Virginia’s Falling Tax Revenues: Cuccinelli Would Cut Them Further

Virginia State Taxes as share of Virginia GDP, FY 1972-2012

A.  Virginia’s Falling State Tax Share

Virginia state tax revenues have been falling as a share of Virginia GDP for decades, as the graph above shows.  Yet predictably, a major plank in the proposals of the Republican candidate for governor, Ken Cuccinelli, is that Virginia state taxes should be cut further.

The line in the graph was calculated from figures on state tax revenues from the US Census Bureau (which collects such data on a consistent basis for all fifty states), with the figures on Virginia state GDP from the Bureau of Economic Analysis (which publishes state figures with its regular GDP accounts).  The downward trend is clear, and a regression line fitted to those figures (in red) confirms it.

With Virginia taxes lower now as a share of income than they were before, it is hard to see how one can argue, as Cuccinelli does, that they are too high and act as a hindrance to economic performance.  The taxes were higher as a share on income in the past, and economic performance then was good.

But the lower share of state taxes in income, coupled with the implications of Baumol’s Cost Disease (discussed in a previous post on this blog), does explain why Virginia state government services are so much worse now than they used to be.  Sub-national governments must over time limit their public expenditures to what they raise in tax revenues (with a limited ability to shift some of these across time through issuance of state bonds), and Virginia has been a particularly strict adherent to such budgetary rules.  With lower revenues, the state government has no longer been able to provide the public services it once had.

I grew up in Virginia in the 1960s, and at that time Virginia took pride in the quality of its public services.  The state highway system was one of the best in the nation.  State universities such as the University of Virginia and William and Mary were among the best state schools in the country, and also ones where good students graduating from high schools in Virginia could reasonably aspire to getting in as spaces were adequate.  This is no longer true.

B.  The Cuccinelli Tax Plan

Virginia is one of only two states holding gubernatorial elections in this off-year (New Jersey is the other).  The Republicans nominated Ken Cuccinelli, the current Attorney General, as their candidate.  Cuccinelli is best known for his support of a radically conservative social agenda.  His tax plan is similarly a radically conservative proposal which would cut revenues drastically.

The key elements of Cuccinelli’s plan are to:

1)  Eliminate the current top individual income tax bracket in Virginia of 5.75%, replacing it by extending the current 5% second highest bracket;

2)  Cut the Virginia corporate income tax rate from 6% to 4%;

3)  Establish a commission to propose further tax cuts;

4)  Close “loopholes” to raise as much in revenue as would be lost through the cuts in the tax rates;

5)  Cap growth in Virginia state government expenditures to the rate of inflation plus population growth.

But note on each of these proposals:

1)  Eliminating the top tax bracket, and only the top tax bracket, of 5.75%, means that only those households paying the top tax bracket will benefit from lower rates.  By construction, only the richest households will benefit.  The Commonwealth Institute for Fiscal Analysis, a nonpartisan institute based in Richmond, has estimated that fully three-quarters of the benefits from this lower tax rate will accrue to households earning more than $108,000 a year, and that 25% will go to the richest 1%.

2)  The corporate tax rate would be cut by a third, a huge cut, and would bring Virginia’s rate to the lowest of any of the 44 states in the US that have a corporate income tax.  The other six states follow a different tax structure.

3)  The mandate of the proposed commission would be to make even further tax cuts.

4)  It has now become the norm in Republican tax plans that while there is great specificity in the taxes that would be cut, there is no specificity at all on what taxes would be raised (other than that they are all “loopholes”) so that overall tax collections will remain unchanged.  Mitt Romney did this for his presidential campaign last year, and independent analysis showed that his plan was simply not mathematically possible.  Paul Ryan has similarly left undefined what loopholes he would close to raise sufficient revenues to offset his proposed cuts in tax rates, in the budget plans he has set out for the Republicans in Congress.

It would probably not be correct to say that Cuccinelli is keeping secret what tax loopholes he would close.  Keeping them secret would imply that he has looked at the issue and has a plan that he refuses to disclose.  There is no evidence that any such plan exists, much less any assessment of whether the revenues thus raised would offset the losses.  But it may be astute politically to propose sharp reductions in tax rates, while asserting that he will come up with the same in revenues by closing unspecified loopholes that one can believe only others benefit from, and not yourself.

5)  Capping growth in Virginia government expenditures at inflation plus population growth implies absolutely zero growth in real per capita terms.  But for an economy to grow, you need to grow supportive public services.  Hindrances such as a totally inadequate road and public transportation network result when you do not.

Cuccinelli’s tax plan is radically right wing, with sharp cuts in tax rates focussed on the rich and the corporate sector, while asserting with no evidence that it will be made revenue neutral by closing unspecified “loopholes”.  But this is consistent with Cuccinelli’s history of radically right wing policies, although in the past on social issues.  Cuccinelli has been strongly opposed to equal rights for homosexuals; believes that the police powers of the state should be used against couples for engaging in certain sexual acts in what most thought would be the privacy of their bedrooms; has insisted, as Attorney General, that new regulations be applied retroactively to shut down clinics providing health care services to women, in particular poor and minority women, since these clinics have provided also fully legal (and constitutionally protected) abortion services to women in need; has attacked basic academic freedoms by insisting that the University of Virginia turn over to him materials, including private emails, of a scientist doing research on global warming (he lost the case); co-sponsored a bill which would have declared that human life begins at the moment of conception under Virginia law, and hence women using certain forms of birth control (and presumably also their doctors) would be guilty of murder; within five minutes of Obama signing into law the Affordable Care Act to extend health care to the currently uninsured, Cuccinelli filed a case in court to block the act (he lost the case, and well before the Supreme Court ruling on the law); sponsored legislation which would not allow children of undocumented immigrants to become citizens, despite the US Constitution saying that they are; and more.

