Americans need less “have a nice day” and more “strive hard.” Tolerance of mediocrity and an openness to slouching through each day is not the route to productivity growth. It’s the path to Western European-style economic stagnation.
The United States is the world leader in advanced technologies and possesses the world’s most productive economy. But the U.S. economy is built on the quicksand of the federal debt. The federal debt, owned by the public, is now equal to about 100% of gross domestic product, or $100,000 per person. It’s a dangerous path to go down.
France’s political and economic systems are being tested in part because of excessive government debt. French equity and debt markets are in turmoil because of an upcoming national parliamentary election and because France’s national debt is unsustainably large. France is thus a loud siren for the U.S. Each 1% increase in the cost of borrowing for the federal government raises the debt service cost by 1% of GDP, or almost $300 billion. Like France, the U.S. is borrowing to service existing debt.
That is not sustainable. And things are getting worse. The nonpartisan Congressional Budget Office has just revised its forecast for the federal deficits. The CBO put it plainly, “The deficit will equal about 7.0% of GDP in fiscal year 2024 and 6.5% in fiscal year 2025. Moreover, for the next decade deficits will average over 5%, significantly more than the 3.7% that deficits have averaged over the past 50 years.”
President Joe Biden bears significant blame here. He has embraced Modern Monetary Theory. He thinks deficits don’t matter. Biden is using federal debt to increase dramatically the size of the federal government and to create a European-style welfare-nanny state. Biden has grown the government by 10% or more in less than four years.
The correlation is clear. As the government grows, economic growth slows. Over the past 15 years, U.S. share of global output has increased slightly. The share of global output as generated by the European Union and Great Britain has decreased slightly. Europe is falling behind the U.S. and the other major economies of the world. Today U.S. GDP is almost 45% larger than the GDP of the free countries of Europe.
What explains this divergence?
For a start, Europe chooses statist economic policies, including a comprehensive regulatory regime. Biden and many Democrats seek to emulate Europe. But to achieve the goals of a strong economy, not burdened with excessive debt, not suffocated by regulations and without unnecessary government interference in the daily lives of responsible citizens, the country must return to first principles.
The foundational principle is to restore economic freedom. Enable Americans to decide what to produce, what to consume, and what to buy and sell. Choose capitalism, not statism and government-led industrial policy. America was founded on the principle of liberty, and capitalism provides invisible structures so people are free to choose how to live their lives.
Government policy should be directed toward strengthening the market economy, not state-directed mandates as are common in Western Europe. That goal can be achieved through deficit reduction, comprehensive tax reform, a root canal on the administrative state, and a renewed focus on government-funded research and development.
The deficit looms large here. The U.S. economy is operating at full employment. But the federal deficit is 7% of GDP. Outside of the coronavirus pandemic, the deficit has never been this high in a time of near or full employment. Deficits have exploded under Biden, but the underlying driver of the deficit is entitlements: Social Security, Medicare, other mandatory spending, as well as interest on the debt. The public loves entitlements. And there is no political will to reduce them.
But the federal government must pay for the debt it has accumulated. And rising deficits push interest rates higher, raise the cost of capital for business, reduce investment, lower long-run productivity growth, and make the American dream of homeownership a mirage for many.
Ultimately, entitlement reform will be necessary. Most people receive more in Social Security and Medicare benefits than they pay in to the trust fund systems. A 1% increase in the employee contribution to Social Security and Medicare would close the deficit gap by about 1% of GDP. But raising the employer contribution would be a tax on employment. It is better to tax entitlement than employment. We should not emulate Europe where mandatory taxes on employment can reach 40%.
Still, the U.S. social welfare system has already largely eradicated real poverty. The research of Bruce D. Meyer and James Sullivan shows that, at most, 1% or 2% of the U.S. population lives in true poverty as measured by consumption. When the markets force reform, Congress should look to reduce entitlement benefits for the wealthiest people, reform the bloated Social Security disability outlays, and increase eligibility ages across the board. Discretionary spending restraints and civil service reform would also provide for greater accountability and efficiency in government.
But so also is comprehensive tax reform important. That means some hard choices. For one, the U.S. should institute a 5% value-added tax on all goods and services. That would raise about 1% of GDP each year. Fixing the deficit will not be pain-free. Politicians with courage and common sense could persuade the public that a VAT is necessary to restore fiscal sanity. Sell the new tax as a tariff on excessive consumption. But a small VAT is not enough to bridge the structural deficit, which is about 5% of GDP. To reduce the budget deficit to 2% of GDP, more revenues are necessary.
