will hopefully spark.


The President has noted that in crisis lies opportunity. Mr. Obama should seize the opportunity before him to not only lead a short-term recovery but enact policies that set a course for generations of American prosperity.

The U.S. tax system: sacred cow or bum steer?

One of the FEW benefits of a major financial crisis is that it gives policy makers the chance to drive sacred cows to the slaughterhouse. In the last month we've seen politicians, business leaders and academics posit ideas that heretofore bordered on political blasphemy. Grass-root, rural Republicans are calling for bank nationalization. Anti-corporate, urban Democrats are opening up the government coffers to buy reams of corporate paper. Global investment gurus are calling for tighter regulatory oversight, and environmental champions are calling for domestic drilling to ease energy prices.

As the financial crisis extends into an economic one, hopefully we’ll begin to cull the herd of sacred economic policies. One possible output could be a complete reevaluation of our national tax system. In this presidential election, the battle over taxes between Obama and McCain has rarely evolved beyond locker room comparisons (see: "My tax cut is bigger than yours, part I"). One can only hope that severity of the times will force us to go deeper, and perhaps question some of the underlying tenets of our tax system:

-Are interest tax shields too generous? In particular, have mortgage interest tax shields helped to fuel the residential real estate bubble?
-Is the corporate/personal tax burden weighted appropriately, or should it be inverted?
-Is a progressive income tax system the right approach for funding the federal government, or like state governments do we need to utilize a mix of income, consumption and property taxes (the so-called "three-legged stool") to more equitably distribute wealth without impeding its creation?

On this last point, it is worth touching on the WSJ’s discussion of the marginal tax rates offered by Obama’s plan.

Their analysis highlights one of the underlying deficiencies of a progressive income tax system coupled with wealth redistribution programs- the marginal disincentive to work. Starting from the middle, as individuals move towards the right end of the curve the increasing tax rate provides a marginal disincentive to work. Starting on the left, as individuals move towards the middle and price themselves out of social welfare programs, they face a similar disincentive. Republicans have traditionally fought to decrease the right hand slope of the curve, while Democrats focused on flattening the left hand side of the curve. The Obama and McCain tax plans reinforce this trend.

While battle has raged on the poles, the equator has remained remarkably stable. The tax rate for median income households has remained relatively constant over the last 40 years, ranging from 25-28%. (It should be noted that despite the mutual animosity between the poor and the rich, both groups have proven remarkably adept at gaming the system through political influence; rich constituents press their Senators to create tax loopholes that violate the spirit of the tax code, while poor constituents lobby their Congressmen to expand and extend spending programs well beyond their original purpose).

Fast-forward to our current crisis. Over the last decade, the greatest relative decrease in earning power has been felt by the middle class. Stagnant growth in real wages, coupled with increased costs of living and the recent collapse in the value of homeowner's equity has left the middle class scrambling to bridge the gap between their lifestyle and their income. The prevailing reaction- largely from Sen. Obama and the Democratic party, but joined by an ever-increasing chorus of Republicans- has been to ante up on our progressive tax system. Crank up marginal tax rates on the rich while raising the threshold used to qualify recipients of wealth redistribution. Get as much money as you can (either from the rich or off of the Fed’s printing presses) and pump it into Peoria. While the short-term, Keynesian effects will likely reduce the depth of the recessionary trough we are sliding into, the long term consequences will be dire.

Those consequences are two-fold. First, increased upper-income tax brackets will create the aforementioned marginal disincentive to work for wealthy individuals. In reality this will be manifested in a small but noticeable exodus of the most productive employees to countries with better tax structures. While the “brain-drain” threat is real, it will likely be concentrated in the financial sector. Frankly speaking, that sector can afford to lose some weight.

The second, much more deleterious effect will occur as the welfare pool (not to be confused with the welfare class) expands. Households making $40,000 a year might suddenly find it economically advantageous not to work longer hours or take on another job to move their income to say, $45,000. In doing so they may decrease their government program eligibility by greater than the salary increase of $5,000. This is precisely what occurred prior to welfare reform that took place in 1996. The record shows that people- irrespective of tax bracket- act rationally to maximize their income, even if that means working less.

But in a time when the productivity of the American middle class is decreasing relative to the rest of the world, we can scarce afford to encourage working less. This could force a destructive cycle, with ever-increasing benefits needed to maintain the same quality of life. The middle class could eventually become a welfare class, a frightening proposition for a country whose economic, political and cultural identity is built on an aspirational middle class.

This is in no way meant to suggest that McCain's proposed tax plan would prove any more effective. The idea that the fruits of wealthy American's labor will- taken alone- sustain economic growth throughout the rest of the economy has been disproven over the last two decades. As the U.S. Gini coefficient sprints towards .5, we find ourselves leaving behind a pack of peer nations and joining the company of such prosperous oases of egalitarian opportunity as Mexico and Brazil.

With the tax plans currently on the table, American middle class voters have the dubious privilege of choosing to become a welfare queen or a member of the working poor. Hopefully, whomever emerges victorious from this election will think about alternative taxation policies, policies that promote savings, discourage conspicuous consumption and asset speculation, reward workers who create real economic value and limit social safety nets to those Americans who truly need a helping hand.

Something radical needs to be done, but as of yet we have not heard any new ideas. The public's negative perception of the federal government seems to suggest that the solution, whatever “it” is, will require turning a few sacred cows into hamburgers.

Weekend Update expresses this sentiment perfectly. (Go to 4 minutes in on this clip)