The one point on which all agree, liberal and conservative, is that Cuccinelli would radically change Virginia, if he has the chance.

The Big Squeeze on Government: Consequences of Baumol’s Cost Disease

Government Share of GDP and Baumol's Disease, 1952 to 2012

A.  Introduction

A point on which all agree, whether conservative or liberal, Republican or Democrat, is that the cost of government keeps rising.  Whether it is the cost of building new roads or new military jet fighters, or the cost of schools or health services, the cost now is much more than in the past.  And this is not simply general inflation.  The cost of government services has risen at a significantly faster pace than general inflation.

This is true.  But what is not generally recognized if the fundamental cause, nor the implications as we as a nation have struggled to maintain government services.  The fundamental cause is not waste and corruption, nor lazy government workers.  Rather, it lies in the nature of the goods and services used for the public services the government provides.

This blog post will first review the facts on what has happened to expenditures on government goods and services (which for brevity, will hereafter often simply be referred to as government goods) over the past 60 years.  The 60 year period is taken so as to encompass most of the post-World War II period, but to begin once the numbers had stabilized from the very high levels during the war and the immediate post-war fluctuations.

The post will then review the fundamental cause, drawing on the work that has come to be called “Baumol’s Cost Disease”.  The post will discuss how this applies to the government sector, and the implications.

B.  The Share of Government Expenditures in GDP

The share of government spending in GDP has declined over the last 60 years, from almost 25% of GDP in 1952 to less than 20% in 2012, a fall of a fifth.  It is shown as the blue line in the graph at the top of this post.  [Note:  The definition of “government spending” used here is for government as it appears in the GDP demand accounts.  It includes all level of government – federal, state, and local – but only includes direct government spending on goods and services.  Hence it excludes government transfers payments, such as for Social Security or farm subsidies.  Transfer payments are spent by those receiving the funds.]

A fall of a fifth is a significant reduction in the government share.  But it does not show the true extent of the fall, as such GDP share calculations are based on the prices of each given year.  One also needs to know how much one received in real terms for what was spent, and this depends on how prices have changed.

The GDP accounts issued by the BEA do include estimates of the changes in the relative prices of the different components of the GDP accounts.  Over the 60 years from 1952 to 2012, the GDP deflator (the index of inflation for all the goods and services making up GDP) rose at an annual average rate of 3.3%.  Over this same period, the deflator for government spending rose at a somewhat higher rate of 4.1% a year.  This might seem to be only modestly higher, and for a short period it would be.  But compounded over 60 years, this difference in inflation rates cumulates to a difference of 58% in the prices of goods and services used for government vs. goods and services used in overall GDP.

With this relative price change, it now (in 2012) on average costs 58% more (compared to 1952) to produce goods to be used for government expenditures, than it does to produce goods for overall GDP.  Since GDP is also our income (i.e. what we as a nation receive for what we produce), it takes a higher share of our income today to buy the same real goods used for government expenditures as it would have at the relative prices of 60 years ago.

Put another way, to get the same real goods used for government expenditure in 2012 as one would have gotten at the relative prices of 60 years ago, one will now have to spend 58% more.  Or if one spends the same dollar amount adjusted for general (GDP) inflation, one will receive only 1/1.58 = 63% as much.

This impact is huge.  We are indeed receiving far less now in government services for a given dollar expenditure than we would have at the relative prices of 1952.

One way to view this is to ask how much would we have spent as a share of GDP in 1952, for the same real level of goods used for government in that year, if the prices then were instead the relative prices we had in 2012.  The result is the red line in the graph at the top of this blog.  The same goods used for government in 1952 would, at the prices of 2012, have been equivalent to expenditures of 39% of GDP in that year.

Over time, this red line then fell.  It fell in part because the share of GDP used for government (in the contemporaneous prices of each year) was reduced over time and by a fifth by 2012, but more importantly also because the relative prices of the goods used for government provided services rose by 58% over the period.  The government share fell until it reached just 19 1/2% of GDP in 2012.  That is, correcting for the fact that prices of goods used for government were rising (relative to other prices) over time, in addition to the cut-back in the share at contemporaneous prices by a fifth, real government expenditures in terms of GDP share were only half as much in 2012 (19 1/2% of GDP) as what they were in 1952 (39% of GDP).

This fall by half is huge, and explains why we seem to get less and less from our government expenditures (whether on roads, or for military equipment, or in schooling), even though government spending as a share of GDP only fell by a fifth when measured in the current prices of each year.

