Sometimes It's Even Worse

Well, I'll admit I was wrong.  A week or so ago, before the CBO score was out, I estimated that the Senate sequester replacement plan would defer most of the deficit reduction until later and do very little of it in 2013.

So in summary, the best case is that the bill reduces the deficit by about $8 billion this year.  The worse case is that it adds about $3 billion to the deficit this year.  Neither is anywhere close to $85 billion in deficit reduction this year.

Well now the CBO score is out and it is in fact worse than I thought.  Let's start with spending.  The Senate bill increases spending relative to the baseline with the sequester included by $63 billion.  In other words, it eliminates $85 billion in spending reductions in 2013 and replaces them with $22 billion in net spending reductions over the next 10 years.  And of this $22 billion, only $5 billion (net) comes in the next 5 years.

On the tax side, it adds $55 billion of tax increases, almost all of which come from the application of a new alternative minimum tax, beginning at incomes of $1 million.

So to review, the bill as scored by the CBO, replaces $85 billion in deficit reduction in 2013 achieved by spending reductions with $400 million of deficit increase in 2013 (a small spending increase almost offset by a small tax increase) and $77 billion of deficit reduction over the next 10 years, 72 percent of which ($55 billion over $77 billion) is tax increases.

So the "balanced proposal" of the Senate achieves no deficit reduction in 2013, less deficit reduction over 10 years than the sequester would achieve in 1 year, and has more than 70 percent of the deficit reduction coming from tax increases.

A replacement it is not.

The Impact of "A Balanced Approach"

All the discussion from the President has been about the need for "a balanced approach" to the sequester which, roughly stated, means replacing half of the spending cuts with tax increases.  Let's leave aside, for the moment, that the other aspect of "a balanced approach" seems to be kicking the can to the future and focus for a moment on the impact on spending growth and tax rates of this approach assuming it were to happen.

For the purposes of this argument, I'm going to assume that this notion of balance applies to both the sequester and the BCA caps.  The reason I'm making this assumption is that, were one to believe the President's argument, it probably should.  After all, why allow caps to be all spending when you can achieve the same deficit reduction through a mix of spending and taxes.

To make the analysis simple, I'm going to focus on the last year of the caps, fiscal 2021.  In the CBO baseline, total government spending is forecast to grow by 5.25% on average per year.  Now what happens if we let the caps go.  Well, in 2021, the caps and the sequester restrain spending by $178 billion (Table 1-5).  But we are going to go halfsies so we'll raise spending by only $89 billion that year.  This then would take the growth rate of spending up to 5.46% and spending as a percentage of GDP up to 22.8% from the current forecast of 22.4%

Now on the tax side, let's make the assumption that all of the tax increases come from "the rich" and that this plan continues through the period.  In total, on a 10 year basis, this would equate to a tax increase at least as large at the increase that just went through on the top rate over 10 years.  That increase raised the effective tax rate of the top 1% of taxpayers by 3 percentage points.  We might rightly assume that this would do similar taking the effective tax rate of that group to 39.4 percent, the highest rate ever by a fair margin.

Such is the effect of "a balanced approach."  Spending back up over 23 percent of GDP by the end of the forecast, the highest effective rates in measured history (which I remind you only goes back to 1979 where there was a 70 percent marginal tax rate), and an accelerating deficit and debt to GDP ratio.

The Times Should Know Better

You can expect the New York Times Op Ed page to be liberal but you should also have a reasonable expectation that it be factual.  Today, it published an editorial that may be the least factual thing I've ever seen.  I'm going to take the unique step of taking the major claims one by one only because it is such an awful piece.

Both are wrong. To reduce the deficit in a weak economy, new taxes on high-income Americans are a matter of necessity and fairness; they are also a necessary precondition to what in time will have to be tax increases on the middle class. Contrary to Mr. Boehner’s “spending problem” claim, much of the deficit in the next 10 years can be chalked up to chronic revenue shortfalls from the Bush-era tax cuts, which were only partly undone in the fiscal-cliff deal earlier this year.

OK.  As a starting point, this is ridiculous.  The CBPP link in the quote is obvious hokum and is completely devoid of historical context.  Tax receipts over the coming decade are planned to average 18.9% of GDP while during the 8 fiscal years of the Clinton administration (FY93 to FY01), they averaged 19.1% of GDP according to the OMB historical tables.  So, over the next 10 years, tax receipts are .2% of GDP lower than they were during the Clinton administration (aka before the "Bush Tax Cuts.")  But you should keep this thought in mind as we move through the editorial.

