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The U.S. economy finds itself at a crossroads of overlapping challenges. Long-term productivity and economic growth are low, while income and wealth inequality are high. Meanwhile, the country faces a series of challenges: from collapsing economic security for middle- and working-class Americans to climate change and more.¹ Addressing these challenges will undoubtedly require the deployment of significant federal resources since the private sector has failed to do so.

The good news is that the economic evidence suggests there is indeed room for the government to address the country’s current challenges. And the economic research shows ways this can be accomplished by using spending and tax policy more effectively than how it has been used in the past. The content of those investments is crucial: smart investments that boost competitiveness and secure economic stability for working families will yield returns, while wasteful tax cuts will create massive, long-term deficits without clear, tangible benefits. In short, America still can do big things—and it can do those more effectively than it has in the past. Each dollar spent on smarter, more effective government programs and tax policy will then go a lot further in boosting the economy and strengthening a struggling middle class.

To be clear, the deficit-busting 2017 tax cuts show that policymakers fighting for working families should not fall for letting the debt and deficit be used as a heads-I-win-tails-you-lose political trick deployed against only working families’ economic priorities. But the tax cuts also revealed the depth of their own flawed approach to debt. Yes, policymakers still need to take seriously how to budget for economically appropriate and sustainable levels of debt and deficits. But a large economic literature shows that debt incurred in a smarter way translates into faster growth, which, in turn, makes repaying that debt far easier than the wasteful, inefficient, and ineffective supply-side tax cuts that have dominated fiscal policy of the past two decades. With such a smarter approach, guided by economic evidence, policymakers will be able to confidently say that America can build an economy that works for all, while also meeting its financial obligations for the future.

This report seeks to lay out guideposts for fiscal policy to help Congress and future administrations evaluate the choices they make going forward and better accomplish the goals of meeting today’s national challenges in a financially responsible way for the future. Findings include:

• Different choices on spending and taxes than those made in the past can substantially increase the chances for faster growth and less inequality. The evidence shows that a country’s ability to manage deficits and debt are greater when the money is spent on things that will reliably and sustainably boost economic growth, such as more infrastructure spending, education, and social insurance to reduce inequality.
• Current debt levels largely reflect wasted resources in the past and, to that extent, pose drag on the economy, because tax cuts in recent decades predictably did not translate into faster growth and higher wages. In fact, long-term growth did not accelerate while income inequality remained high because of the tax cuts.

Existing debt levels simply as a stand-alone matter pose manageable challenges. The government has the room to increase spending and reform taxes while putting a lower priority on deficit reduction, provided those investments are made in the smart way outlined herein. The bottom line is that addressing this country’s national challenges today and securing its fiscal future tomorrow can be done through a coordinated approach to spending, tax revenue, and borrowing that ensures a more competitive, inclusive economy in the most expedient and effective way possible. The economic research, summarized in this report, shows how this is doable.

Public debt is not inherently bad. In fact, it can be quite useful, depending on for what purposes the money was used. It allows the federal government to make immediate investments that yield benefits now and in the future, when done efficiently, focusing on measures that have been shown to boost growth and reduce inequality. Debt has enabled the United States to achieve victory in both World War II and the Cold War, build a modern infrastructure, produce groundbreaking innovations, recover from economic crises, and more. Indeed, maintaining a reasonable level of federal debt is actually economically essential for both the U.S. and the global economy. U.S. debt forms the foundation of the U.S. financial system, serving as collateral and liquidity for a wide range of financial markets and institutions. Worldwide, assets are priced in relation to U.S. debt. The question is not whether the United States should have debt—instead, it is how much.

