Stiglitz on Global Imbalances

In today's NY Times, economist Joe Stiglitz tells us how to deal with global imbalances, including the U.S. trade deficit. His answer: Cut government spending and make the tax code more progressive.

Here's Joe:

There is one way out of this seeming impasse: expenditure cuts combined with an increase in taxes on upper-income Americans and a reduction in taxes on lower-income Americans. The expenditure cuts would, of course, by themselves reduce spending, but because poor individuals consume a larger fraction of their income than the rich, the “switch” in taxes would, by itself, increase spending. If appropriately designed, such a combination could simultaneously sustain the American economy and reduce the deficit.

I can understand the argument for cutting government spending (although Joe ducks the hard question--deciding which spending to cut). Lower government spending would increase national saving, and increased national saving would in turn reduce our reliance on foreign capital inflows. The dollar would fall in foreign exchange markets, and the trade deficit would shrink. This is all textbook international macroeconomics (which we will discuss in ec 10 in the spring).

But increased progressivity is an odd prescription for global imbalances, for two reasons. First, Joe rests the case on different marginal propensities to spend for high-income and low-income taxpayers. Although there is strong evidence for different average propensities to consume, the evidence for substantially different marginal propensities is much weaker. And it is the marginal propensities that are key to Joe's story.

Second, even if I grant Joe the different marginal propensities, I can't see how this plan would work to balance global trade flows. If the tax switch increased consumer spending, then it would decrease national saving, offsetting the increase in national saving from reduced government spending. With national saving unchanged, I can't see how international capital flows and the trade deficit would be any different. In other words, if a decrease in public spending were matched by an increase in private spending, as Joe seems to suggest, the budget deficit would be smaller, but the trade deficit--the focus of Joe's article--would be the same.

I can understand why a left-leaning economist like Joe would favor increased progressivity: If a person wants to reduce inequality and is willing to pay the price of reduced efficiency (that is, if one is willing to shrink the economic pie in order to give everyone a more similar slice), then Joe's proposal is the way to go. But that's not the case that Joe is making, which is why I am puzzled. As a solution to global imbalances, increased progressivity of the tax system seems like a non sequitur.