Latvians, Homework and Budget Balancing

I went to a Latvian wedding last weekend and the dog ate my homework. Anyway, because of this or that my usual blog post may be a little shorter than usual. But I have been wanting to do this with or without the excuses anyway. This post is just a little data exercise to provide some perspective on what the so-called special committee is doing. Politics aside, their assignment is not really that difficult. One takeaway is that there is too little attention given to the fact that we are trying to create one solution for two very different problems. It’s like trying to find one shirt for Dolly and Gary Coleman. One size just won’t fit all.

The special committee is supposed to find roughly $1.2 trillion in deficit reduction over a time period of 10 years. In looking at spending and revenue possibilities everything gets lumped in and examined together – the Bush tax cuts, loopholes, spending on the military, etc. As a result we have an economic and ideological debate about what is and what isn’t a fair change. But the truth is that we really have two issues. The first one has to do with the short-run. We have a recession followed by a slow growth economy. The second one is the longer term issue of how to deal with an aging population. Separating these issues might help create some simple insights – and some simple remedies.

Let’s take the short-run first. The data is very clear. We jumped from having a very reasonable deficit of $161 billion in 2007 to one of about $1.3 trillion in 2010. That’s a 8-fold increase. The data is very clear about the source of that increase – between 2007 and 2010 government spending increased by $727 billion and taxes decreased by 406 billion. But that’s not the best measure of what happened. If government spending had grown at its normal rate (average rate since 1971) it would have increased in those years by $661 billion. Thus, only about $66 billion was an extraordinary increase in spending. It tax revenue had grown at a normal pace from 2007 to 2010, tax revenues would have increased by $602 billion. A tax decrease of $406 billion means that tax revenues were $1.008 trillion off their normal pace. It is absolutely clear that 2007 to 2010 was different from normal because: spending rose $0.066 trillion more than normal and tax revenues increased $1.008 trillion less than normal.

You spending clippers do not like this result because it focuses our attention away from cutting government spending to raising taxes. But you are wrong for two reasons. First, the spending issue has more to do with the long-run and I will get to that soon below. Second, I cannot tell you we need to raise specific taxes or tax rates because the tax reductions came from two very different sources – those that came from policies (e.g. Bush tax cuts, Obama tax cuts, etc) and those that came automatically as households, firms, and investors had less incomes and capital gains to claim. I can tell you that the fall-off of taxes was shared. Between 2007 and 2010 personal income taxes declined by $268 billion while business taxes decreased by $179 billion. Social Security taxes declined by only $5 billion.

Let’s move on to the longer-run. I am defining the long run as the 10 years from 2010 to 2020. Over those years government spending under existing law will increase by a total $1.705 trillion. This is, total federal government spending will go from $3.456 trillion in 2010 to $5.161 trillion in 2020. The changes in government spending over those years are projected to be:

               

Total                      $1,705 billion

                Social Security         502

                Medicare                 383

                Medicaid                 247

                Net Interest             436

                Everything else        137

Notice that if we don’t change any of those programs – and we cannot change net interest – we will need to raise taxes in 10 years by $1.7 trillion to cover spending. There isn’t much to cut from “everything else” and we can’t touch net interest. But we do have a nice hunk of future spending equal to $1.132 trillion that shows some promise.

Let’s emphasize now what is and what is not a cut. For example, Social Security spending is going to INCREASE by $502 billion. Just imagine that your check goes up by $502 billion by 2020. I would be pretty happy with that. But now, let’s say we decide to reduce the increase by 10% or by $50 billion. You would still find yourself $452 billion ahead of where you were in 2010. That will still buy a few nice prunes!  That is NOT a cut. It is an increase of $452 billion.

Speaking of Social Security, Medicare, and Medicaid if we slowed the increase by 10% we could save ourselves tax increases of $112 billion. If we cut the increase by 20% we would save $225 billion.

This short-run/long-run breakdown suggests that we have two different problems. The first one is to try to improve the tax system to offset reductions in taxes accruing from two recessions in the last decade and the tax cut policies that treated the recessions. As the temporary tax programs automatically are rescinded and as economic growth improves, much of that tax problem will disappear without any policy whatsoever. Of course, some attention to tax loopholes and attention to reversing temporary spending increases could hasten that short-run problem even more. 

With respect to the longer run the only game in town is spending. No program has to be cut. And tax revenues will increase. But reining in spending growth is necessary if we are to address our debt and deficit issues. Right now the baseline estimates have the deficit declining by a large amount in 2013 as temporary tax changes end with the deficit declining to 1.2% of GDP by 2010. I wouldn’t trust that number but it does show with some marginal attention to Social Security, Medicare, and Medicaid, all this is within reason.

I have not said a word about optimal spending and tax policies for long-term growth. I have not said anything about flat taxes or tax reform in general. Those are issues very worth addressing in another post. But what I am saying here is that we can do something about our worst debt and deficit problems. The solutions are not as impossible as our politicians make out.

If the European debt mess doesn’t send us a signal I don’t know what will. Our growth and our employment are dangling precariously as our leaders drink martinis and tell war stories. Boehner calls Obama a goof ball and ReidPelosi calls the Republican candidates worse names. They have within them to power to play political games that will soon seriously damage our country or they can wear big person clothes and address the humdrum but very doable task of letting the world know that we can handle our financial messes. From what I see in the news it sounds and looks more like continued political posturing and less attention to simple solutions. We should send all our government officials Barbie Dolls!