The key measure that economists consider in answering that question is the ratio of debt to gross domestic product (GDP). There is undoubtedly a level of debt to GDP that is too high for any country. If a country reaches that point, it could face a financial crisis, whereby investors lose confidence in a government’s ability to repay its debt. The result would be quickly rising interest rates as money flees an economy, falling exchange rates, slowing economic growth, and possibly a deep recession with sharp increases in unemployment. But with a wealthy and largely productive economy, a stable rule of law, and efficient tax collection mechanisms, the United States remains extraordinarily creditworthy.² Certain factors, moreover, make this additionally true, such as the U.S. dollar currently being the leading global reserve currency, whereby other countries want to invest their savings in U.S. dollars as a safe haven from all kinds of economic and political risks. The U.S. government also has independent control over its currency, which lowers the risk of sharp interest rate increases due to changes outside of the United States. This is not always the case for other countries, including the eurozone—the European countries that share the euro as their common currency. But even for the United States, debt beyond a certain level could create challenges that deserve serious consideration and appropriate management.

Given that the United States is still far away from debt levels where such risks would begin to materialize, as the summary discussion below shows, the key question is how deficits could grow such that debt levels become a burden—as the discussion on debt crises further below shows—rather than a useful way of financing today’s social needs. First laying out how and why debt to GDP can increase, stay the same, or even fall, will provide a useful organization for the rest of this report.

The growth of the debt-to-GDP ratio depends on deficits, interest rates, inflation, and, critically, economic growth. Larger primary deficits and higher interest rates, all else equal, mean that the debt-to-GDP ratio will increase. Faster inflation and economic growth, on the other hand, will lead to a decline in the ratio. GDP is measured here in noninflation-adjusted terms so that faster price increases help to reduce the debt-to-GDP ratio. Importantly, this is just an accounting statement, not a theory on causal relationships between the key variables—deficits, interest rates, inflation, and growth.³

The following sections then discuss the existing evidence on the potential causal relationships among the key variables. Specifically, this report looks at how deficits influence interest rates, economic growth, and inflation. A more thorough understanding on the causal relationships between these variables will permit a consideration of future trends in the debt-to-GDP ratio. If the underlying causes of deficits such as tax cuts or spending increases result in faster growth without offsetting increases in interest rates, the debt-to-GDP ratio may grow more slowly or even fall. Alternatively, if deficits, caused by past policy choices, do not translate into faster growth, the debt-to-GDP ratio will increase.

Today’s debt is the accumulation of past government deficits. As noted, there may be good reasons to run deficits, but government deficits are not entirely like that of a business or family, as the government has a special role to play in the macroeconomic cycle.

Deficits often arise in the context of slow economic growth or recessions. It is important, though, to distinguish here between cyclical and structural deficits. A budget deficit may widen as the economy turns into a recession. Tax revenues fall, and spending on social programs and other activities increases. Some of this is automatic due to the progressivity of income taxes, for instance, and the social insurance nature of many spending programs such as the Supplemental Nutrition Assistance Program, Social Security, and unemployment insurance. In addition, some part of the cyclically widening deficit may follow from legislative decisions to temporarily stimulate the economy with tax cuts and spending increases. Either way, cyclical deficits may lead to a more stable economy than would be the case if governments actively engaged in policies to keep deficits from rising or even tried to reduce deficits in the middle of a recession—a process commonly known as austerity.

Structural deficits follow from longer-term policy decisions that are often, albeit not always, intended to boost longer-term, or trend, economic growth. Congress may decide to cut taxes, especially corporate taxes and higher-income earners’ personal taxes, to lower the costs of capital for businesses. In widely discredited supply-side theory—also often referred to as trickle-down economics—this should result in more investments and faster economic growth. Alternatively, Congress may decide to spend more on increasing the country’s infrastructure, invest more in education, and raise benefits in social programs. Better infrastructure should reduce business costs as firms presumably can get their goods to market in a faster and more reliable way. Higher-quality education should increase the skills and thus the productivity of workers. And finally, higher benefits in social programs could lower poverty and income inequality as well as improve children’s future prospects. Less income inequality means that lower-income and middle-income families may see faster income growth than otherwise would have been the case. They can both spend more and save more money or, alternatively, incur less debt. The resulting economic security for many families could create pathways to more upward mobility and investments in commodities such as housing, startup businesses, and children’s education—all of which could have positive effects on economic growth over time.

