Tag: government spending

Tax and Expenditure Limits: The Challenge of Turning Mitchell’s Golden Rule from Theory into Reality

The main goal of fiscal policy should be to shrink the burden of government spending as a share of economic output. Fortunately, it shouldn’t be too difficult to achieve this modest goal. All that’s required is to make sure the private sector grows faster than the government.

But it’s very easy for me to bluster about “all that’s required” to satisfy this Golden Rule. It’s much harder to convince politicians to be frugal. Yes, it happened during the Reagan and Clinton years, and there also have been multi-year periods of spending discipline in nations such as Estonia, New Zealand and Canada.

But these examples of good fiscal policy are infrequent. And even when they do happen, the progress often is reversed when a new crop of politicians take power. Federal spending has jumped to about 23 percent of GDP under Bush and Obama, for instance, after falling to 18.2 percent of economic output at the end of the Clinton years.

This is why many advocates of limited government argue that some sort of external force is needed to somehow limit the tendency of politicians to over-tax and over-spend.

I’ve argued on many occasions that tax competition is an important mechanism for restraining the greed of the political class. But even in my most optimistic moments, I realize that it’s a necessary but not sufficient condition.

Another option is budget process reform. If you can somehow convince politicians to tie their own hands (in the same way that alcoholics can sometimes be convinced to throw out all their booze), then perhaps rules can be imposed that improve fiscal policy.

But what sort of rules? Europe has “Maastricht” requirements that theoretically limit deficits and debt, and 49 states have some sort of balanced budget requirement, but these policies have been very unsuccessful - perhaps because they mistakenly focus on the symptom of red ink rather than the underlying disease of government spending.

Are there any budget process reforms that do work? Well, I’ve written about Switzerland’s “debt brake,” which has generated some good results over the past 10 years because it actually imposes an annual spending cap.

Some American states also impose expenditure limits. Have they been successful?

Huge Value-Added Tax Increases in Europe Show Why Washington Politicians Should Never Be Given a New Source of Tax Revenue

The most important, powerful, and relevant argument against the value-added tax in the short run is that we can balance the budget in just five years by capping spending so it grows at the rate of inflation, a very modest level of fiscal restraint.

The most important, powerful, and relevant argument against the value-added tax in the long run is that more than 100 percent of America’s long-term fiscal problem is too much spending.

So why even consider giving politicians a new source of revenue such as the VAT, particularly since this hidden form of national sales tax helped cause the European fiscal crisis by facilitating a bigger welfare state?*

And now Europeans are doubling down on that failed approach, thus confirming that politicians will rarely make necessary spending reforms if they think more revenue can be squeezed from taxpayers.

Here’s a chart taken from the recent European Commission report on taxation trends in the EU. As you can see, the average VAT rate in Europe has jumped by nearly 2 percentage points in just five years.

VAT EU Increase

As I explained last week, European politicians also have been increasing income tax rates, so taxpayers are getting punished when they earn their income and they’re getting punished when they spend their income.

Which helps to explain why much of Europe is suffering from economic stagnation. Given the perverse incentives created by redistributionist fiscal policy, it makes more sense to climb in the wagon of government dependency.

For more information, here’s my video that describes the VAT and explains why it’s a bad idea.

*The same thing is now happening in Japan.

P.S. I don’t know if you’ll want to laugh or cry, but the tax-free bureaucrats at the Organization for Economic Cooperation and Development actually argue that the VAT is good for jobs and growth.

Where Are the European Spending Cuts?

Paul Krugman recently tried to declare victory for Keynesian economics over so-called austerity, but all he really accomplished was to show that tax-financed government spending is bad for prosperity.

More specifically, he presented a decent case against the European-IMF version of “austerity,” which has produced big tax increases.

But what happens if nations adopt the libertarian approach, which means “austerity” is imposed on the government, rather than on taxpayers?

In the past, Krugman has also tried to argue that European nations have erred by cutting spending, but this has led to some embarrassing mistakes.

Now we have some additional evidence about the absence of spending austerity in Europe. A leading public finance economist from Ireland, Constantin Gurdgiev, reviewed the IMF data and had a hard time finding any spending cuts:

…in celebration of that great [May 1] socialist holiday, “In Spain, Portugal, Greece, Italy and France tens of thousands of people took to the streets to demand jobs and an end to years of belt-tightening”. Except, no one really asked them what did the mean by ‘belt-tightening’. …let’s check out expenditure side of Europe’s ‘savage austerity’ story… The picture hardly shows much of any ‘savage cuts’ anywhere in sight.

