James Pethokoukis

It may be long past time that US state and local governments start watching their pennies a bit more closely. As new research from George Mason University has found (bold mine):

Since the close of World War II, aggregate state and local spending grew 34 percent faster than the private sector and 37 percent faster than federal government spending. In recent years, the difference in growth rates has widened. From 2000 to 2009, state and local government spending grew nearly twice as fast as the private sector (while over the same period, the federal government grew even faster). … In this paper, I review some of these trends and then estimate what would have happened under an alternate scenario in which spending growth had been restrained. I look at the ten states with the largest FY2009 budget gaps and the ten states with the largest FY2010 budget gaps. Because six states make both lists, I analyze fourteen states in total. For each, I estimate what its FY2009 spending level would have been had its budget grown at the pace of population growth and inflation, beginning in two periods: 1987 and 1995. In twelve of the fourteen states, the entire FY2009 budget gap would have been avoided had the state kept spending at real 1995 per capita levels. In thirteen of the fourteen states, the budget gap would have been avoided had the state kept spending at real 1987 per capita levels.

To reiterate, higher taxes are not the answer to deficit problem (via the Tax Foundation):

So for fun, we’ve been putting pencil to back of envelope to see how else lawmakers could raise revenues to erase the deficit using tax increases alone. The results (and these are very much back of the envelope) are truly frightening.

To erase this year’s estimated $1.5 trillion deficit, we would need either to:

• Enact a 25% VAT (Greece is still a mess with a 19% VAT);

or,

• Take 130% of the taxable profits earned by U.S. companies this year (that’s what you call net operating losses);

or,

• Raise the top three tax brackets (28%, 33%, and 35%) to 100%. Actually, this would still not raise enough money to erase the deficit – of course, assuming all the wealthy taxpayers didn’t flee to Switzerland.

or,

• Take 100% of the business income earned by individual taxpayers in 2008.

In other words, new taxes are not the solution to Washington’s deficit problem. That is, unless we want to wreck our economy for decades to come.

The EU’s central bank argues against spending more government cash (via taxpayers) to boost economies:

Finally, our results indicate that rising government debt is the main reason for declining spending multipliers at longer horizons, and thus increasingly negative long-run consequences of fiscal expansions. In the spirit of Giavazzi and Pagano (1990) and Giavazzi, Jappelli, and Pagano (2000), we interpret this finding as an indication that further accumulating debt after a spending shock leads to rising concerns on the sustainability of public finances. In this context, agents may expect larger fiscal consolidation in the future which, in turn, depresses private demand and output.

Me: The study also found that each $1 of government stimulus spending only produces 50 cents of GDP growth.

The end of this NYTimes piece on N.J. Gov. Chris Christie sums up why Uncle Sam should not bail out the states:

It remains to be seen how well Mr. Christie will wear on New Jersey voters. Over the next year, people will begin to see the effects of his policies in their schools and towns, in his cut in funds for family planning or, for government workers, in their paychecks. The need to focus on fiscal issues has obscured some other areas where his positions are less popular, like his opposition to abortion.

It is also unclear how he would govern in boom times, when austerity is a harder sell. The governor said he would have preferred not to make some of his budget cuts, but suggested that in any climate he would have pushed for less government.

Me:  The economic crisis has created a moment of opportunity to make the sorts of budgetary changes need to put states on a sustainable path. This moment is being missed on the federal level. It is also illustrative that CC is focusing on cutting spending rather raising taxes, the exact opposite of the medicine that liberal/centrist DC policy wonks advocate.

Washington commissions are usually political punchlines. Even President Barack Obama has mocked them in past. Yet his much-hyped deficit commission is a symbol of White House plans to fix America’s long-term budget problems. Actually, it kind of is the White House plan, it kind of is the fiscal strategy.

And maybe skepticism over the commission is overdone. Erskine Bowles, the panel’s Democratic co-chair, surprisingly favors big spending cuts over huge tax increases. That may be the best policy, but looks like increasingly savvy politics, too. Such an approach makes a deal with Republicans — and therefore real results – a bit more likely.

Bowles, a North Carolina investment banker and former Clinton White House chief of staff, is suggesting a cap on overall government spending and revenue of 21 percent of gross domestic product. The federal government currently spends 25 percent of GDP and takes in 15 percent as revenue, though both numbers are a bit distorted by the recent recession. By 2035, according to the Congressional Budget Office, spending could leap to 35 percent of GDP with revenue at 19 percent. By those numbers Bowles is suggesting that some 90 percent of the gap should be closed by cutting the spending side of the ledger.

The economic logic is sound. Spending cuts tend to be less injurious to growth than tax increases. Few countries have escaped debt traps through austerity alone. Canada is often pointed out as an example of successful austerity. But its 1990s economy also had an export boom thanks to a weak currency and more trade with the United States. Emphasizing reduced spending over higher taxes is even one of the fiscal ten commandments of the International Monetary Fund:

Strong growth has a staggering effect on public debt: a one percentage point increase in potential growth – assuming a tax ratio of 40% – lowers the debt ratio by 10 percentage points within 5 years and by 30 percentage points within 10 years, if the resulting higher revenues are saved. An acceleration of labor, product and financial market reforms will thus be critical. …

This will require a bias towards (current) spending cuts, as spending ratios are high in advanced countries and require highly distortionary tax levels. Some cuts should be no-brainers: for example, shifting from universal to targeted social transfers would involve significant savings, while protecting the poor. Containing public sector wages – which have risen faster than GDP in several advanced countries in the last decade – will be necessary.

