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How to Solve America’s Worsening Fiscal Mess
America’s fiscal future is very grim, largely because of an ever-expanding burden of entitlement spending.
To see the magnitude of the problem, let’s peruse the Budget and Economic Outlook, which was released yesterday by the Congressional Budget Office has some.
Most people are focusing on how deficits are going to climb from $1 trillion to $2 trillion-plus over the next 10 years.
That’s not good news, but we should be far more worried about the fact that the burden of government spending is growing faster than the private economy. As a result, government will be consuming an ever-larger share of national output.
The budget wonks who (mistakenly) focus on red ink say the problem is so serious that we need higher taxes.
They look at this chart, which is based on CBO’s baseline forecast (what will happen if taxes and spending are left on autopilot), and assert we have no choice but to raise taxes.
They point out that the annual deficit in 2032 will be almost $2.3 trillion and that it’s impossible cut spending by that much.
Needless to say, it would be a near-impossible political undertaking to cut $2.3 trillion in one year (though it would fulfill libertarian fantasies).
But what if, instead of kicking the can down the road, policymakers imposed some sort of overall spending cap to avoid a giant deficit in 10 year.
This second chart displays that scenario. I took CBO’s baseline (autopilot) numbers and assumed that spending could only increase by 1.4 percent annually starting in 2024.
As you can see, that modest bit of fiscal discipline completely eliminates the project $2.3 trillion annual deficit in 2032.
In other words, there is no need for any tax increase.
Especially since politicians almost certainly would respond to the expectation of additional revenue by increasing spending above the baseline (as would happen with Joe Biden’s so-called Build Back Better scheme).
I’ll close by noting that there’s no need to fixate on whether the budget is balanced by 2032. What matters is trend lines.
It’s not good for government to grow faster than the private economy in the long run. And it’s not good for deficits and debt to climb as a share of economic output in the long run.
Both of those outcomes can be avoided if we have some sort of spending cap so that outlays grow slower than the private sector.
The stricter the cap, the quicker the progress.
- I prefer actual cuts (a requirement to reduce nominal spending each year).
- I would be happy with a hard freeze (like we had for a few years after the Tea Party revolt).
- As noted above, a 1.4 percent spending cap balances the budget by 2032.
- But we would make progress, albeit slow progress, even if the spending cap allowed the budget to grow by 2.0 percent of 2.5 percent per year.
P.S. I start the spending cap in 2024 because spending is not projected to grow by very much between 2022 and 2023. That’s not because today’s politicians are being responsible, however. It’s simply a result of one-time pandemic emergency spending coming to an end. But since that one-time spending has a big impact on short-run numbers, I delayed the spending cap for one year.
P.P.S. The blue revenue line has a kink in 2025 because the baseline forecast assumes that many of the Trump tax cuts expire that year. If those tax cuts are extended or made permanent, revenues would be about $400 billion lower in 2032. As such, balancing the budget by that year would require a spending cap that allows annual outlays to increase by less than 0.9 percent per year.
P.P.P.S. President Biden is bragging that the deficit is falling this year, but that’s only because the one-time pandemic spending is coming to an end.
P.P.P.P.S. A spending cap is a simple solution, but it would not be an easy solution. In the long-run, it would require genuine entitlement reform.
Another Reason for Spending Caps
The United States needs a constitutional spending cap, sort of like the “debt brake” that has been producing positive results in Switzerland for the past two decades.
Imposing a limit on annual spending increases would be a much-needed way of stopping politicians from saddling the nation with “Goldfish Government.”
The best-case scenario is that a spending cap is very stringent (say, limiting annual spending increases to 2 percent annually). This level of fiscal restraint reduces the burden of government spending compared to the private sector (i.e., it fulfills fiscal policy’s Golden Rule).
The avoid-harm scenario is that a spending cap prevents government from becoming a bigger burden. Given dismal long-run fiscal forecasts (a consequence of demographic change and poorly designed entitlement programs), this actually would be an impressive achievement.
There are also some auxiliary benefits of a spending cap.