As seen in his chart, Constantin compared government spending burdens in 2012 to the average for the pre-recession period, thus allowing an accurate assessment of what’s happened to the size of the public sector over a multi-year period.

Austerity in Europe

Here are some of his conclusions from reviewing the data:

Of the three countries that experienced reductions in Government spending as % of GDP compared to the pre-crisis period, Germany posted a decline of 1.26 percentage points (from 46.261% of GDP average for 2003-2007 period to 45.005% for 2012), Malta posted a reduction of just 0.349 ppt and Sweden posted a reduction of 1.37 ppt.

No peripheral country - where protests are the loudest - or France et al have posted a reduction. In France, Government spending rose 3.44 ppt on pre-crisis level as % of GDP, in Greece by 4.76 ppt, in Ireland by 7.74 ppt, in Italy by 2.773 ppt, in Portugal by 0.562 ppt, and in Spain by 8.0 ppt.

Average Government spending in the sample in the pre-crisis period run at 44.36% of GDP and in 2012 this number was 48.05% of GDP. In other words: it went up, not down.

…All in, there is no ‘savage austerity’ in spending levels or as % of GDP.

I’ll add a few additional observations.

Entitlement Spending Is America’s Biggest Fiscal Challenge, but Discretionary Spending Is Still Far too High

If America descends into Greek-style fiscal chaos, there’s no doubt that entitlement programs will be the main factor. Social Security, Medicare, Medicaid, and Disability are all fiscal train wrecks today, and the long-run outlook for these programs is frightful.

Just look at these numbers from the Bank for International Settlements and OECD to see how our fiscal future is bleaker than many of Europe’s welfare states.

Simply stated, if we don’t implement the right kind of entitlement reform, our children and grandchildren at some point will curse our memory.

But that doesn’t mean we shouldn’t worry about other parts of the budget, including the so-called discretionary programs that also have been getting bigger and bigger budgets over time.

That’s why I want to add some additional analysis to Veronique de Rugy’s recent piece in National Review Online, which might lead some to mistakenly conclude that these programs are “shrinking” and being subject to a “Big Squeeze.”

…there is another number to look at in that budget. It’s the shrinking share of the budget consumed by discretionary spending (spending on things like defense and infrastructure) to make space for mandatory spending and interest. This is the Big Squeeze. …in FY 2014 mandatory spending plus interest will eat up 67 percent of the budget, leaving discretionary spending with 33 percent of the budget (down from 36 percent in FY 2012). Now by FY 2023, mandatory and interest spending will consume 77 percent of the total budget. Discretionary spending will be left with 23 percent of the budget.

She’s right that discretionary spending is becoming a smaller share of the budget, but it’s important to realize that this is solely because entitlement outlays are growing faster than discretionary spending.

Here’s some data from the Historical Tables of the Budget, showing what is happening to spending for both defense discretionary and domestic discretionary. And these are inflation-adjusted numbers, so the we’re looking at genuine increases in spending.

Discretionary Spending FY62-14

As you can see, defense outlays have climbed by about $100 billion over the past 50 years, while outlays for domestic discretionary programs have more than tripled.

If that’s a “Big Squeeze,” I’m hoping that my household budget experiences a similar degree of “shrinking”!

Veronique obviously understands these numbers, of course, and is simply making the point that politicians presumably should have an incentive to restrain entitlement programs so they have more leeway to also buy votes with discretionary spending.

But I’d hate to think that an uninformed reader would jump to the wrong conclusion and decide we need more discretionary spending.

Particularly since the federal government shouldn’t be spending even one penny for many of the programs and department that are part of the domestic discretionary category. Should there be a federal Department of Transportation? A federal Department of Housing and Urban Development? A federal Department of Agriculture?

No, NO, and Hell NO. I could continue, but you get the idea.

The burden of federal government spending in the United States is far too high and it should be reduced. That includes discretionary spending and entitlement spending.

P.S. For those who don’t have the misfortune of following the federal budget, “entitlements” are programs that are “permanently appropriated,” which simply means that spending automatically changes in response to factors such as eligibility rules, demographic shifts, inflation, and program expansions. Sometimes these programs (such as Social Security, Medicare, Medicaid, etc) are referred to as “mandatory spending.”

The other big part of the budget is “discretionary spending” or “appropriations.” These are programs funded by annual spending bills from the Appropriations Committees, often divided into the two big categories of “defense discretionary” and “nondefense discretionary.”

Question of the Week: What’s the Right Point on the Laffer Curve?

Back in 2010, I wrote a post entitled “What’s the Ideal Point on the Laffer Curve?

