Why Our Way of Discussing Budgets Must Be Reformed

The following appeared in an article at The Hill online

Republicans are betting that the public will be receptive to the Ryan plan’s measures to balance the budget in just 10 years, through lowering tax rates, $5.7 trillion in spending cuts and a repeal of the president’s healthcare reform law. 

 Of the three claims, one is partially true but misleading, one is false (in any reasonable world) and one is true.  The last one is true...the Ryan budget does repeal the President's health care law but the other two are misleading at best and false at worst.

First the misleading part...the lowering of tax rates.  Yes, the Ryan plan lowers tax rates and balances that with limitations on or eliminations of deductions in the current tax code.  Leaving aside my point of view on Ryan's tax plan, we should be able to agree that the average person, reading the words "through lowering tax rates" could be forgiven for assuming that Ryan plans to reduce government revenues to some degree.  Of course, as I've pointed out, this simply is not the case.  The Ryan plan proposes to increase government revenues by an average of 6.2% per year for the next decade.  It may well be that we should increase revenues more (as other budgets have proposed) but it is certainly not the case that Congressman Ryan has proposed cutting revenues.

Now the false part - $5.7 trillion in spending cuts.  There are no $5.7 trillion in spending cuts in the Ryan budget.  The budget proposes growing spending by 3.4% per year on average for the next 10 years.  Perhaps, some day we will realize that we can't grow spending by 3.4% per year while cutting it by $5.7 trillion.  Clearly today is not that day.

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.

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.

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."

The (Not Quite) Worst Deal Imaginable

Well, I can say this for the current fiscal cliff deal.  It is not quite the worst deal imaginable but it does come close.  Here are some immediate and top of mind reactions.  I reserve the right to change some of these as more of the details come out but for now I think I can stick with...

1. It's mostly a "small" tax increase bill.  The net tax increase is being reported at about $600 billion  over 10 years.  That averages $60 billion a year against deficits that look like they are going to be in the $1 trillion plus range for the foreseeable future off of this baseline.  So we should prepare for our fifth straight year of deficit spending greater than a trillion dollars and 7% of GDP.
2. It gives away some of the benefit of "tax reform" before we've even gotten to tax reform.  It's hard to find exact estimates but the PEP and Pease changes probably raise about $100 billion or so in the 10 year window.  That's $100 billion of the $800 billion or so that has been discussed in "tax reform" discussions.
3. It makes a future "grand bargain" much, much harder.  The notion of a "grand bargain," that is tax increases for spending cuts was always a decent idea in the context of Washington but it would appear that idea is all but dead.  There's just not much one can do on tax increases now without increasing taxes on the middle class and thus the math of a grand bargain is simply not going to work.
4. It smells like a spending increase relative to the baseline.  The only report I've seen says "net" spending reductions are $15 billion.  But Congress includes reduction in debt service as a spending reduction and likely is using current policy as the baseline.  Thus, the debt service change (probably $60 to $90 billion of the $600 total) is probably counted as a spending cut meaning that spending, ex-debt service, most likely increased.

So is there anything good about the bill?  I can only come up with two things.  First, the reported permanent indexing of the AMT to inflation is a really good thing.  Assuming that stays in, it's a positive change from our perpetual patching process.  Second, the continuation of UI benefits is, from my perspective, also a good thing.  We can debate the merits of the UI system but putting some money in the pockets of people who have been employed is a good thing until we figure out a better unemployment system.  Sure it costs $30 billion but we could easily make that up somewhere else if we really wanted to.

And that's pretty much all she wrote.  Can kicking continues and looks like it's going to continue on pace for the foreseeable future.  There will be a lot of griping on both sides but in my view, Washington is simply incapable of dealing with the debt problem we have.  This latest event simply sheds more light on their (and our) dysfunction.

How to be Irresponsible

It's a bit rare that I cross post here but this post from Christopher Demuth is worth reading in its entirety.

In a nutshell, it exposes the loss of focus of both Keynesianism and supply side economics.  Both have been subverted by the political process into a force for moving consumption to today and costs to the future.  In effect, we have a political process that competes for how to be irresponsible as opposed to whether to be.

Which brings me to the current fiscal cliff debate, the perfect incarnation of the how to be irresponsible discussion.  On one side, we have the Democratic party which is asserting that tax increases on 2% of households and (small) unspecified future spending changes will be sufficient to avert the fiscal crisis we face.

On the other side we have the Republican party which is asserting that future unspecified (but larger) spending reductions are sufficient to address the crisis.  I mean, look at these plans in context.  Over the next decade, we plan to spend about $45 trillion and tax about $35 to $40 trillion.  And our tax and spending plans amount to a change of $2 trillion or so in total, a 2.5% change from the most unbalanced place we've ever been.  And that's DC's version of difficult choices.