A new working paper from Italy’s central bank, authored by Anna Laura Mancini and Pietro Tommasino, considers whether spending caps can mitigate the problem of dishonest budgeting by politicians.
…policy-makers have an incentive to “plan to cheat”. That is, they promise an amount of expenditures higher than what they will actually deliver, because this allows them to cater to the demands of the various groups of voters,
and at the same time they present overoptimistic revenue forecasts, in order to preserve the appearance of fiscal discipline. Once the extra revenues hoped for by the government fail to materialize, budgeted investment expenditures are downsized or abandoned altogether. In this context, caps on realized spending can contribute to more realistic ex ante spending plans. Indeed, politicians have less room to inflate planned expenditures, once there is a legal ceiling in place.
The authors crunch the numbers and conclude that spending caps result in a greater level of fiscal honesty.
In this paper, we provide evidence in favour of this theoretical intuition, exploiting a unique dataset including the ex-ante budget plans as well as ex-post budget outcomes of…a rule that constrains capital expenditures in municipalities with more than 5,000 residents. …Our analysis show that the municipalities subject to the new capital-spending rule significantly reduced their over-optimism in expenditure projections… Furthermore, in the new regime revenue projections are also more accurate (less over-optimistic). …The reform reduced the forecast error concerning capital expenditures… The effects is significant both statistically and in economic terms. …the introduction of the cap on investment reduced the forecast error on investment expenditures by almost €1 mln, or 35% of the pre-reform average error.
For wonky readers, Figure 1 shows some of relevant data.
For what it’s worth, we seem to have a different problem in the United States.
Rather than exaggerate potential spending on so-called public investment, as seems to have been the case in Italy, American politicians generally low-ball cost estimates for infrastructure projects.
And then, once the projects get started, we get absurd cost overruns (with the high-speed rail project in California being an especially absurd example).
The good news is that a spending cap solves both the Italian version of the problem and the American version of the problem.
As the authors found in their research, it removes the incentive for dishonest budgeting in Italy. And, if adopted in the United States, politicians would learn that it doesn’t help to produce laughably low cost estimates if a spending cap means there is no way of financing cost overruns in the future.
P.S. There is a spending limit in Hong Kong’s constitution, and it has generated very positive results. Given China’s increasing control, it’s unclear how effective it will be in the future.
P.P.S. There’s also a spending limit in Colorado’s constitution, known as the Taxpayers Bill of Rights. It has been very successful.
P.P.P.S. Last month, I wrote about research from both the IMF and the ECB about the benefits of spending caps.
Steve Forbes is 100 percent correct, as was Milton Friedman. Bloated and wasteful government spending is the problem, not inadequate revenue. Deficits are merely a symptom of over-spending:
The late Nobel Prize-winning economist Milton Friedman once famously observed that he would prefer a federal government budget of $1 trillion (this was when a trillion bucks was real money) with a big deficit to a federal budget of $2 trillion that was balanced. His obvious point was that the bigger Washington is, the more of a burden it puts on the economy, whether it finances its spending via taxation, borrowing or printing money. So it’s not President Obama’s mind-numbing, from-here-to-eternity deficits that we should be worrying about but the increasing deadweight put on the rest of us by Washington’s burgeoning budget bloat. Senate Republicans were right to put the kibosh on the formation of a formal bipartisan deficit-fighting commission. Those things always end up increasing taxes while doing little to reduce spending. …One of the biggest economic myths since the Great Depression is that governments can ameliorate or counteract the ebbs and flows of free markets. Government spending has never worked as a trigger for sustained and vibrant economic growth. Ever. Scholarship has demonstrated that the New Deal perpetuated the Depression rather than cured it. On the eve of the Depression the U.S. had the lowest unemployment rate among developed nations. But a decade later, despite six years of FDR’s New Deal, our unemployment rate was one of the highest among developed economies. Japan’s serial stimulus programs over the past two decades have repeatedly underscored this truth. The more the government takes as a proportion of the economy, the worse equity markets do and the higher the unemployment rate.
Everything You Need to Know about the National Debt
The title of this column is an exaggeration. What we’re really going to do today is explain the main things you need to knowabout government debt.