Except I didn’t answer my own question. I simply pointed out that revenue maximization was not the ideal outcome.

I explained that policy makers instead should seek to maximize prosperity, and that this implied a much lower tax rate.

But what is that tax rate, several people have inquired?

The simple answer is that the tax rate should be set to finance the legitimate functions of government.

But that leads to an obvious follow-up question. What are those legitimate functions?

According to my anarcho-capitalist friends, there’s no need for any public sector. Even national defense and courts can be shifted to the private sector.

In that case, the “right” tax rate obviously is zero.

But what if you’re a squishy, middle-of-the-road moderate like me, and you’re willing to go along with the limited central government envisioned by America’s Founding Fathers?

That system operated very well for about 150 years and the federal government consumed, on average, only about 3 percent of economic output. And even if you include state and local governments, overall government spending was still less than 10 percent of GDP.

Moreover, for much of that time, America prospered with no income tax.

But this doesn’t mean there was no tax burden. There were federal excise taxes and import taxes, so if the horizontal axis of the Laffer Curve measured “Taxes as a Share of GDP,” then you would be above zero.

Or you could envision a world where those taxes were eliminated and replaced by a flat tax or national sales tax with a very low rate. Perhaps about 5 percent.

So I’m going to pick that number as my “ideal” tax rate, even though I know that 5 percent is just a rough guess.

For more information about the growth-maximizing size of government, watch this video on the Rahn Curve.

There are two key things to understand about my discussion of the Rahn Curve.

First, I assume in the video that the private sector can’t provide core public goods, so the discussion beginning about 0:33 will irk the anarcho-capitalists. I realize I’m making a blunt assumption, but I try to keep my videos from getting too long and I didn’t want to distract people by getting into issues such as whether things like national defense can be privatized.

Second, you’ll notice around 3:20 of the video that I explain why I think the academic research overstates the growth-maximizing size of government. Practically speaking, this seems irrelevant since the burden of government spending in almost all nations is well above 20 percent-25 percent of GDP.

But I hold out hope that we’ll be able to reform entitlements and take other steps to reduce the size and scope of government. And if that means total government spending drops to 20 percent-25 percent of GDP, I don’t want that to be the stopping point.

At the very least, we should shrink the size of the state back to 10 percent of economic output.

And if we ever get that low, then we can have a fun discussion with the anarcho-capitalists on what else we can privatize.

P.S. If a nation obeys Mitchell’s Golden Rule for a long enough period of time, government spending as a share of GDP asymptotically will approach zero. So perhaps there comes a time where my rule can be relaxed and replaced with something akin to the Swiss debt brake, which allows for the possibility of government growing at the same rate as GDP.

The Ryan Budget: Is Returning to Clinton-Era Levels of Fiscal Restraint Really Asking too Much?

It can be very frustrating to work at the Cato Institute and fight for small government.

Consider what’s happened the past couple of days.

Congressman Paul Ryan introduces a budget and I dig through the numbers with a sense of disappointment because government spending will grow by an average of 3.4 percent annually, much faster than needed to keep pace with inflation.

But I don’t even want government to grow as fast as inflation. I want to reduce the size and scope of the federal government.

I want to shut down useless and counterproductive parts of Leviathan, including the Department of Housing and Urban Development, the Department of Education, the Department of Energy, the Department of Transportation, the Department of Agriculture, etc, etc…

I want to restore limited and constitutional government, which we had for much of our nation’s history, with the burden of federal spending consuming only about 3 percent of economic output.

So I look at the Ryan budget in the same way I look at sequestration – as a very modest step to curtail the growth of government. Sort of a rear-guard action to stem the bleeding and stabilize the patient.

But, to be colloquial, it sure ain’t libertarian Nirvana (though, to be fair, the reforms to Medicare and Medicaid are admirable and stem in part from the work of Cato’s healthcare experts).

But my frustration doesn’t exist merely because the Ryan budget is just a small step.

I also have to deal with the surreal experience of reading critics who assert that the Ryan budget is a cut-to-the-bone, harsh, draconian, dog-eat-dog, laissez-faire fiscal roadmap.

If only!

To get an idea of why this rhetoric is so over-the-top hysterical, here’s a chart showing how fast government spending is supposed to grow under the Ryan budget, compared to how fast it grew during the Clinton years and how fast it has been growing during the Bush-Obama years.

Ryan Clinton vs Bush Obama

I vaguely remember taking the SAT test in high school and dealing with questions entitled, “One of these things is not like the others.”

Well, I would have received a perfect score if asked to identify the outlier on this chart.