All this would, of course, require massive restructuring of social entitlements. In return, other panel Democrats would demand higher taxes — a supposed “no go” zone for Republicans. But perhaps such a heavy bias toward spending cuts could pry loose a couple of GOPers if tax increases focused on eliminating breaks rather than raising rates.

Then again, tax increases of any sort might not be necessary, assuming spending cuts. If the economy grows somewhat more like it has through the 20th century than what is assumed by dreary CBO forecasts, that alone would reduce projected budget deficits by 25 percent in 2035.

Bowles is a dealmaker. And he’s been here before, leading political negotiations in the mid-1990s that helped create a string of balanced budgets. He just might pull off the trick again.

Just how big a value-added tax would it take to solve America’s budget woes through tax increases alone?  Monstrously big, according to the Tax Foundation:

Bruce Bartlett thinks budget deficits will create a schism among Republicans/conservatives:

At least a few Republicans are now openly suggesting significant cuts in the defense budget, raising concerns among conservatives primarily concerned about national security. I believe that ultimately national security conservatives will be forced to choose between cuts in the defense budget and tax increases to reduce deficits.

Me: I think this would be a really interesting  and important debate. To what extent should US defense strategy be focused on China (and a defense of the Taiwan Strait, I suppose) vs. hunting down terrorists and making sure they don’t have enclaves to operate (which may include some form of nation building)? It is sort of Machines (built by defense contractors) vs. Man budgetary debate. Missile defense systems and carrier battle groups vs., say,  retaining the veterans of the Iraq/Afghanistan wars. Geopolitical strategist Tom Barnett, whom I admire greatly, argues that while the US should maintain a powerful warfighting force of the sort that raced through Iraq, it will need to focus more and more on nation building in disconnected areas of the world. Both assume an active and globally engaged US defense posture  but yet have a very different perceptions of the future geopolitical landscape.

National Review’s Stephen Spruiell makes the following point:

Italy (debt-to-GDP: 118 percent) has put together an austerity package that relies mostly spending cuts to do the heavy lifting. Portugal (debt-to-GDP: 86 percent) has put together an austerity package that relies mostly on tax increases. Because Italy is cutting spending instead of raising taxes, it has better economic growth prospects, and will bring down its level of indebtedness more quickly, than Portugal. That markets believe this is reflected in CDS spreads of 189 basis points for Italy, compared with 289 points for Portugal.

Me: Traditional fiscal austerity (higher taxes and less spending) has a poor track record because higher taxes are a growth killer. The way heavily indebted nations escape their fiscal traps is either through inflation or higher growth or default. The US should take Door #2 while also cutting spending.

Cutting 5 percent of optional government spending won’t plug America’s fiscal hole. Still, President Barack Obama’s proposal may buy a bit more time with nervous financial markets. It could even kick-start a needed rationalization of government outlays. Every little helps — but Obama needs to go further.

The tweaks that Obama seems to be calling for land well short of the big cost-cuts eventually needed to get the U.S. budget in order. They would affect only discretionary spending unrelated to security, and only starting in 2012. In that year, the projection for such expenses (outside defense and homeland security) is roughly $600 billion. So a 5 percent cut would be $30 billion, or 0.2 percent of GDP. The budget deficit that year is expected to be $915 billion, or 5.8 percent of GDP, according to the Congressional Budget Office. The cuts, in other words, would easily disappear in the overall deficit forecast’s margin of error.

Entitlements are where the real money is. A 5 percent cut in health and pension programs, for instance, would amount to $105 billion. And such “mandatory” spending will increasingly dominate. Currently, this category of spending is half as large again as all discretionary spending. By 2020, that ratio could expand to 120 percent unless Obama’s deficit commission is able fashion a set of entitlement reductions acceptable to Congress.

Then again, even small cuts in wasteful or inefficient discretionary spending are good news. Obama also wants federal agencies to identify their poorly performing programs, an effort to force them to measure and critique performance — and cut expenditure that doesn’t get results.

And Obama has plenty more scope. Defense spending is half of the total discretionary category. Some Republican budget hawks might even applaud well-chosen cuts. And reducing the federal workforce by 25 percent would save $650 billion by 2018, according to simulations run by the Committee for a Responsible Federal Budget. Eliminating earmarks — self-serving pork slipped into spending bills by members of Congress — would save another $160 billion by that year. It would also show the public that Congress takes austerity seriously.

The 5 percent cuts may be at least 50 percent PR. But if they make voters more willing to accept future fiscal pain, they are 100 percent a good start.

Bond guru Bill Gross makes this point:

Tougher sovereign budgets produce government worker layoffs, pay cuts, reduced pension benefits and a drag on consumption and the ability of the private sector to accept an attempted hand-off from fiscal authorities. Recession becomes the fait accompli, and the deficit/GDP ratio moves ever higher because of skyrocketing risk premiums and a plunging GDP denominator. In many cases therefore, it may not be possible for a country to escape a debt crisis by reducing deficits.

Me:  This certainly seems to be the case with Ireland, as it has for most countries trying this path to escape a debt trap. As I point out in this Weekly Standard piece I wrote, the best way to solve a sovereign debt problem is by cutting spending and boosting economic growth.