We’ll start with this video from Kite and Key Media, which correctly observes that entitlement programs are the main cause of red ink.
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I like that the video pointed out how tax-the-rich schemeswouldn’t work, though it would have been nice if they added some information on how genuine entitlement reform could solve the problem (as you can see here and here, I’ve also nit-picked other debt-themed videos).
Which is why I humbly think this is the best video ever produced on the topic.
As you can see, I’m not an anti-debt fanatic. It was perfectly okay, for instance, to incur debt to win World War II.
But I’m very skeptical of running up the nation’s credit card for routine pork and fake stimulus.
But my main message, which I’ve shared over and over again, is that deficits and debt are merely a symptom. The underlying disease is excessive government spending.
And that spending hurts our economy whether it is financed by taxing or borrowing (or, heaven forbid, by printing money).
Now let’s look at some recent articles on the topic.
We’ll start with Eric Boehm’s column for Reason, which explains how red ink has exploded in recent years.
America’s national debt exceeded $10 trillion for the first time ever in October 2008. By mid-September 2017 the national debt had doubled to $20 trillion. …data released by the U.S. Treasury confirmed that the national debt reached a new milestone: $30 trillion.
…Entitlements like Social Security and Medicare are in dire fiscal straits and will become even more costly as the average American gets older. Even without another unexpected crisis, deficits will exceed $1 trillion annually, which means the debt will continue growing, both in real terms and as a percentage of the economy. The Congressional Budget Office estimates that the federal government will add another $12.2 trillion to the debt by 2031.
As already stated, I think the real problem is the spending and the debt is the symptom.
But it is possible, of course, that debt rises so high that investors (the people who buy government bonds) begin to lose faith that they will get repaid.
At that point, governments have to pay higher interest rates to compensate for perceived risk of default, which exacerbates the fiscal burden.
And if there’s not a credible plan to fix the problem, a country can go into a downward spiral. In other words, a debt crisis.
This is what happened to Greece. And I think it’s just a matter of time before it happens to Italy.
Heck, many European nations are vulnerable to a debt crisis. As are many developing countries. And don’t forget Japan.
Could the United States also be hit by a debt crisis? Will we reach a “tipping point” that leads to the aforementioned loss of faith?
That’s one of the possibilities mentioned in the New York Timescolumn by Peter Coy.
It’s hard to know how much to worry about the federal debt of the United States. …Either the United States can continue to run big deficits and skate along with no harm done or it’s at risk of losing investors’ confidence and having to pay higher interest rates on its debt, which would suppress economic growth. …the huge increase in federal debt incurred during and after the past two recessions — those of 2007-09 and 2020 — has used up
a lot of the “fiscal space” the United States once had. In other words, the federal government is closer to the tipping point where big increases in debt finally start to become a real problem. …any given amount of debt becomes easier to sustain as long as the growth rate of the economy (and thus the growth rate of tax revenue) is higher than the interest rate on the debt. In that scenario, interest payments gradually shrink relative to tax revenue. …but it doesn’t explain how much more the debt can grow. …Past a certain point, there’s a double whammy of more dollars of debt plus higher interest costs on each dollar. …sovereign debt crises tend to be self-fulfilling prophecies: Investors get nervous about a government’s ability to pay, so they demand higher interest rates, which raise borrowing costs and produce the bad outcome they feared. It’s a dynamic that Argentines are familiar with — and that Americans had better hope they never experience.
For what it’s worth, I think other major nations will suffer fiscal crisis before the problem becomes acute in the United States.
I really this will make me sound uncharacteristically optimistic, but I’m keeping my fingers crossed that this will finally lead politicians to adopt a spending cap so we don’t become Argentina.
P.S. The Wall Street Journal recently editorialized on the issue of government debt and made a very important point about the difference between the $30 trillion “gross debt” and the “debt held by the public,” which is about $6 trillion lower.
…the debt really isn’t $30 trillion. About $6 trillion of that is debt the government owes to itself in Social Security and other IOUs. …The debt held by the public is some $24 trillion, which is bad enough.