Another way to look at this would be to ask what government spending would be now, if it had been allowed to grow over the 60 years at the same pace as GDP grew.  If there had been no relative price change, then at equal rates of growth the share of government in GDP would not have changed.  But with the relative price changes, a higher share of GDP would have been spent on government to provide such a bundle of goods for government. The fact that we spent less than that is a measure of how much government spending has been squeezed.
The result is the green curve in the graph at the top of this post.  It shows what would have been spent on goods used for government in each year, if government spending had grown at the same rate as GDP in that year, and valued in the prices of each year.  From 1952 to 2012, real GDP grew at an average rate of 3.1% a year (note this is total, not per capita, GDP).  Real government spending grew only at a rate of 1.9% a year over that period.  Cumulated over 60 years, the difference in growth rates meant that GDP grew by a total of twice as much as government did.  And the goods used for government provided services would have totaled 39% of GDP in 2012 at this constant growth share, or double the 19 1/2% of GDP actually spent in 2012.
[Note:  It is not a coincidence that the 39% of GDP in 2012 on the green line is the same as the 39% of GDP in 1952 on the red line.  The red line figure shows what the spending would have been at the government share in 1952 but at 2012 prices.  The green line figure projects forward this same 1952 share, leaving it unchanged relative to GDP in real terms, and in 2012 shows what this share would then have been at 2012 prices.  But the paths between 1952 and 2012 will differ, and are not mirror images.]
Whichever way one looks at it, this reduction by half in the government share is a huge squeeze on public services.  It goes a long way to explaining why our roads are so much more inadequate now compared to decades ago, with extreme congestion and poor repair.  It explains why our state universities are charging so much more in tuition, while state support has declined.  It explains why what we receive today in public services simply is not what it used to be.  But why have these costs of goods for public use risen so much faster than the cost of other goods?

 

C.  Baumol’s Cost Disease

What has come to be called Baumol’s Cost Disease (or sometimes simply Baumol’s Disease) was developed by William J. Baumol (then Professor of Economics at Princeton), together with William G. Bowen (then also Professor of Economics at Princeton, and later President of Princeton) in the mid-1960s.  They were engaged in a research project looking at why the cost of tickets to live performances of the fine arts had to rise continually, at rates above the general inflation rate, and yet still could not keep up with costs.  A recent re-statement of the issue (but with a particular focus on health care), is provided in the 2012 book by Baumol and others, titled “The Cost Disease:  Why Computers Get Cheaper and Health Care Doesn’t”.

In a nutshell, the fundamental cause of the cost problem is that labor productivity, while perhaps rising in all sectors, will not rise as fast in some sectors as in others.  The sectors where labor productivity rises relatively less fast will face increasing costs, as labor in such sectors will need to be paid more, due to competition for such labor from those sectors where productivity is rising faster.  Yet those sectors with the relatively slower productivity growth will not be able to offset that rising cost of labor with a rate of productivity growth that is as high as that enjoyed by the other sectors.  If we still want or need what the sectors with the relatively slower productivity growth produce, we will need to pay a higher relative price to cover those higher costs.

This is clear in the example of the performing arts.  A Mozart string quartet that required four performers 20 minutes to play in 1780, still required four performers 20 minutes to play in 1966, or in 2013.  Their productivity has not grown at all in over two centuries. Such performers could instead be employed in other sectors, and paid at increasing rates over time there, as labor productivity rose in those other sectors.  If they are going to be employed still to perform Mozart, they will need to be paid more, even though their productivity in playing a Mozart string quartet has not risen in centuries.

Baumol’s Cost Disease will arise whenever productivity growth in the sector being examined is less than productivity growth in the rest of the economy.  There has been a good deal of discussion recently of the implications of this in health (as for example in the Baumol “The Cost Disease” book cited above), as well as in education (explaining why university tuition has steadily risen at a pace greater than general inflation).  But it applies generally for sectors where the goods produced are labor intensive or hand crafted.

Much of the goods and services used by government for the services it provides are of this nature.  Roads, for example, are custom made for the specific site; military jet fighters (and most high tech military equipment generally) are made by highly skilled technicians in small batches of a perhaps a few dozen a year; elementary school teachers teach in classes that are similar in size now as they were 60 years ago; public health workers need to examine patients one on one; and public safety workers (police, firemen, prison guards, and other security workers) provide what they do by their direct presence; and so on.  Teachers, health care workers, and public safety workers, plus military personnel and postal workers facing similar issues, account for most public sector employees (keep in mind we are referring to all levels of government in this note).  And by its nature, the work of those in general public administration (“bureaucrats”) is also highly labor intensive.

It should be emphasized that productivity growth in the provision of government services has not been zero or negligible.  There have been efficiency gains in the government sector.  But the important point for Baumol’s Cost Disease is not that the productivity growth in that sector is zero, but rather that it is simply something less than the rate of productivity growth in other sectors.

And the nature of what government provides makes it impossible to match the productivity growth rates that one has seen most spectacularly in goods such as microchips and hence computers, but more generally in manufacturing and agriculture.  Government services, like many services, have had improvements in productivity, but at rates that simply cannot match the pace of productivity growth possible elsewhere.

Hence, because of Baumol’s Cost Disease the relative price of government services should be expected to go up over time.  This is precisely what has been observed.  There is no reason to attribute this rise in the relative price to allegations of corruption or lazy government workers.  It is of course possible that corruption and lazy workers exist, but for this to have caused the rise in the relative price over time one would need to make the case that corruption and lazy workers are not only worse now than before, but that they have become steadily worse over time.  There is no evidence that supports this.