It stands to reason that a deficit caused partly by inadequate revenue must be corrected in part by new taxes. And the only way to raise taxes now without harming the recovery is to impose them on high-income filers, for whom a tax increase is unlikely to cut into spending.

Two problems here.  First, it absolutely does not stand to reason that a problem caused by inadequate revenue must be corrected by new revenue.  That's the very fallacy I discussed earlier in regard to the argument that it's all a health care spending issue.  But even more shocking is the Times inability to understand the GDP accounting identity.  In the view of the editorial writers, it appears to be GDP = C+G.  That's it.  There's no such thing as I in the accounting identity.  Thus, tax increases that cut investment don't affect GDP, only those which affect spending do.  Such a fundamental misunderstanding of macroeconomics 101 really is a bit shocking.

As it happens, those taxpayers are the same ones who benefited most from Bush-era tax breaks and who continue to pay low taxes. Even with recent increases, the new top rate of 39.6 percent is historically low; investment income is still taxed at special low rates; and the heirs of multimillion-dollar estates face lower taxes than at almost any time in modern memory.

Well this point is more misdirection than outright deception or misinformation but let's take the three points in order.  Those taxpayers are the same ones who benefited most from Bush-era tax breaks.  This isn't actually true if you look at changes in effective rates but why debate this when those tax breaks are no longer in force for those people.  Wouldn't you think that's a relevant thing to mention?

 Even with recent increases, the new top rate of 39.6 percent is historically low;  Wow.  But of course, people don't pay marginal tax rates, they pay effective tax rates and based on effective tax rates, the current rates of the wealthiest Americans are quite high relative to the last 33 years of history (the only good history we have).  The only year we have on record where the top 1% paid a higher rate than they are scheduled to pay in 2013 was 1979.  For the top 0.1%, the 2013 rate is the highest on record.

...investment income is still taxed at special low rates.  Investment income has been taxed at a differential rate in almost every year since the creation of the income tax.  The Times makes it sound as if this is some new innovation in the tax code.  We can debate differential taxation for capital income but this is not the way to do it, by pretending it is some new phenomenon.  We might also choose to note that the new tax rate on capital gains (23.9% including the ACA tax) is higher than the effective income plus social security (both sides) tax rate of all Americans except those making over $1 million.

It is true that estate tax rates are low today relative to recent history.  Of course it's also true that estate tax raise very little revenue so, in the context of a debate on the US's fiscal health, they are not terribly important.

On the spending side, Republicans are resisting cuts to defense. That implies brutalizing cuts in nondefense discretionary areas, like education and environment, which are already set to fall to their lowest level as a share of the economy since the 1950s.

Frequent readers will know that I personally have no issues with defense cuts; however, the Times is taking license and not informing again.  First, the government did not track nondefense discretionary spending until the 1960s so we don't know what we spent in the 50s (although I would assume the editorial is correct).  Most substantively, including the BCA and the sequester, defense spending is forecast to fall to its smallest share of GDP since 1940 (defense spending was actually measured by the government that far back).  Again, we can have a debate on whether we should care about either of these facts but not to mention both is simply spinning.

As for entitlements, Republicans mainly want to cut those that mostly go to the middle class and the poor, while ignoring nearly $1.1 trillion in annual deductions, credits and other tax breaks that flow disproportionately to the highest income Americans and that cost more, each year, than Medicare and Medicaid combined. 

The entitlements on which Republicans are focused are Medicare and Social Security which go to the elderly regardless of income.  One would imagine the Times is aware that the elderly are the wealthiest cohort of American society.  We might also wonder what the rationale is from the editors to pay Medicare benefits to Mr. Buffet and Mr. Gates.

But ignoring the $1.1 trillion in deductions, credits and tax breaks that flow disproportionally to the highest income Americans and that cost more, each year than Medicare and Medicaid combined requires a bit of unpacking.  First, the authors conveniently exclude Social Security, which, by itself, is planned to cost $810 billion in 2013.  SS and Medicare together are a $1.4 trillion expense item.  That comparison would seem germane given the discussion that has occurred over entitlements.

But about that $1.1 trillion number.  Interestingly in an editorial with links, it's unlinked.  Here you can find a link that gets you to a number that rounds to $1.1 trillion but that includes corporate and individual tax rates and one of the tax preferences is the already mentioned differential in the treatment of capital income.  And, importantly, tax preferences are more equally distributed than tax contributions.  In other words, people who pay 40% of the taxes get less than 40% of the tax expenditures.  Thus, the total elimination of tax expenditures would make the tax code less progressive.