A number of different schools of thought exist that link fiscal policy with long-term economic growth, especially in the current context of modest economic growth, slow business investment gains, persistent underemployment, and very high income inequality. Many of these favor more government spending—especially to boost infrastructure spending and reduce income inequality, for example—through larger social insurance programs, as the evidence in this paper discusses.

The evidence on the effectiveness of fiscal policy to boost long-term economic growth gained more attention from economists of all stripes amid the modest economic growth following the Great Recession. Some economists argued that the United States was stuck with unsatisfactorily slow growth due to structural problems.⁴ The need for additional government spending to strengthen the economy may then be especially important when structural problems such as massive inequality and financial bubbles hold back the economy from growing more quickly. Importantly, monetary policy, the other macroeconomic policy lever to increase economic activity, may not work because interest rates are already near zero percent. Under those circumstances, more public spending may have to offset the lack of private activity.

Several structural problems, such as low investment spending and high income inequality—and, thus, limited demand that hampered economic growth immediately after the Great Recession—continue, while others, such as tight credit after the bursting credit bubble, have diminished. The evidence reviewed in this report suggests that more public spending on infrastructure, education, and measures to reduce income inequality can boost economic growth. Debt relative to the size of the economy may even shrink in this case, as economic growth outpaces debt growth from new deficits and interest rates.

The economic evidence discussed in this paper shows that more public spending on infrastructure, education, and measures to reduce income inequality is a much more effective and more efficient way of using government resources than cutting taxes for high-income individuals and corporations. It then also follows that a more effective fiscal policy will make it easier for governments to manage any associated deficits and public debt. In fact, the data indicate that effective investments, even when financed with deficits, could potentially result in less debt relative to the size of the economy because of faster economic growth that outpaces increases in debt.

Cyclical deficits, interest rates, inflation, and long-term growth

Cyclical deficits go along with shorter-term, temporary downturns in the economy. But there is also a link between these temporary deficits and longer-term growth. Cyclical deficits reflect fewer taxes and more spending. Both less revenue and more outlays counter the underlying cause of a recession: a drop in demand. Families and businesses will have more after-tax income; thus, the underlying causes of the cyclical deficits will make a recession less severe than otherwise would be the case. This is especially true when deficits increase as a consequence of more social insurance spending, such as unemployment insurance and Social Security.⁵

Whether cyclical deficits increase automatically due to the progressive features of taxes and spending, so-called automatic stabilizers, or whether they result from discretionary policy responses to an economic downturn, they will counteract recessions and quicken economic recovery.

A key implication is that a country can strengthen its automatic stabilizers—and, as a result, its ability to counteract recessions—with more progressive taxation and larger social insurance systems. The impact of automatic stabilizers tends to be more pronounced in the European Union than in the United States. The evidence suggests that the automatic stabilizers in the European Union mitigated income shocks resulting from the Great Recession more effectively than in the United States, especially with respect to unemployment rates.⁶

Some economists, such as Alberto Alesina and Silvia Ardagna, though, argue against using spending increases and tax cuts to help a weak economy. They assert that governments that have shrunk their deficits mainly by cutting spending and maintaining tax rates will ultimately be in a better position to grow again.⁷ Under this expansionary austerity theory, smaller deficits make consumers and businesses feel more confident about the future of their economies, thus they spend and invest more than they otherwise would. Those effects outweigh the contractive effects of cutting government programs or increasing the government’s revenue take.

This argument has occasionally been used to support cutting deficits or, at least, not expanding them to boost economic growth when it is weak. In fact, a number of politicians seized on the expansionary austerity theory and argued for more spending cuts immediately following the Great Recession.⁸ The underlying data used to support this viewpoint, however, rely on findings from just a few Organization for Economic Cooperation and Development (OECD) countries that were near or at full employment—far away from an actual recession.⁹ Moreover, the research did not distinguish between planned fiscal policy measures and changes brought on by automatic stabilizers. Considering the entirety of the evidence on budget deficit reductions via spending cuts indicates that these cuts indeed tend to lower economic growth, presumably harming an economy when it is in a recession or a phase of weak growth.¹⁰ Thus, the evidence does not support the notion of expansionary austerity.