It is also important to note that while the relative price of government services has risen over time in the past, with this also expected to continue going forward, this does not imply that we as a society will be unable to afford the government services at the higher relative price.  Labor productivity is growing, in the government sector as well as in the rest of the economy, and hence the cost in terms of labor time of the goods of government as well as this cost in the rest of the economy are both getting cheaper.  Hence we can afford to devote a higher share of GDP to government services over time, if we so choose, as the relative cost of government services rises.  And since what government provides, whether in education and health services, or infrastructure, or security and national defense, are all important, we should want to ensure they are adequately provided.

There is therefore nothing wrong for the share of government in GDP to rise over time, as Baumol’s Cost Disease will predict will happen if the services government provides are important.  They would need to be paid for, through higher taxes, but as the society grows richer from the productivity growth in both the government and non-government sectors, we can afford this.  The only problems that arise come from not recognizing this.

D.  Implications, and Conclusion

Since the implications of Baumol’s Cost Disease for government services has generally not been recognized, there are indeed problems.  There has been a tremendous squeeze on government, leading to government services that are an embarrassment for a rich country.  As the numbers above indicate, we are now spending only half as much on government in real terms as we would have had government been allowed to grow at the same pace as GDP since 1952.

Note that this is not an argument that government spending should have been twice as much in 2012 as it was.  This would have matched the real share that it was in 1952, and therefore is an indicator of how much government has been squeezed over this period, but the 1952 benchmark is arbitrary.  And with the 58% higher relative price for government goods over this period, it would be rational to try to scale back on the expenditures for the now more expensive goods.  But cutting back by half is extreme. Rather, the argument made here is that one should be making a well-considered decision at any point in time on whether particular government expenditures (whether for education, or for police, or for military jets) are worthwhile at the price of the time.  If so, one should do it.  But one should not subject total government expenditures to some arbitrary cap, and say that expenditures under that cap are fine while expenditures over that cap should not be allowed.  Since the higher prices over time (due to Baumol’s Cost Disease) reflect differential but still positive productivity growth rates, we can afford those higher government expenditures if we so choose.

Unfortunately, much of the budget discussion in recent years has focussed precisely on setting some fixed cap on government expenditures as a share of GDP.  There have been calls for such a cap directly, or indirectly by saying government revenues should be set at some cap as a share of GDP and that there should then also be a balanced budget (or a budget surplus).

For example, the Bowles-Simpson budget plan called for federal government revenues to be capped at 21% of GDP, with expenditures then set to match this.  The Paul Ryan budget plan called for federal revenues to be capped at 19% of GDP, with expenditures reduced to meet this and then to fall even further.  [Note that both of these figures are for total federal government expenditures, including transfers.  The figures in the graph at the top of this post are for government direct spending only, excluding transfers, but for federal, state, as well as local government.]

Understanding the underlying dynamics resulting from Baumol’s Cost Disease shows how misguided such constant share of GDP targets are.  They ignore that a growing economy, with a growing population, will need to be supported by growing government services.  Given the nature of government services, one cannot expect the rate of productivity growth  in government to match that enjoyed elsewhere in the economy.  There is nothing wrong with that, and does not necessarily reflect a lack of innovation or skill.  Some goods are simply more labor intensive than others, and productivity growth will generally be less for such goods.

By Baumol’s Cost Disease we can see that then the prices of the goods used for government will rise relative to others, and that if we still wish to obtain such goods, we will need to pay more.  The GDP share will rise, but we can afford it as productivity is rising in all the sectors.  They are simply rising at different rates.

Eurozone Unemployment at Record High: The Consequence of Austerity Programs

Eurozone Unemployment Rate, Dec 2007 to March 2013

As reported in the recent release from Eurostat, Eurozone unemployment rose again in March to a record 12.1%.  This is the highest rate ever for the Eurozone, and indeed the highest rate since at least 1983 (the earliest date for unemployment data reported by Eurostat) for the underlying countries.

Austerity programs do increase unemployment, despite what senior European officials have said.  On this, one might recall the famous assertion in June 2010 of Jean-Claude Trichet, then head of the European Central Bank, that austerity programs would be expansionary and lead to job creation.  As was discussed in an earlier post on this blog, in a June 2010 interview with La Repubblica (the largest circulation newspaper in Italy), Trichet said:

Trichet:  … As regards the economy, the idea that austerity measures could trigger stagnation is incorrect.

La Republicca:  Incorrect?

Trichet:  Yes …

And in an interview a month later in the newspaper Libération of France:

Libération:  Do the austerity plans announced amid monumental disarray by the Member States pose the risk of killing off the first green shoots of growth?

Trichet:  It is an error to think that fiscal austerity is a threat to growth and job creation. …

At the urging of Trichet, other European officials, and especially German government officials, most of Europe then began to reverse the stimulus programs of late 2008 and 2009  –  programs that had stopped and then reversed the free fall resulting from the 2008 economic and financial collapse.

Exactly one year after Trichet made his famous assertion, unemployment rates in the Eurozone began a steady upward march, which have continued ever since.