At the margin, tax loopholes can be closed. A consumption tax can be imposed on the extremely wealthy so that they cannot avoid income and estate taxes by borrowing against appreciated assets.
The combination of sensible tax, spending, and entitlement reform would reduce the deficit from the current 7% of GDP toward revenue balance. Restoring fiscal sanity would lower borrowing costs for the federal government and for all households. Americans could dream again.
But tax reform is not enough to prevent the U.S. from becoming a European social welfare state or a nanny state like Denmark or Sweden, where top marginal tax rates reach 56% and higher. Very high marginal tax rates reduce incentives and cause legal tax avoidance. The administrative state must be rolled back. Excessive regulation imposes a clear tax on business. Regulatory costs account for 1.34% of the country’s total wage bill, or almost $150 billion a year. Through regulation reform, employers would be able to raise wages and undo some of the effects of higher entitlement contributions.
Profit and investment are fundamental to economic growth. Western Europe has turned its back on capitalism. The consequences are clear: The people of Europe become poorer. But profit is not a dirty word. Profit should be cheered. Profit drives investment, and investment drives productivity gains.
Because of low corporate taxes, the U.S. is attracting strong foreign direct investment. Western Europe is deindustrializing. European manufacturers are turning to the U.S. because the U.S. has not fully embraced “green zealotry.” Corporate taxes should not be raised when the renewal of the provisions of the Tax Cuts and Jobs Act of 2017 is debated in 2025. Investment surged because of the TCJA. Capital was repatriated. Wages rose. The effects of the corporate tax reforms on the deficit were de minimis.
The struggle to dominate the technologies, goods, and services of the future will also be key. U.S. policy should especially support investment in research and development. Fifty years ago, the federal government funded two-thirds of the country’s R&D spending. Today the private sector finances over 70% of R&D. Entitlement spending has crowded out government-funded R&D. The private sector is not going to invest in moonshot technologies, but the government can. Look at what the Trump administration achieved with Operation Warp Speed, the rush to secure COVID-19 vaccines.
Reallocating federal spending from welfare to R&D would be greatly beneficial. Congress should also eliminate Biden’s green energy subsidies and redirect those monies to fundamental R&D. Prominent economists recently concluded that government-funded R&D is key to productivity growth, point-blank stating:
“A declining public sector role in R&D has coincided with a slowdown in productivity growth and a stagnating standard of living for most Americans. … Research demonstrates that after about 8 years, increases in federal government appropriations for fundamental research and development programs productivity starts to significantly and steadily increase.”
In plain language, government-funded R&D jump-starts productivity and long-run shared prosperity.
People matter, too. Uncontrolled immigration is bad for America. Biden waited too long to make any effort to secure the border. But the evidence is overwhelming: Controlled immigration is great for America. We should secure the border while keeping the door open for those who self-select for grit and hard work. Policy should encourage immigration to the U.S. of the best and brightest from overseas. Immigrants are responsible for 36% of innovation in America. Immigrants self-select for intelligence, for determination, for grit, and for hard work.
Winning the race for artificial intelligence dominance is equally critical. The EU is suffocating AI with regulations. The U.S. must reject that approach. AI could increase long-run productivity growth in the U.S. by 0.5% to 1%. If realized, such increases would have a profound effect on national welfare and the long-run trajectory of the budget deficit. The CBO observed that without any tax increases or spending cuts, “if the productivity of labor and capital in the nonfarm business sector grew 0.5 percentage points per year more quickly than CBO projects, federal debt held by the public in 2054 would be 124% of GDP not the 211% currently projected.”
Top line: Future deficits could be almost halved by the full realization of AI. But the data centers that power AI require vast amounts of energy. Researchers project that AI energy demand will soar from 3% of national energy consumption to 8% by 2030. That matters because green energy is too expensive and is not yet a 24/7-ready fuel. The U.S. has a strong comparative advantage in fossil fuels. Europe has turned its back on fossil fuels. That decision is hollowing out the economies of Western Europe. Absurdly, however, Biden has said he wants to eliminate fossil fuels.
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That is nihilistic. We must instead rush to develop AI and power that transformative technology with America’s cheap and abundant fossil fuels.
The U.S. has great potential to continue dominating the global economy and providing increased living standards to its citizens. But unless bold leadership is forthcoming, we risk replicating Europe’s economic rot.
James Rogan is a former U.S. foreign service officer who later worked in finance and law for 30 years. He writes a daily note on the markets, politics, and society.