The editorial closes with But there will never be a consensus for more taxes from the middle class without imposing higher taxes on wealthy Americans, who have enjoyed low taxes for a long time. And I can only add to the end "but no longer do."

The Tax Rates of the 50s and 60s

You can't throw a stick without hitting someone saying that everything would be fine if only we would go back to the tax rates of the 1950s and 1960s.  Normally, when this point is made, it is in a discussion about income tax rates and how low they are.  I have often been perplexed by this perspective since I have always thought that total tax receipts were lower during that period.  So I took a look.


The top graph shows personal tax receipts as a percentage of GDP by decade historically from the OMB historical tables and the bottom graph shows the current CBO forecast of personal tax receipts from 2013 to 2023 (post the changes in the ATRA).

Two conclusions make themselves pretty immediately evident.  First, the personal tax receipts were lower in the 1950s and 1960s than they were in any subsequent decade despite the higher marginal tax rates that were in place during that time.  Second, projected tax receipts under the ATRA quickly outpace the average of any decade during the entire postwar history of the country.  So while one can always argue that personal tax rates should be even higher, it is very difficult to argue that based on a "getting back to the successful economy of the 50s and 60s" framing.

The next part of this debate is to deal with the distributional question, namely that personal taxes on "the rich" were a lot higher in the 50s and 60s.  This is also not true but more on that in the next post.

When $85 billion is Really Less than $10 billion

There's been lots of reporting and hyperventilating about the sequester, so imagine the sighs of relief that must have gone up when the Senate Democrats announced their replacement bill.  Of course, it being Congress (either House), the bill is not actually available in any public forum.  We do know the name of the bill - The American Family Economic Protection Act - but the text is not yet available.

This article at Business Insider seems to be the best summary of the bill I can find.  Let's review the bidding.  First, the sequester is expected to reduce spending by $85 billion this year (that's fiscal 2013) from what would otherwise be spent and therefore reduce the deficit by the same amount.  So how much does the AFEPA reduce the deficit this year?  Let's take the bill's provisions one by one.

1.  Defense

Defense cuts are not implemented until 2014 and are then simply capped at .5% lower than the caps that already exist in 2014 and beyond in the BCA.  So defense savings in 2013 are zero and deficit reduction in 2013 is zero.

2.  Agriculture

It gets a little bit harder here.  The bill summary claims it saves $27.5 billion net, $31 billion gross but doesn't say anything about two critical points - whether interest is included and when the additional spending happens.  So the best case is let's say 1/10 of $27.5 billion or $2.75 billion savings this year.  The worst case would assume interest savings are in the total and the new spending all happens this year (in my view the most likely case given Washington budget language) and the savings start in 2014.  In this case, the bill probably has savings about about -$3 billion this year, meaning it marginally increases the deficit.

3.  Buffet rule

The bill claims roughly $50 billion in savings from the Buffet rule.  Based on previous CBO scoring of the Buffet rule, this almost assuredly includes interest savings.  What is again unclear is what assumption is being made about implementation.  I've found things that say now and things that say 2014.  So best case here is about $5 billion in deficit reduction and worse case is zero.

4.  Other tax changes

They account for only $3 billion in total over 10 years so their one year impact is negligible in any event.

So in summary, the best case is that the bill reduces the deficit by about $8 billion this year.  The worse case is that it adds about $3 billion to the deficit this year.  Neither is anywhere close to $85 billion in deficit reduction this year.

Interestingly, both would push the deficit forecast this year back over $1 trillion.

The contraction in State and Local spending

I'm getting a little bit tired of reading about the state and local government contraction.  So I decided to look it up.  Here's the graph

So state and local governments are contracting by spending more.  It does make you wonder why people post things without looking at the data first.

There's no doubt that state and local government employment is down through the recession.  But spending is not down.  So that tells you that state and local governments prioritized other things over employment.  That may or may not be a bad thing but it's certainly not a contraction, at least as it is defined in the economic literature.

A Balanced Plan?

The White House is fond of arguing that our changes in fiscal policy should be "balanced" between tax increases and spending cuts.  As a recent example, see this from Dan Pfeiffer.  In it, Mr. Pfeiffer refers as an example of the President's notion of balance to his proposal to the supercommittee.  So I decided to take a look at it in a little bit more detail.

The conclusion was surprising even to me.  The way I would suggest the math is "fair" would score the President's proposal at $70 in tax increases for every $1 in real spending cuts.  I wasn't expecting balance but I was expecting more balance than this.  Let me tell you how I got there.