The Impact of the Budget Sequester: There Are Better Ways to Cut the Debt

Alternative Budget Scenarios, FY13-23

A.  Introduction – The Impact of the Bush Tax Cuts

The budget sequester, the across the board budget cuts that Republicans in Congress insisted on in August 2011 as a condition for allowing the public debt ceiling to be raised, entered into effect on March 1.  While there were some immediate impacts, the primary effects will start a month to two later as government employee furloughs begin to go into effect and public procurement contracts are cancelled or are not signed when they otherwise would have.  Fiscal drag will grow, aggregate demand in the economy will be reduced, and growth in both output and employment will be less than they otherwise would have been.  And this hit is coming when there have been signs that the US had started to enter into a more robust recovery, with the housing market starting to recover and consumer demand growing.  The sequester will now slow this down, and possibly reverse it.

The argument for the sequester was that such budget cuts were necessary to bring down the public debt.  Public debt as a share of GDP has indeed grown sharply in recent years.  But as was discussed and analyzed in a posting on this blog from more than a year ago, this issue arose not because of government spending under Obama, but rather because of the Bush tax cuts, the spending on the Afghan and Iraq Wars (the first wars in US history which were not paid for at least in part by tax hikes, but rather purely by borrowing), and the economic and financial collapse that began in 2008, in the last year of the Bush Administration.  That blog shows that without the Bush tax cuts and without the unfunded wars, but still assuming the 2008 downturn happened (thus reducing public revenues while increasing expenditures that rise in a downturn such as for unemployment compensation) and including all the spending of the Obama years (other than for the wars), public debt at the end of FY2012 would have been only 32% of GDP instead of 73%.

The difference between a public debt ratio of 32% of GDP and a ratio of 73% of GDP is not small.  The Bush tax cuts (mostly) and the unfunded wars (to a still significant, but lesser, extent) certainly weakened the US fiscal position.  Without that increase in the debt due to those two decisions, there might have been less pressure on Obama to cut back on government spending, with the resulting fiscal drag that has slowed the recovery.

Looking forward, that blog post also showed that even with the history of the Bush tax cuts, the unfunded wars, and the effects of the 2008 downturn, a phasing out of the Bush tax cuts (thus returning to the rates of the Clinton years) would have led to a steady fall in the public debt to GDP ratio from FY2014 to at least FY2022.

Unfortunately, the Bush tax cuts have now been made permanent for all but the richest 1% of the population.  As a direct consequence of this, the public debt to GDP ratio will not now see a steady fall (to at least FY2022) as it otherwise would have.  The graph above shows what the CBO now projects the public debt to GDP ratio will be under its baseline scenario, along with calculations I did (based on numbers provided in the CBO report and its accompanying data files) under several alternative scenarios.

B.  CBO Baseline and CBO True Baseline

The CBO Baseline scenario presents, as the CBO is required to do, its projections of what the budget and debt will be assuming current law is followed.  In this scenario, the CBO projects that the public debt to GDP ratio will peak at 77.7% of GDP in FY2014, and then fall to a trough of 73% of GDP in FY2018 before starting to rise again.  It would reach 77% of GDP in FY2023.

This longer term dynamic, with its renewed rise in the public debt to GDP ratio after FY2018, is primarily driven by two factors:

  1. The permanent extension of the Bush tax cuts for 99% of the population, which reduces sharply government revenues (by 2 1/2% of GDP now, rising to 3% of GDP in the 2020s and more beyond, for the full Bush tax cuts, as discussed in this blog post).  As noted above and discussed in the cited blog post from a year ago, if the Bush tax cuts had been phased out, the public debt to GDP ratio would have been falling to at least FY2022.
  2. The CBO’s projection that government health care costs (primarily for Medicare and Medicaid) will continue to rise as a share of GDP as general health care costs rise in the US, and (to a lesser extent) due to the aging of the population.  The reforms achieved through ObamaCare will reduce Medicare expenses by a significant amount as more of the currently uninsured become insured (since the uninsured cannot cover the full cost at hospitals of their treatment, so hospitals must shift a portion of those costs onto what they charge Medicare, as discussed in this blog post).  But there is a need for more such savings, which reduce costs while they maintain delivery of currently covered services.

As noted, the CBO is required to present in its Baseline scenario the consequences of current law, including that certain expenditures will continue beyond FY2013 as the law provided for in FY2013 (although adjusted for inflation).  This can lead to some perverse assumptions, which the CBO recognizes but is not allowed to change its Baseline to reflect.  However, the CBO does provide the data needed so one can make such adjustments.  Specifically, the scenario labeled “CBO True Baseline” in the graph above reflects:

  1. The assumption that a portion of the special appropriation enacted in January for Hurricane Sandy relief will not be repeated each year going forward.  This will lead to $353 billion in lower federal expenditures than CBO had to assume in its Baseline over the ten year period of FY2014-23 (including lower debt service following from the consequent lower debt).
  2. The assumption that overseas troops (primarily in Afghanistan) will continue to be drawn down, from 115,000 in FY2012 and 85,000 in FY2013, to a projected 60,000 in FY2014 and 45,000 in FY2015 and after.  The CBO assumes there will still be a significant number of such special combat troops overseas after FY2015, but not as many as now.  This will lead to savings of $693 billion over ten years.
  3. But increasing costs is the assumption that the so-called “Medicare Doc Fix” will continue.  Under a law originally passed in 1997, Medicare payments to doctors would be cut according to a formula.  But that law has been overridden each year since 2002, and everyone expects that will continue.  If it were not, payments to doctors would be slashed by 27% this year.  Continuing the override, the ten year cost to the budget would be $167 billion.
  4. Also increasing the deficit, by reducing revenues, is CBO’s assumption that a large set of 75 different corporate tax “provisions” (others might call them loopholes) will continue to be extended, rather than allowed to expire as per current law.  The cost of extending these tax provisions over the ten years is an estimated $1,142 billion.

