Tag Archives: policy

We Have a Revenue Problem: Government Debt to GDP Would Fall Without the Bush Tax Cuts

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Debt to GDP Ratio, FY1790 to 2038, no Bush Tax Cuts

A.  Debt to GDP Would Fall Without the Bush Tax Cuts

If the Bush tax cuts had not been extended at the start of this year for almost all households, the public debt to GDP ratio would be falling rapidly.  Even though health care costs are rising and Social Security payments will need to increase as baby boomers retire, the US would be generating more than sufficient tax revenues to cover such costs, if we simply had reverted to the tax rates that held prior to the Bush tax cuts.

The figures on this can be calculated from numbers provided by the Congressional Budget Office with its annual Long-Term Budget Outlook, which was published earlier this week.  Most of the attention paid to the report focussed on the base case projection by the CBO of the public debt to GDP ratio if nothing changes in current policy.   The ratio had risen sharply as a consequence of the economic collapse of 2008, in the last year of the Bush administration, and subsequent weak recovery.  But with the economy recovering and with other measures taken, the ratio is now projected to stabilize and indeed fall modestly for several years.  However, the ratio would then start to grow again in fiscal year 2019, and especially after 2023.  As the graph above shows, the CBO projects that, under current policy, the debt to GDP ratio would rise to 100% of GDP by fiscal 2038, reaching levels last seen at the end of World War II.

This has been interpreted by Republicans as a runaway spending problem, and have asserted this calls for further sharp cuts.  But the data issued by the CBO with its report allows one also to work out what the consequences were of allowing most of the Bush tax cuts (primarily – there were also some other tax measures) to be extended from January 1, 2013.  The Bush tax cuts had been scheduled to expire on that date.  They were instead extended and made permanent for all but the extremely rich (those households earning more than $450,000 a year, the richest 0.7% of the population).

Specifically, the CBO provided in the projections it had made last year (in 2012) what public revenues would have been if the tax cuts had expired, as scheduled, at the start of 2013.  The new report provides those figures for comparison, updated to reflect the new methodology for GDP that the BEA adopted in July.  One can combine those revenue projections with CBO’s current projections of non-interest expenditures, along with a calculation of what interest would then be on the resulting (lower) debt, to estimate what the fiscal deficit and debt to GDP figures would then be.

The resulting path of federal government debt to GDP is shown as the green line in the graph above.  The debt to GDP ratio plummets.  Instead of reaching 100% of GDP in fiscal 2038, it instead would fall to just 37% of GDP in that year.  And a simple extrapolation of that line forward would bring the debt all the way to zero in a further 24 years.

The extension of the Bush tax cuts for most households can therefore, on its own, more than fully account for the projected rise in the public debt to GDP ratio.  With tax rates as they had been under Clinton, there would be no debt issue.

B.  A Longer Term Perspective

The CBO report also provides data on the federal government debt to GDP ratio going back to the founding of the republic in 1790.  I have put the projected paths on a graph with the history to put them in that context.  The fall in the debt ratio that would follow if the Bush tax cuts had not been extended is similar to the falls seen in that ratio in the periods following the Revolutionary War, the Civil War, World War I, World War II, and during the Clinton years following the run-up during the Reagan and first Bush presidencies.

Public debt reached a peak of 106% of GDP in fiscal year 1946, at the end of World War II.  The ratio then fell steadily in the 1950s and 1060s, and was just 25% in 1981, at the end of the Carter presidency.  It fell during this period not because there were large budget surpluses, but rather because of generally strong economic growth.  This also shows that strong growth is possible even if the debt ratio is as high as 106%, undermining the argument made by the economists Carmen Reinhart and Ken Rogoff in a 2010 paper, that debt in excess of 90% of GDP will lead to a sharp reduction in growth.  Republican politicians had quickly jumped on the Reinhart and Rogoff conclusion, arguing that this work supported their views.  But aside from numerous counterexamples, such as the US after World War II, researchers later discovered that there had been a coding error in the spreadsheet Reinhart and Rogoff used to assemble their data.  More fundamentally, researchers showed that to the extent there is a relationship between high debt and slow growth, it is that downturns and slow growth lead to a rise in the debt to GDP ratio (as we saw in the US after the 2008 collapse), rather than that a high debt ratio leads to slow growth.