As I’ve noted when writing about Social Security, the IOUs in government trust funds are not real.
They’re just bookkeeping entries, as even Bill Clinton’s budget freely admitted.
Indeed, if you want to know whether some is both honest and knowledgeable about budget matters, ask them which measure of the national debt really matters.
As you can see from this exchange of tweets, competent and careful budget people (regardless of whether they favor big government or small government) focus on “debt held by the public,” which is the term for the money government actually borrows from credit markets.
If you want to know the difference between the various types of government debt – including “unfunded liabilities” – watch this video.
P.P.S. This column explains how and when debt matters. If you’re interested in how to reduce the debt, there’s very good evidence that spending restraint is the only effective approach. Even in cases where debt is enormous.
P.P.P.S. By contrast, the evidence is very clear that higher taxesactually make debt problems worse.
Yes, Starve the Beast
As part of a recent discussion with Gene Tunny in Australia, I explained why I support “Starve the Beast,” which means keeping taxes as low as possible to help achieve the goal of spending restraint.
The premise of Starve the Beast is very simple.
Politicians like to spend money and they don’t particularly care whether that spending is financed by taxes or financed by borrowing (both bad options).
As Milton Friedman sagely observed, that means they will spend every penny they collect in taxes plus as much additional spending financed by borrowing that the political system will allow.
The IMF published a study on this issue about 10 years ago. The authors (Michael Kumhof, Douglas Laxton, and Daniel Leigh) assert that there’s no way of knowing whether Starve the Beast will lead to good or bad results.
…there is no consensus regarding the macroeconomic and welfare consequences of implementing a starve-the-beast approach, henceforth referred to as STB. …it could be beneficial in the ideal case in which it results in cuts in entirely wasteful government spending.
In particular, lower spending frees up resources for private consumption, and the associated lower tax rates reduce distortions in the economy. On the other hand, …lower government spending may itself entail welfare losses…if it augments the productivity of private factors of production. …the paper examines whether the principal macroeconomic variables such as GDP and consumption, both in the United States and in the rest of the world, respond positively to this policy. …In addition, the paper assesses how the welfare effects depend on the degree to which government spending directly contributes to household welfare or to productivity.
The authors don’t really push any particular conclusion. Instead, they show various economic outcomes depending on with assumptions one adopts.
Since plenty of research shows that government spending is not a net plus for the economy (even IMF economists agree on that point), and because I think a less-punitive tax system is possible (and desirable) if there’s a smaller burden of government spending, I think the findings shown in Figure 4 make the most sense.
Now let’s shift from academic analysis to policy analysis.
In a piece for National Review back in July 2020, Jim Geraghty notes that Starve the Beast has an impact on government finances at the state level.
…we’re probably not going to see a massive expansion of government at the state level in the coming year or two. …Thanks to the pandemic lockdown bringing vast swaths of the economy to a halt, state tax revenues are plummeting.
…So states will have much less tax revenue, constitutional balanced-budget requirements that are not easily repealed, and a limited amount of budgetary tricks to work around it. State governments could attempt to raise taxes, but that’s going to be unpopular and hurt state economies when they’re already struggling. Add it all up and it’s a tough set of circumstances for a dramatic expansion of government, no matter how ardently progressive the governor and state legislatures are.
For what it’s worth, Geraghty warned in the article that fiscal restraint by state governments wouldn’t happen if the federal government turned on the spending spigot.
And that, of course, is exactly what happened.
Now let’s look at the most unintentional endorsement of Stave the Beast.
A couple of years ago, Paul Krugman sort of admitted that cutting taxes was a potentially effective strategy for spending restraint.
…the same Republicans now wringing their hands over budget deficits…blew up that same deficit by enacting a huge tax cut for corporations and the wealthy. …this has been the G.O.P.’s budget strategy for decades. First, cut taxes. Then, bemoan the deficit created by those tax cuts and demand cuts in social spending.