Making these four changes, will have the net effect of adding $263 billion to the ten year deficit.  This is, however, a more realistic estimate of the baseline.  The resulting public debt to GDP ratio would be 78% of GDP in FY2023, rather than 77%.

C.  Impact of Revoking the Sequester in FY2013-16

There are many scenarios one could run against these baselines.  For the graph above I have shown two.

The first alternative scenario looks at the impact of revoking the sequester in fiscal years 2013 to 2016.  The rest is as in the CBO Baseline.  While not a primary focus of the CBO budget work, the CBO forecasts that the economy will recover only slowly from the current downturn (in part precisely because of the fiscal drag from the budget cuts that have been and are being implemented), and will only reach full employment production in FY2017.  The CBO then assumes the economy will grow from that point forward at the rate of growth of potential GDP (what GDP would be at full employment), which it projects based on its projections of growth in the labor supply and productivity.

The No Sequester FY13-16 scenario revokes the sequester in those four fiscal years, and includes the impact of such extra spending in creating demand for production, assuming a multiplier of two.   With this modest boost to GDP (higher growth rates of 0.6% points in FY13 again in FY14, and then about the same as in the CBO Baseline), tax revenues will also rise.  The projection also assumes that 33% of this additional GDP growth will provide resources to reduce the deficit, either through additional tax revenues (mainly) or by reducing certain government expenditures such as for unemployment compensation (to a lesser extent).  The 33% is a rough estimate of the impact of these two together.  They will offset part of the impact on the deficit of the cost of the extra expenditures if the sequester is revoked.

Due to the modestly faster recovery of GDP if the sequester is revoked in those years when the economy is operating at less than full employment, the debt to GDP ratio is in fact lower in fiscal years 2013 to 2016 than it is in the CBO Baseline, despite the higher government spending.  It hits 77.2% of GDP in FY2014 rather than the 77.7% of GDP in the CBO Baseline.  This illustrates how austerity policies (the sequester) have a perverse impact on the public debt to GDP ratio in the near term when an economy is functioning at less than full employment, due to a lack of demand.

The revocation of the sequester in FY13-16 will, however, lead to a somewhat higher debt than in the baseline, under the stated assumptions.  And from FY2017 onwards GDP is already at its potential level at full employment and cannot go higher.  Hence the debt to GDP ratio will be higher from FY2017 onwards, by about a half percentage point of GDP.  But that would then be the time to cut back on government spending if one is concerned about the public debt to GDP ratio.  That is, do not cut back further on demand when it is already insufficient, leading to higher unemployment.  Rather, the time to reduce government demand, if the debt ratio is of concern, is when the resources in the economy are fully employed and will be used for other purposes and not left idle.  Cutting back on such demand for workers when resources are idle, with unemployment high, simply leads to even higher unemployment.

D.  Preferred Scenario

Many alternative scenarios could be constructed.  I will just show one here, based on the CBO numbers and without looking at more fundamental changes.  This scenario starts with the CBO True Baseline, but makes the following changes:

  1. The sequester is revoked in all years.  This will increase expenditures by $1,223 billion over ten years (including the impact on debt service).
  2. Rather than cutting spending, as in the sequester, one instead boosts government spending in fiscal years FY2014 (by $400 billion) and FY2015 (by $250 billion).  These levels were chosen as such extra spending will, under the stated assumptions, boost growth sufficiently to bring the economy back to full employment and then keep it there, in the years when there would otherwise be high unemployment.
  3. Rather than draw down overseas troops only to 45,000 from FY2015 and after, as in the CBO True Baseline, the Preferred Scenario brings down troops faster and further, to only 5,000 from FY2015 and after.  This will save a further $702 billion over ten years, above the savings of $693 billion CBO estimates will be achieved by bringing overseas troops down to 45,000.
  4. The CBO True Baseline assumes that the 75 different corporate tax provisions will be extended when they would otherwise expire under current law (mostly this year and next), at a budgetary cost of $1,142 billion over ten years.  The Preferred Scenario assumes these will not be extended.

Under the Preferred Scenario, the public debt to GDP ratio falls sharply in FY2014, despite the extra spending and indeed a higher fiscal deficit, because of the boost to GDP bringing it to full employment levels.  Commentators often forget that the debt to GDP ratio depends not only on what the debt is, but also what GDP is.  The sharp fall in the debt to GDP ratio also holds in FY2015 (compared to the Baseline scenarios), because of the boost to GDP, but by FY2016 and FY2017 the ratio is close to that in the Baseline scenarios as GDP approaches the ceiling of its potential level in the CBO projections, and cannot go higher.

Going forward, with GDP at the ceiling of its potential level, the debt to GDP ratio follows a lower path than it does under the CBO Baseline (or True Baseline) scenarios.  The reason is that in those years the savings from the lower troops deployed overseas in combat, plus the additional revenues from not extending the 75 corporate tax provisions, leads to lower deficits and lower debt growth.  It is in such periods, when the economy is operating at full employment (by CBO assumption), that one should focus on reducing deficits if the debt to GDP ratio is of concern.