The President and his team present this as a "balanced" proposal over and above the savings from the Budget Control Act.  The administration provides a convenient summary of its proposal in Table S-6.

American Jobs Act - $447 billion
Mandatory Savings - $(257) billion
Health Savings - $(320) billion
Cap OCOs - $(1084) billion
Tax reform - $(1573) billion
Interest savings - $(715) billion

When I first looked at the table, I didn't think much of it but then I started reflecting on the word choice.

The first thing that occurred to me was the use of the word "savings" in relationship to what others might call spending cuts.  I started by assuming it was just a word choice thing but then I decided to go look at table S-4 where the specific programmatic recommendations are made.

Here are some of the components of "Mandatory Savings" and their sizes:

Increase government fees charged by Fannie Mae and Freddie Mac - $27.5 billion
Increase the passenger aviation fee - $15.0 billion
Raising Unemployment Insurance taxes - $33.0 billion
Recoup financial sector assistance (a tax one presumes) - $30 billion

So of the $257 billion in mandatory savings, at least $100 billion are tax or fee increases.  This ignores increased copays for Tricare and other things that are individual costs.  So roughly 40% of the "savings" are actually tax increases.

In the administration's defense, most of the health savings are actual spending reductions, the largest of which is negotiating drug prices for Medicare.

But now on to the big items, the capping of OCOs and interest.  Capping OCOs is nothing more than not spending money we never intended to spend.  For example, we save $135 billion in 2021 according to this logic but not continuing the wars in Iraq and AfPak until that time.  Is there anyone who seriously expects those wars to be going at the current pace in 2021?  This is an accounting gimmick and nothing more.

Which brings us to interest.  First, it's worth noting that the interest number includes reduced interest from the BCA as well as these new items rather than breaking out the interest as would be more honest.  But more substantively, including the interest savings as a spending cut in the notion of balanced is ridiculous since it would allow a package that was all tax increases to have 15 percent or so of the savings come from "spending cuts."  As I've argued before, interest should be reported separately as it is not a policy change but the outcome of various policy changes.

All of which brings us back to the President's past balanced proposal.  Here's a quick restatement.

Phantom spending cuts (aka cuts that are reductions in money we never intended to spend) work out to $1.1 trillion.  Real spending cuts work out to about $25 billion over 10 years (remembering the President proposed $450 billion in incremental spending).  Tax increases are about $1.7 trillion.  So if we leave the phantom stuff and interest savings out, it's about 70 dollars in tax increases for every dollar of programmatic spending cuts.  An interesting definition of "balance" for sure.

How much growth does it take not to "cut" spending?

Here's a nice quote from Speaker Pelosi today.

"The fact is we've had plenty of spending cuts, $1.6 trillion in the Budget Control Act. What we need is growth," Pelosi said in an interview on "Fox News Sunday." 

But of course, we know that spending in the latest CBO forecast is planned to grow 5.3% per year between now and 2023.  So we are to simultaneously believe that we are cutting spending by $1.6 trillion and growing it by 5.3%.  Of course, that 5.3% assumes the BCA caps hold through 2023, those same caps that the Congress is trying to get rid of for 2013 as we speak.

One is left to wonder how fast spending in Washington would have to grow before we would stop claiming credit for large spending "cuts."

Assume Everything Goes Your Way...

That's more or less my take on the current projections offered by the CBO.  To summarize and build on the work of William Gale

They assume:

1.  The economy reaches full employment/output by 2017 and stays there through 2023.  This both assumes rapid growth between now and 2017 and no recession or crisis between 2017 and 2023.  The budget outlook would markedly deteriorate were this not the case.

2.  Inflation remains low and (therefore) interest rates remain modest.  They CBO does assume a rapid climb in the real interest rate closer to historical levels (about 3%).  This would be welcome relief for savers but is consistent with the economic performance they are expecting.

3.  The savings in the BCA (the caps through 2023) hold, driving both defense and non defense discretionary levels to their lowest levels as a share of GDP since 1940 and 1962 (when tracking was started) respectively.  While, in my view, feasible and desirable, this is vanishingly unlikely.

4.  Health care inflation remains tame.  The CBO grandfathers recent trends in health care inflation into their forecast.  That's certainly possible but again it's an optimistic assumption given long term trends.

5.  The picture on the ACA does not deteriorate further and certain long term assumptions hold.  Among the assumptions in the ACA are the cadillac tax, the number of people in the exchanges, and the reduction in exchange subsidies beginning, I believe, in 2018.  Again, these are all optimistic assumptions.