Bush and Obama have been irresponsible big spenders, while Clinton was comparatively frugal.

And all Paul Ryan is proposing is that we emulate the policy of the Clinton years.

Now ask yourself whether the economy was more robust during the Clinton years or the Bush-Obama years and think about what that implies for what we should do today about the federal budget.

At the very least, we should be copying what those “radical” Canadians and other have done, which is to impose some genuine restraint of government spending.

The Swiss debt brake, which is really a spending cap, might be a good place to start.

Senator Patty Murray Is Right…and Completely Wrong…about the 1990s

I wrote about the Ryan budget two days ago, praising it for complying with Mitchell’s Golden Rule and reforming Medicare and Medicaid.

But I believe in being honest and nonpartisan, so I also groused that it wasn’t as good as the 2011 and 2012 versions.

Now it’s time to give the same neutral and dispassionate treatment to the budget proposed by Patty Murray, the Washington Democrat who chairs the Senate Budget Committee.

But I’m going to focus on a theme rather than numbers.

One part of her budget got me particularly excited. Her Committee’s “Foundation for Growth” blueprint makes a very strong assertion about the fiscal and economic history of the Clinton years.

The work done in the 1990s helped grow the economy, create jobs, balance the budget, and put our government on track to eliminate the national debt.

As elaborated in this passage, the 42nd President delivered very good results.

President Bill Clinton entered office in 1993 at a time when the country was facing serious deficit and debt problems. The year before, the federal government was taking in revenue equal 17.5 percent of GDP, but spending was 22.1 percent of the economy—a deficit of 4.7 percent. …The unemployment rate went from 7 percent at the beginning of 1993 to 3.9 percent at the end of 2000. Between 1993 and 2001, our economy gained more than 22 million jobs and experienced the longest economic expansion in our history.

And the Senate Democrats even identified one of the key reasons why economic and fiscal policy was so successful during the 1990s.

…federal spending dropped from 22.1 percent of GDP to 18.2 percent of GDP.

I fully agree with every word reprinted above. That’s the good news.

So what, then, is the bad news?

Well, Senator Murray may have reached the right conclusion, but she was wildly wrong in her analysis. For all intents and purposes, she claims that the 1993 tax hike produced most of the good results.

President Clinton’s 1993 tax deal…brought in new revenue from the wealthiest Americans and…our country created 22 million new jobs and achieved a balanced budget. President Clinton’s tax policies were not the only driver of economic growth, but our leaders’ ability to agree on a fiscally sustainable and economically sound path provided valuable certainty for American families and businesses.

First, let’s dispense with the myth that the 1993 tax hike balanced the budget. I obtained the fiscal forecasts that were produced by both the Congressional Budget Office and the Office of Management and Budget in early 1995 because I wanted to see whether a balanced budget was predicted.

As you can see in the chart, both of those forecasts showed perpetual deficits of about $200 billion. And these forecasts were made nearly 18 months after the Clinton tax hike was implemented.

So if even the White House’s own forecast from OMB didn’t foresee a balanced budget, what caused the actual fiscal situation to be much better than the estimates?

The simple answer is that spending was restrained. You can give credit to Bill Clinton. You can give credit to the GOP Congress that took power in early 1995. You can give the credit to both.

But regardless of who gets the credit, the period of spending restraint that began at that time was the change that produced a budget surplus, not the tax hike that was imposed 18 months earlier and which was associated with perpetual red ink.

But spending restraint tells only part of the story. With the exception of the 1993 tax hike, the Clinton years were a period of shrinking government and free market reform.

Take a look at my homemade bar chart to compare the good policies of the 1990s with the bad policies. It’s not even close.

You may be thinking that my comparison is completely unscientific, and you’re right. I probably overlooked some good policies and some bad policies.

And my assumptions about weighting are very simplistic. Everything is equally important, with a big exception in that I made the government spending variable three times as important as everything else.

Why? Well, I think reducing the burden of government spending during the Clinton years was a major achievement.

But maybe we shouldn’t rely on my gut instincts. So let’s set aside my created-at-the-spur-of-the-moment bar chart and look at something that is scientific.

This chart is taken directly from Economic Freedom of the World, which uses dozens of variables to measure the overall burden of government.

As you can see, the United States score improved significantly during the Clinton years, showing that economic freedom was expanding and the size and scope of government was shrinking.

In other words, Patty Murray is correct. She is absolutely right to claim that Bill Clinton’s policies “helped grow the economy, create jobs, balance the budget.”

Now she needs to realize that those policies were small government and free markets.