President Obama has been fixated on returning the top marginal income tax rates on higher income earners to their Clinton-era levels. Increasing these rates is troubling because even if the president got his way, it wouldn't make a dent in our deficit, and it would pose negative consequences for our economy in the long term. Moreover, our problem is a spending one, not a revenue one. So how about we return to Clinton-era spending levels?
However, aggregate labor supply data, such as the differences in hours worked among countries with different levels of taxes, suggest a very different conclusion. Nobel laureate Ed Prescott, in his famous 2004 paper "Why Do Americans Work So Much More Than Europeans?" shows that workers spend considerably more hours working when marginal tax rates on their incomes are lower. So basically, over time people will reduce the number of hours of work, economic growth slows down, and less revenue is collected.
And then there's the long run. In recent years, economists have shown that higher taxes may not dissuade current rich people from working, but they will hurt incentives for younger people to invest in education and career choices that would have made them the rich people of tomorrow. That too does not benefit future economic growth and tax revenue.
So overall, increasing taxes on the rich isn't a good idea. Yet, it is true that the Clinton years saw economic growth, increasing median income, vanishing deficits and relative peace. Why doesn't the president try to copy all Clinton-era policies? Because that would mean seriously cutting spending.
On Jan. 27, 1996, President Clinton proclaimed that "the era of big government is over, but we can't go back to a time when our citizens were just left to fend for themselves." He added, "So, again, last Tuesday, I asked Congress to join with me to make the cuts we agree on. Let's give the American people the balanced budget they deserve with a modest tax cut and the lower interest rates and brighter hope for the future it will bring." And they came through on that promise.
During his two terms in office, Clinton reduced spending as a share of gross domestic product from 21 percent in fiscal year 1994 to 18.2 percent of GDP in fiscal year 2001. Today, spending stands at 24.3 of GDP. According to the Office of Management and Budget, Obama's two-term average spending level is projected at 23.4 percent of GDP as opposed to 19.9 percent for Clinton. During his two terms, Clinton grew spending by 12.3 percent in real terms -- a sharp contrast with the Reagan years and the Bush years. When he left office, total spending was close to $2 trillion, and the federal government registered a surplus of $142 billion (all numbers are adjusted for inflation). In fiscal 2012, federal spending was $3.2 trillion, and our deficit was $1.1 trillion.
For all the talk about returning to Clinton-era policies, the president is sadly silent about his predecessor's spending levels. To be fair, the only way that we could go back to these spending levels is if Congress finally reforms Social Security, Medicare and Medicaid. And reforming those programs is also the only way to put this country back on a sustainable financial path. So what are we waiting for?