The debt to GDP ratio nevertheless starts to rise again after FY2018 in the Preferred Scenario, as it does in all the scenarios.  The blog post from last year cited above noted that phasing out the Bush tax cuts would have led to a declining debt to GDP ratio until at least FY2022.  But with the extension of the Bush tax cuts for 99% of the population this will now no longer hold from FY2018.

The primary reason these debt to GDP ratios ultimately turn up is the continuing rising cost of health care unless something is done.  And note this is not because government provided health care through Medicare is more expensive than health care provided through private insurance.  For similar risk populations, Medicare is indeed more efficient and cheaper to provide than private health insurance.  The CBO estimated that in 2007, private insurance of Medicare beneficiaries cost the government 12% more than traditional Medicare would have.

The problem rather is that health care costs are rising, and while there are savings through government programs such as Medicare, these savings are not enough to offset the expected long term rise in health care costs unless something further is done to reduce the costs.

E.  Conclusion

The debt to GDP ratio has risen in recent years as a consequence of the Bush tax cuts, the unfunded wars in Iraq and Afghanistan, and the economic collapse of 2008 with the subsequent slow recovery.  But as high as it has risen, it is now foolish to follow austerity programs, such as the sequester, with unemployment still excessively high.  These austerity measures serve just to hold back the economy, and will increase, not decrease, the near term debt to GDP ratio over what it would have been without such fiscal drag holding back growth.  A program of fiscal stimulus sufficient to bring the economy back to full employment would indeed lead to a sharp reduction in the debt to GDP ratio over the next few years.

Longer term, there is a rise in the debt to GDP ratio in all the scenarios after FY2018, due to a rise in health care costs unless something is done to reduce these costs.  The problem is not that government supported health care funded through Medicare or Medicaid is more expensive or less efficient than private insurance funded health care – the government programs are indeed cheaper and more efficient.  The problem is health care cost itself in the United States.  But that is an issue I hope to address in future posts on this blog.

The Republican Campaign to Shift the Blame for the Sequester To Obama: If You Don’t Want It, Pass a Simple Bill To End It

John Boehner Obamaquester

It appears increasingly likely that the Congressionally mandated severe and across-the-board budget cuts, known as the sequester, will begin on March 1.  Serious negotiations are not underway, Congress is only back in session now after having been gone for most of the past two weeks, and public statements are not focused on negotiating an agreement but rather on shifting blame.  Should the sequestration budget cuts go into effect, not only will critical federal functions be suspended, but the sudden cuts in spending levels will likely push the country back into recession.  As was noted in an earlier posting on this blog, cuts in Government spending were already the primary cause for a fall in GDP in the fourth quarter of 2012 (according to the initial estimate, which may be revised).  More broadly, had government spending been allowed to rise following the 2008 downturn as it had during the Reagan presidency following the 1981 downturn, we would now likely be at full employment.

The situation is serious, but the new assertion by the Republican leadership that the sequester is there only at the insistence of Obama is almost farcical.  As part of this campaign, Speaker Boehner has staged events for the cameras such as that pictured above, behind a podium labeled with the hashtag “#Obamaquester”, and in front of a clock marked as “Countdown to #Obamaquester”.  Boehner is now asserting that the sequester is only there due to “the president’s demand”, and he refers to the cuts as “the president’s sequester”.

Even some of Boehner’s Republican colleagues find it absurd to try to blame Obama for the sequester.  For example, Representative Justin Amash, a conservative Republican from Michigan (who voted against the bill that set up the sequester mechanism) said:  “I think it’s a mistake on the part of Republicans to try to pin the sequester on Obama.  It’s totally disingenuous.  The debt ceiling deal in 2011 was agreed to by Republicans and Democrats, and regardless of who came up with the sequester, they all voted for it.  So, you can’t vote for something and, with a straight face, go blame the other guy for its existence in law.”

With these new assertions from Boehner and similar assertions from colleagues such as Congressman Paul Ryan (the Republican Chair of the Budget Committee in the House), it may be of interest to review briefly the history of how the sequester mechanism came to be:

  1. The sequester’s origin came from the strategic decision by the key Republicans in Congress in early 2011 to use the routinely required authorization to raise the public debt ceiling as leverage to force through drastic cuts in the budget.  Eric Cantor, the then new Republican House Majority Leader, was the principal architect and proponent of the strategy, which he proposed in January 2011 at a closed-door retreat of Republican congressional members in Baltimore.  He was soon stating publicly that the Republican controlled Congress should not approve an increase in the debt ceiling without drastic spending cuts.  
  2. What this meant was that they would hold the economy hostage to their budget demands, as a refusal to raise the debt ceiling would force the US to default on its debt.  While speeches and pontificating are routine whenever Congress has had to approve an increase in the nominal public debt ceiling, never before had such demands been attached to this approval.
  3. And default on the US public debt would be serious.  US Treasury Bonds are held as risk-free assets both in the US and around the world, and are indeed the foundation of the modern international monetary system.  The impact of default on such assets cannot be predicted with certainty, as it has never happened before, but the consequences could quite possibly throw the global economy into a downturn that would make the 2008 collapse look mild. 
  4. [As an aside:  While I am not a lawyer, the constitutionality of a refusal by Congress to raise the debt ceiling (and hence force a default on the public debt) looks to me to be questionable.  The Fourteenth Amendment to the Constitution (passed in 1866, following the American Civil War) reads in its Section 4:  “The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.”  In their oath of office, Congressmen pledge to uphold the Constitution.  They cannot then take actions (or defer taking action) which would violate the Constitution by forcing a direct default on the public debt.  However, as noted above, I am not a lawyer, and obtaining such Congressional approval for increases in the debt ceiling has been customary since substantial borrowing needs developed during World War I.]
  5. As the country was coming increasingly close to breaching the existing debt ceiling in July 2011, negotiations were underway at many levels in Washington.  I will not try to review them all here, but the most senior were direct negotiations between Obama and Speaker Boehner.  These talks broke up when Boehner was not able to convince his Republican congressional colleagues to support an approach that included even a relatively small share of revenue increases along with larger expenditure cuts.  In fact, Boehner had to reverse himself twice from tentative agreements he had reached with the President, as he could not get backing from sufficient numbers of his Republican colleagues in Congress.  At the time, Boehner stated publicly that the President had negotiated in good faith.  But in his op-ed piece in the Wall Street Journal this month, Boehner now says the opposite, and asserts the talks failed because the President had reversed his position.
  6. As the deadlines approached and it became clear that agreement would not be possible on a specific set of spending cuts and revenue increases, Jack Lew, then the head of the Office of Management and Budget in the White House (and soon likely to be US Treasury Secretary), suggested consideration of a mechanism that had been used in the 1980s, in budgetary negotiations during the Reagan term.  In its final form and as passed by Congress, the mechanism established a Joint Committee made up of 12 members of the Senate and Congress (split evenly between Republicans and Democrats), who would by a certain date (November 21, 2011) develop a plan to achieve $1.2 trillion in deficit reduction (over 9 years) through a combination of spending cuts and revenue increases.  If the Joint Committee could not reach agreement, an automatic cut in spending of $109 billion per year over nine fiscal years (FY2013-21) would be required, split evenly between Defense and non-Defense programs.  These automatic across-the-board cuts were known as the “sequester”, and were deliberately crude and draconian to serve as an inducement to the Joint Committee to reach an agreement on more palatable means to achieve a similar reduction in the deficit.
  7. The mandate of the Joint Committee was to reach agreement on measures that would reduce the deficit by $1.2 trillion over ten years.  Such measures could include both spending reductions and revenue increases.  And the revenue increases could be achieved not only by raising tax rates, but also by closing tax loopholes, cutting expenditures that are implemented via tax subsidies, and/or broadening the tax base.  But the Joint Committee never reached an agreement, as Republicans refused to agree to any revenue measures at all.
  8. At the time, Boehner, Paul Ryan, and other Republicans praised the sequester mechanism as a means to force what they were seeking.  Boehner famously said in a CBS interview on August 1, 2011, that he had gotten “98%” of what he wanted.  Ryan emphasized and praised the sequester mechanism in an interview on Fox News on August 1.  Following his recent reversal now to criticize the sequester, a YouTube video was even put together showing a series of Ryan statements over the years in favor of sequester mechanisms (including this one specifically) and statutory spending caps.  And a Power Point presentation put together by Boehner when he made the case to his Republican colleagues to vote in favor of the bill that established the sequestration mechanism, makes clear his approval of it at the time.
  9. Obama, in sharp contrast, had always wanted a clean bill authorizing an increase in the public debt ceiling, without additional conditions added on.  It is indeed rather absurd to think that Obama would want to see a bill passed that would deliberately tie his hands.  Obama had proposed alternative approaches to reducing the deficit, including in his FY2013 budget (in great detail) and during the negotiations with Boehner.  Obama still stands by these proposals.  But while the Republicans assert that Obama has not offered any such plans, the issue is rather that the Republicans have rejected the plans Obama has offered.
  10. Jack Lew only suggested the option of the sequester mechanism as a fallback if no agreement is reached, late in the negotiations when it became clear that agreement on a specific set of spending cuts and revenue increases would not be possible.  But Obama and Lew would have greatly preferred a clean bill without any such conditions.  It is absurd to say, as Boehner now does, that the sequester mechanism is there only because it was something Obama “insisted upon in August 2011”.

The automatic sequester will cut government expenditures by $85.3 billion over the remainder of the fiscal year, from March 1 to September 30, 2013.  If nothing is done, there would be further cuts of $109.3 billion in each of the next eight fiscal years to FY2021.  The $85.3 billion cut over seven months would be equal to roughly 1% of the seven month GDP.  With a multiplier of two, this would by itself drive down GDP by 2% from what it would be otherwise.  The Congressional Budget Office estimates that the US economy is producing at about 5 1/2% below what it potentially could be producing at full employment.  An additional 2% reduction would be significant.

Agreement is difficult in Washington, particularly in the current political environment.  But if Boehner, Ryan, and others now hold to the view that the sequester is a bad idea, there is a simple solution.  All that they would need to do would be to pass a simple bill which revokes it.  Obama would certainly sign it.  The budgetary mechanism would then revert to the standard process, and that standard process could be followed to determine whether certain public expenditures should be cut and by how much, and whether revenues should be increased by closing loopholes, cutting tax subsidies, raising rates, or some other approach.

But there is nothing that requires the sequester mechanism.  If Boehner, Ryan, and the others do not want it, they can pass a simple bill to end it.