Economic research instead generally concludes that wider deficits during a recession help stabilize the economy. The literature finds that spending measures, especially those improving social insurance benefits and infrastructure spending, tend to have the largest effects for each dollar spent on stabilizing the economy, while tax cuts tend to have relatively mild effects.¹¹ Research on the economic effects of ARRA shows that it helped reverse the decline in the U.S. economy. Researchers find that ARRA alone boosted economic growth by more than 3 percent.¹² While the Great Recession was the worst downturn in recent history, the evidence suggests that ARRA and other policy responses prevented it from being far worse. (see Figure 1)

A large fiscal policy intervention to combat the Great Recession was especially warranted since the other policy lever—lowering interest rates—was ultimately limited when interest rates effectively fell to zero. Bradford DeLong and Lawrence Summers argued that deficit-financed government spending amid very low interest rates and high unemployment could ultimately reduce the debt-to-GDP ratio—not only in a cyclical downturn, but also in an environment where the economy grows very slowly.¹³ In a recession, the economy would grow faster than otherwise would be the case due to the additional government spending that fills in the gap left by the lack of private investment and consumer spending. By definition, there is a lot of room to grow in a recession, illustrated, for instance, by low investment and high unemployment. Debt growth, on the other hand, is limited due to low interest rates when the government runs a deficit. To be clear, this research also implies that fiscal inaction comes with a substantial cost. People will lose out on jobs and wage gains that would allow them to pay their bills and save for their future when the government decides that austerity and debt reduction should take precedent over investing in the economy and its people amid underemployment, massive inequality, and modest growth.

After the Great Recession, the positive effect of stimulus spending came about because ARRA increased consumer spending, especially for automobiles and retail sales. At the same time, the law had no measurable inflationary effect.¹⁴ It also raised employment above where it otherwise would have been, especially from assistance to low-income households and infrastructure spending.¹⁵ The bottom line is that a substantial, temporary stimulus can help stabilize economic growth, especially if it prioritizes aid to low-income households and infrastructure. Helping low-income households means that money will be spent right away. Spending on infrastructure typically boosts manufacturing and construction—two sectors that are generally disproportionately hurt in a recession.¹⁶

More economic stability can then translate into more long-term economic growth. Economic research has shown that countries that have smaller swings in economic growth over time tend to also grow more quickly over the long term.¹⁷ One key mechanism that is likely at work here is that smaller and less frequent economic swings make it easier for businesses to plan for the future and thus to invest in longer-term projects.¹⁸ More productive investments following more economic stability will ultimately translate into faster long-term economic growth.

However, higher interest rates could offset the positive benefits from wider cyclical deficits. They could emerge due to two factors. First, fiscal stimulus would increase the demand for goods and services in an economy. If the economy is already running at a reasonable clip, greater demand should result in higher prices. Second, the Federal Reserve may become worried about increasing inflation and decide to increase short-term interest rates. Moreover, governments will typically borrow more money to finance wider deficits, thus increasing the demand for debt. The price of debt, the interest rate, should then, in theory, go up.

Should, ultimately, interest rates rise, economic growth will subsequently slow. Businesses will find it harder to finance their investments, and households will have to pay more for their debt for everything from credit cards to home mortgages. Higher interest rates could then dampen the positive effects of wider cyclical deficits as economic growth is slower than it would be otherwise. Again, the critical underlying question is for what purposes the deficits were used, especially whether the underlying investments promoted faster economic growth.