And that's the debate...a debate about how to be irresponsible...about which irresponsible ideology will prevail.  Unfortunately, regardless of the outcome of the debate, the future is the same.  We run up debt until we can't anymore.  At that point, some combination of future taxpayers and asset holders get well and thoroughly screwed.

Principled Spending - The Numbers

So now we come to the actual numbers that we would use for our principled spending budget.

Let's start with putting some numbers on the principles.  As you recall, our first principle has to do with base spending growth equally the growth rate of inflation plus population.  To get at this, I've used the last 5 year inflation rate for medical spending and other spending from the CPI.  For population, I've used the US population numbers with the exception of for Medicare and Social Security.  So to summarize, Medical spending has a projected inflation rate of 3.6% which is assumed constant for the next decade and the senior population grows between 2.7% and 3.5% per year depending on census projections.

The second set of numbers requires us to understand the current level of emergency spending and take it out of the budget over time.  For this, I have estimated reducing $100 billion in overseas contingency operations (Iraq and AfPak) and $200 billion in "income security."  Both of these are consistent with government estimates and the spending is reduced over a 4 year period from 2013 to 2016.

Finally, I apply an efficiency factor to government spending of 1% per annum.  In effect, this requires government to improve efficiency of delivery by 10 percent over the next decade but this factor is not applied to pure transfer programs (namely social security and other income security).

Finally, baseline defense (ex-OCOs) is treated as a special case.  Defense is assumed to grow only with the rate of inflation since population has little to do with the need for defense spending.

With these assumptions, we arrive at the following growth rates by category.

Defense (including OCO spending) - (0.4%)

Medicare - 5.7%

Social security - 5.2%

Non defense discretionary - 1.6%

Medicaid - 3.2%

Total spending - 2.2%

Or graphically, to compare the President's budget to the forecast, you get something that looks like the following:

And there you see the impact of excess spending over a principled baseline.  You may be wondering about the deficit against current baselines.  This number is pretty hard to calculate because of the large number of baselines.  However, using the revenue assumptions in the Ryan budget as a proxy for the current policy baseline, we would have a deficit in 2022 of 1.6% of GDP in 2022.  The deficit would fall below 3% of GDP in 2016.  All this from a simple change in spending orientation.

In the next post, I'll talk about how the tax code might change to fund this projected level of spending, since, as you recall, the principled approach to to tax enough to cover your spending.

Principled Spending

Well, it took me a lot longer than I had thought it would to come back to this but I did want to return to the principled view on taxes and spending.  As I said I would, let's start with spending and what the principles are that we might use and what they might mean.

So what are the principles we could use for spending?  I'd say there are really only 3.

1.  Government spending should grow no faster than the historical rate of inflation plus “relevant population growth.”  It is critically important to argue that government should be on a COLA the same way that our seniors are.  Why should government be able to expand its budget faster than anyone else simply because it perpetually borrows the difference?
2. Government may still institute “emergency” spending during recessions but this spending will be accounted for separately and brought to zero as the economy improves.  Explicit countercyclical spending should in fact be accounted for separately.  Failure to do this is what has allowed the budget to expand under President Obama.  The stimulus was baked into the baseline, a terrible mistake from the standpoint of fiscal responsibility.
3. This COLA approach (excluding any emergency spending) will form the new baseline for government spending from which we will attempt to drive even greater efficiency.  In other words, the COLA approach serves as a ceiling rather than a floor for spending (ex-emergencies).

Let's explore these a bit more in depth.  As to the first, we should ask our politicians to set some threshold that isn't a baseline for how fast government should grow.  As a cost center, government shouldn't need to grow faster than the population it serves plus the rate of inflation.  In fact, growth at inflation plus population more or less assumes no positive returns to scale.

Principle 2 is equally important for fiscal sustainability.  The government should differentiate emergency spending from baseline spending with the assumption that emergency spending will be reduced to zero once the emergency has ended.  Overseas Contingency Operations (the wars) are a good example of this but so are automatic stabilizers (like extended unemployment insurance).  Without an assumption that these emergencies go to zero, we never can differentiate whats "in the base" from what's "temporary."  Putting things in the temporary bucket ties them to external events.

Finally, the third principle is what we the people ultimately ask government to do on our behalf.  The more efficiency we demand from government (or the more economies of scale we believe exist), the more we should ask for a rate of growth below the "COLA baseline."

These principles may seem small but in point of fact their application would dramatically improve our fiscal position, a point I will cover after we cover tax principles in the next post.