The debt ratio then rose sharply during the Reagan and first Bush presidencies, rising from 25% of GDP in fiscal 1981 to 48% in fiscal 1993.  This was the first such rise in the debt ratio in American history, aside from the times when the country went into war or at the start of the Great Depression.  During the Great Depression the ratio rose during the Hoover years from 15% in fiscal 1929 to 39% in fiscal 1933, and then to 43% in fiscal 1934.  But it is interesting that during the Roosevelt presidency, and in stark contrast to the common view that the New Deal was characterized by big increases in government spending, the ratio then stayed in the range of 40% to 44% until 1942, following the entry of the US into World War II.

The debt ratio then fell during the Clinton presidency, from 48% in fiscal 1993 to 31% in fiscal 2001.  But with the Bush tax cuts and then the 2008 collapse, the ratio rose to 52% in  fiscal 2009, and to 73% this year.   As noted above, the ratio would now start to fall again if the Bush tax cuts had not been extended, reaching a projected 37% in fiscal 2038.  But with most of the Bush tax cuts made permanent, the ratio (with the same government spending levels) is instead projected to rise to 100% in that year.

C.  Conclusion

The first step in addressing some problem is to understand the cause.  The cause of the current fiscal problems, which if not addressed would lead to a public debt rising to 100% of GDP by fiscal 2038, is the Bush tax cuts.

An earlier post on this blog looked at what the debt to GDP ratio would have been had the Bush tax cuts never been enacted (in 2001 and 2003) and the Afghan and Iraq wars had not been launched.  It found that even assuming the 2008 economic downturn would still have occurred, the public debt to GDP ratio would have risen only to about 35% by fiscal 2014, and would then start to fall.  That post also showed that even assuming the cost of the wars and with the Bush tax cuts in place from 2001 to 2013, phasing out the tax cuts starting in fiscal 2014 would have led the public debt to GDP ratio to fall until at least fiscal 2022 (the last year in the CBO figures then available).

The current post has made use of the CBO’s new long term projections, and finds that if the Bush tax cuts had not been extended at the beginning of 2013, the debt to GDP ratio would be on a sharp downward path to at least fiscal 2038.  The current conventional wisdom appears to be that rising health care costs and the increase in the number of retirees as the baby boom generation reaches 65 means that a rise in the debt to GDP ratio is inevitable, unless there are sharp cut-backs in Medicare and Social Security.

But that is not the case.  The debt ratio would be falling rapidly if it were not for the Bush tax cuts.

Armed Guards Cannot Stop Mass Shootings

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Following the horrific shootings at  Sandy Hook Elementary school in Connecticut last December, many called for strengthened controls on access to guns in the US.  Most of us thought that even the NRA would now support sensible measures.  However, the NRA then surprised us when, in a flamboyant press conference, NRA head Wayne LaPierre instead called for armed guards to be posted at all schools in the country.  As I noted in a blog post at the time, there is no evidence that this would do any good, that placing more loaded weapons in the schools would indeed make more weapons available to shooters who made the guard one of their first victims, and that even if it were possible to place armed guards in all of the over 130,000 schools in the US, how would one also do this in all of the movie theaters, college campuses, shopping malls, fast food restaurants, churches, commuter trains, Christian prayer rallies, post offices, other work places, and all the other locations where mass shootings had been inflicted in the US in recent years.

The mass shooting at the Washington Navy Yard on September 16 has now provided us a test of the NRA proposal.  The Navy Yard is a military facility, with armed guards and secure entrances.  The shooter, a former full-time Navy reservist, was now a private contractor working at the facility, and came in on morning of September 16 with a shotgun in a backpack.  He had purchased the shotgun, legally, two days before at a gun store in Virginia not far from DC.  He went to a bathroom on the fourth floor of the building, took out his gun, and started to shoot innocent people.  At one point he shot an armed guard, took the guard’s weapon, and then used that weapon to shoot more people.  Police arrived at the scene within two minutes of receiving notice of the shootings, and were inside the building within six minutes.  The police, not the armed guards posted at the facility, eventually shot the killer.  But 13 died, including the shooter.

If armed guards at a military facility cannot stop such mass shootings, how can anyone believe that the NRA’s plan of armed guards in our schools will protect our school children?

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

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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.