In the context of an economic downturn, there are typically few worries about higher interest rates. First, faster inflation may in fact be desirable to some degree since it makes it easier for people and businesses, for example, to pay back their debt. It also makes it easier for the Fed to use its traditional tools of monetary policy to bring the economy to full employment. As a result, it is unlikely that the Fed will counter with higher interest rates. A recession, after all, goes along with slowing inflation and the possibility of deflation—declining prices—if the recession is severe enough. Monetary policymakers and economists worry about slowing inflation and deflation for several reasons. For one, less inflation and deflation make debt more expensive and hold back businesses and individuals from making major purchases. Businesses and households may also hold off spending their money in the present in the expectation that things will be substantially cheaper in the future. Reducing the chance of deflation by returning to more normal levels of inflation is thus desirable, and the Fed will not respond by raising interest rates. Second, a recession means that private market activity is slowing, possibly declining. Businesses will borrow less as a result, leaving more money to be lent to the government. In other words, the rising demand for government debt offsets the falling demand for private sector debt in the middle of a recession. All of this was precisely what occurred, at an extreme level, during the Great Recession leading to the extraordinarily low interest rates that followed.

The economic evidence indeed finds no link among cyclical deficits, inflation, and higher interest rates. Instead, countercyclical budget balances tend to be associated with shallower recessions and faster economic recoveries. For instance, Bill Dupor and his co-authors find that ARRA successfully boosted consumer spending but had no significant inflationary impact.¹⁹ Even outside such extreme events such as a financial crisis coupled with a severe recession, temporary cyclical deficits do not contribute to higher interest rates.²⁰

The bottom line is that wider cyclical deficits can have some positive effects on both short-term and long-term economic growth.

Structural deficits and long-term growth

Structural deficits by definition follow from policy decisions to either reduce taxes below the level necessary to fund existing and promised spending or to increase spending beyond the level of current and expected revenues.

Many, though not all, structural deficits result from policies intended to promote faster long-term growth.²¹ The Tax Cuts and Jobs Act of 2017 is the most recent example of using tax cuts to incentivize more investment that could result in faster growth. The underlying argument of this policy change is that reducing marginal tax rates on corporations and high-income earners would supposedly lower the cost of capital for firms.²² The lower cost of capital, the argument goes, would then translate into faster investment growth and ultimately result in more growth. The evidence for both the United States and other countries, however, suggests that supply-side tax cuts have a very small—if any—positive effect on long-term growth.²³

The reason for the lack of such a positive correlation between lower costs of capital and more economic activity should not be surprising. Businesses invest their money for a number of reasons. These include the expectation of more customers in existing or new markets, the quality of the infrastructure where they plan to invest, and the skill levels of potential new employees, among others.²⁴ Taxes play at best a small role in affecting investments. Lower taxes for high-income individuals could lower the cost of capital, because people save more money and give it to businesses. But this matters only for more investments if businesses have a hard time finding adequate financing for their projects to begin with. This does not seem to be the case, as corporations hold a lot of liquidity, interest rates are low, and lending standards by banks for business lending have eased in recent years. In addition, lower corporate taxes could theoretically make it more attractive for businesses to invest as they can more quickly recover their investments.²⁵ But effective corporate tax rates in the United States have been on a decline for some time due to special tax breaks. As a result, lowering corporate tax rates would have a very small effect on investment and economic growth. Moreover, the boom in stock buybacks and the run-up in corporate debt instead of using corporate resources for real investments highlight how business behavior is being corrupted by other forces, including corporate short-termism or insufficient competition. Lower taxes and supply-side policies are ineffective at best and adding fuel to the fire of corporate misspending in all likelihood.²⁶

Alternatively, structural deficits could emerge because governments increase spending. Additional spending could go toward new infrastructure measures, higher education, and larger social programs. All three measures could, in theory, result in faster long-term growth.

Infrastructure measures include better roads, fewer bottlenecks at harbors and airports, faster broadband service, and improved transit options, among a range of other capital investments. Such investments can immediately reduce the costs of operation for business, as it is easier to transport goods across the economy. Employees will also spend less time commuting due to this improved infrastructure, resulting in increased productivity. Finally, a better infrastru