Lather, rinse, repeat. This strategy, known as “starve the beast,” has been around since the 1970s, when Republican economists like Alan Greenspan and Milton Friedman began declaring that the role of tax cuts in worsening budget deficits was a feature, not a bug. As Greenspan openly put it in 1978, the goal was to rein in spending with tax cuts that reduce revenue, then “trust that there is a political limit to deficit spending.” …voters should realize that the threat to programs… Social Security and Medicare as we know them will be very much in danger.
In other words, Krugman doesn’t like Starve the Beast because he fears it is effective (just like he also acknowledges the Laffer Curve, even though he’s opposed to tax cuts).
Let’s close by looking at some very powerful real-world evidence. Over the past 50 years, there’s been a massive increase in the tax burden in Western Europe.
Did all that additional tax revenue lead to lower deficits and less debt?
Nope, the opposite happened. European politicians spent every penny of the new tax revenue (much of it from value-added taxes). And then they added even more spending financed by additional borrowing.
To be fair, one could argue that this was an argument for the view of “Don’t Feed the Beast” rather than “Starve the Beast,” but it nonetheless shows that more money in the hands of politicians simply means more spending. And more red ink.
P.S. I had a discussion last year with Gene Tunny about the issue of “state capacity libertarianism.”
Friedman & Sowell: Should Our School System Be Privatized?
What if the NFL Was Run Like the Government School System?
October 4, 2011 by Dan Mitchell
Regular readers know that the two things that get me most excited are the Georgia Bulldogs and the fight against a bloated public sector that is ineffective in the best of circumstances and more often than not is a threat to our freedoms.
So you will not be surprised to know that I am delighted that former Georgia Bulldog star Fran Tarkenton (who also happened to play in the NFL) has a superb piece in the Wall Street Journal ripping apart the inherent inefficiency of government-run monopoly schools.
Here is the key passage.
Imagine the National Football League in an alternate reality. Each player’s salary is based on how long he’s been in the league. It’s about tenure, not talent. The same scale is used for every player, no matter whether he’s an All-Pro quarterback or the last man on the roster. For every year a player’s been in this NFL, he gets a bump in pay. The only difference between Tom Brady and the worst player in the league is a few years of step increases. And if a player makes it through his third season, he can never be cut from the roster until he chooses to retire, except in the most extreme cases of misconduct. Let’s face the truth about this alternate reality: The on-field product would steadily decline. Why bother playing harder or better and risk getting hurt? No matter how much money was poured into the league, it wouldn’t get better. In fact, in many ways the disincentive to play harder or to try to stand out would be even stronger with more money. Of course, a few wild-eyed reformers might suggest the whole system was broken and needed revamping to reward better results, but the players union would refuse to budge and then demonize the reform advocates: “They hate football. They hate the players. They hate the fans.” The only thing that might get done would be building bigger, more expensive stadiums and installing more state-of-the-art technology. But that just wouldn’t help.
This sounds absurd, of course, but Mr. Tarkenton goes on to explain that this is precisely how government schools operate.
If you haven’t figured it out yet, the NFL in this alternate reality is the real-life American public education system. Teachers’ salaries have no relation to whether teachers are actually good at their job—excellence isn’t rewarded, and neither is extra effort. Pay is almost solely determined by how many years they’ve been teaching. That’s it. After a teacher earns tenure, which is often essentially automatic, firing him or her becomes almost impossible, no matter how bad the performance might be. And if you criticize the system, you’re demonized for hating teachers and not believing in our nation’s children. Inflation-adjusted spending per student in the United States has nearly tripled since 1970. According to the Organization for Economic Cooperation and Development, we spend more per student than any nation except Switzerland, with only middling results to show for it.
Actually, I will disagree with the last sentence of this excerpt. We’re not even getting “middling results.” Here’s a chart from an earlier post showing that we’ve gotten more bureaucracy and more spending but no improvement over the past 40 years.
So what’s the solution to this mess? Well, since government is the problem, it stands to reason that competition and markets are the answer.
Sweden, Chile, and the Netherlands are just some of the countries that have seen good results after breaking up state-run education monopolies.
Watch this video to get more details.
Economics 101: School Choice Example Shows Why Government Monopolies Are Bad
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