And under these scenarios, the budget picture remains basically unchanged.  The debt to GDP ratio at the end of the period is slightly higher than it was in 2012.  The deficit is above 3 percent of GDP and nearly back to a trillion dollars.

I spend most of my time in business.  If you're presented with a plan that assumes everything has to break your way in order for you to move sideways, you know you are in trouble.  We are definitely (still) in trouble, despite about a 1 percent of GDP increase in tax receipts (between the ATRA and the end of the payroll tax holiday).

Real Budgeting is Still Better

As promised, I've updated my "real" budget projections on the basis of the CBO forecast that was just released (more observations from the CBO report coming up soon).  A quick summary of the assumptions and findings follows below.

Critical Assumptions

• Spending for each budget category grows at the relevant rate of growth of inflation and population.  Thus, Medicare spending grows at the rate of medical inflation (3.2% over the last 5 years) and the over 65 population (each year as projected by the Census)
• Tax receipts are as assumed in the CBO forecast
• Interest expense is calculated based on public debt and effective interest rate calculated from the CBO projections
• OCO spending assumed to decline to $50 billion and remain there
• Disaster spending rebased to $20 billion in 2013 and beyond
• Discretionary spending, Medicare, and Medicaid assumed to become 10% more efficient over the decade
• UI spending rebased to full employment economy per the numbers in the CBO forecast

The net effect of this is that all major class of spending grow, albeit most grow more slowly than in the CBO baseline forecast.  Medicare for example, grows at 5.3% per annum on average (including efficiency effect).  Defense (including OCO spending) grows at 0.4% per annum but continues to grow in nominal terms.

Meanwhile, revenue is projected to grow at 6.2% per annum.  The combination of these results in a rapid and continued reduction in deficit spending versus the CBO baseline.  I summarize the results in the two charts below.  First, we'll look at deficit to GDP ratios.

The basic change here comes in the medium and long term.  In the CBO forecast, the deficit picture deteriorates dramatically in the latter half of the forecast.  In the "real" baselines, the deficit picture continues to improve to 2023 ending the period nearly 300 basis points better as a percentage of GDP.

Not surprisingly, the debt picture is similar.  Instead of improving and then getting worse as in the CBO forecasts, the "real" budget picture continues to improve over the entire course of the forecast.  So the learning here remains.  A more restrained view of the growth of federal spending can dramatically improve the budget picture without making any major changes to the revenue side of the equation.

The Fallacy of Causation and Solution

This post from Kevin Drum is a good example of one of the fallacies that seems to be making the rounds these days.  In the body of a typical argument about why Republicans are unserious on the deficit (true for most in my view), Kevin makes the following argument.

It's all healthcare, baby. If all of the pressure on the deficit were being applied to serious proposals for reining in healthcare spending, in an effort to get U.S. spending levels down to those prevailing in socialist Europe, I'd probably applaud. 

So the solution to the deficit is all about healthcare.  You can see similar arguments popping up all over the left blogosphere.  Mostly, as in this case, these are arguments for universal health care but leave that aside.  The point is that they represent a fallacy, the fallacy that if A is the cause of a problem then a change in A must be the solution.  Certainly we can look at changing A (health care) but there's no particular reason that changes in A must be the answer.

To make the point, let's take a look at taxes and spending relative to 2000 (the last time the budget was balanced).  I'm going to look at this in two ways.  First, I'm going to look at effective tax rates across the income distribution (similar to my previous post comparing to 1979).  Using the same TPC and CBO assessments, one gets the following picture.

So, relative to the last time we had a surplus, effective federal tax rates in 2013 are projected to be lower for every income group except for the top 1% where rates are projected to be 3.4 percentage points higher than they were in 2000.

By the Kevin Drum logic, I should therefore cut the tax rates of the top 1% and increase the tax rates of everyone else since that would be the way to correct the problem by addressing the changes that led to the problem in the first place.  I rather doubt that Mr. Drum or his intellectual comrades would be in favor of this approach.

We can of course extend this thinking by looking at the spending side of the equation.  In 2000, spending on domestic discretionary programs was 3.0 percent of GDP.  In 2011 (2012 is not yet available), these same programs consumed 4.3% of GDP.  Should we therefore cut these programs by 30% in nominal dollars?  I rather doubt this is the plan that would be embraced by Mr. Drum.  Indeed we know this is not the case since "It's all healthcare, baby."

The point here is not to argue that addressing healthcare isn't an important part of our long term deficit picture but rather to argue the fact that healthcare spending has increased and will continue to do so does not imply that the only (or primary) solution is to reduce or slow the rate of growth of health care spending.  The prescription may or may not be right, the logic is not.