Archives: 02/2017

Trump’s Budget Situation

President Donald Trump will lay out some of his budget priorities in an address to Congress tonight. He wants to increase spending on defense, a border wall, and perhaps infrastructure. He also wants to cut taxes and balance the budget, yet does not favor reductions to Medicare or Social Security. His budget chief, Mick Mulvaney, faces a challenge in meshing all those priorities.

The chart shows federal spending in four categories as a percent of gross domestic product (GDP). No doubt, Mulvaney is pondering the CBO baseline projections to the right of the vertical line for 2018-2027. As a share of GDP, entitlement and interest spending are expected to soar, while defense and nondefense discretionary spending are expected to fall. Below the chart, I discuss the ups and downs of the four categories since 1970.

Here are some of the causes of the fluctuations seen in the chart:

1970s: Defense spending plunges as the Vietnam War subsides in the early 1970s. But the cost of new Lyndon Johnson/Richard Nixon entitlement and discretionary programs skyrockets.

1980s: Ronald Reagan boosts defense spending, and interest costs soar due to the rising debt. But Reagan cuts numerous discretionary and entitlement programs. For example, “income security” programs fall from 1.6 percent of GDP in 1981 to 1.1 percent by 1989.

1990s: The end of the Cold War prompts large defense cuts. But the recession and spendthrift approach of George H.W. Bush causes other spending to rise early in the decade. Bill Clinton lucks out as Social Security spending falls from 4.4 percent in 1992 to 4.0 percent by the end of the decade, while spending on Medicare and Medicaid remains fairly flat.

2000s: Medicare spending soars under George W. Bush, partly due to his Part D drug plan. Bush also pushes up spending on defense, homeland security, food stamps, education subsidies, and other programs. However, Bush benefits from the Fed’s policy of low interest rates, which moderates federal interest costs.

2010s: The recession of 2007 to 2009 causes spending on entitlements—such as unemployment insurance and food stamps—to soar. The Obama stimulus package includes big increases for many discretionary and entitlement programs in 2009 and subsequent years. The early Obama years also include high levels of Iraq and Afghanistan war spending. However, Obama also benefits from the Fed’s interest rate policies.

2018-2027: CBO projections show entitlement and interest costs rising rapidly, and deficits topping $1 trillion by 2023. To sustain economic growth and avert a fiscal disaster, Trump should push to terminate and privatize programs in every federal department. He talks a good game, but we will see whether he is interested in actual budget reforms in coming weeks as he rolls out specific proposals.

Notes: CBO data is here. I adjusted the entitlement line to take out TARP from 2009-2011 because it ended up costing taxpayers little or nothing.

For ways to cut federal spending, see this essay at

The End of Self Government?

In Federalist 39, James Madison asks whether the 1787 Constitution

be strictly republican. It is evident that no other form would be reconcilable with the genius of the people of America; with the fundamental principles of the Revolution; or with that honorable determination which animates every votary of freedom, to rest all our political experiments on the capacity of mankind for self-government.

The political scientist John DiIulio, Jr. answers ten questions about big government. He shows that regulations and spending by the federal government have risen a lot over the past half century. At the same time, representatives of the people have less control over the people who implement big government. The feds delegate implementation to state and local governments and contractors. These “agents of the people” by and large, he argues, do a poor job.

DiIulio concludes that Americans “want big government benefits and programs, but they do not want to pay big government taxes and they prefer not to receive their goods and services directly from the hand of big government bureaucracies.” Add some lobbying by contractors and state and local officials, and you have big, incompetent government.

DiIulio recalls Alexander Hamilton’s claim that “the true test of good government is its aptitude and tendency to produce a good administration.” That’s a Hamiltonian thing to say!

Madisonian things ought also be said. The U.S. Constitution promised republican self-government, not efficient tax collection and a skilled civil service. The government DiIulio outlines involves so many people doing so much that elected representatives can hardly be expected to control this vast administrative state. The old hope for republican liberty too has been diminished by the rise of big government.

Deductions Could Spell WTO Trouble for the GOP “Border Adjustable Tax” Plan

In a previous Cato blog post, I explained how the House Republican “Better Way” corporate tax plan, which replaces our current 35% corporate income tax with a 20% “destination-based cash flow tax” (DBCFT), could theoretically avoid litigation at the World Trade Organization (WTO) and member countries’ eventual, WTO-approved retaliation against billions of dollars worth of US exports. I concluded therein that, while there wasn’t yet enough concrete information about the DBCFT’s final form to determine its WTO-consistency, the conventional wisdom was wrong to assume that any US corporate tax plan would violate the United States’ international trade obligations. Today, on the other hand, I’ll explain the quickest way that the DBCFT could get into trouble at the WTO. 

Spoiler: it’s all about the deductions.

I won’t reiterate here how the DBCFT is intended to operate and again will acknowledge that we haven’t actually seen any legislative text yet. That said, there is a pretty clear consensus view among economists that the DBCFT would essentially operate as a modified “subtraction-method” value-added tax (VAT) on US corporations’ domestic sales revenue, minus taxable input purchases. This was helpfully summarized in a recent Paul Krugman blog post (emphasis mine):

[A] VAT is just a sales tax, with no competitive impact. But a DBCFT isn’t quite the same as a VAT. With a VAT, a firm pays tax on the value of its sales, minus the cost of intermediate inputs—the goods it buys from other companies. With a DBCFT, firms similarly get to deduct the cost of intermediate inputs. But they also get to deduct the cost of factors of production, mostly labor but also land. So one way to think of a DBCFT is as a VAT combined with a subsidy for employment of domestic factors of production. The VAT part has no competitive effect, but the subsidy part would lead to expanded domestic production if wages and exchange rates didn’t change.

Just so we’re clear that I’m not playing partisan favorites here, Krugman’s view was essentially echoed by Republican/conservative economist Greg Mankiw, who called the DBCFT “like a value-added tax” on corporations’ US sales with “a deduction for labor payments.”

While economists disagree about the economic and trade effects of the DBCFT, the aforementioned descriptions have generated significant (though certainly not consensus) concerns with respect the whether the new tax would be consistent with WTO rules—concerns that don’t arise with a VAT. As I discussed last time, the DBCFT would have to clear at least three hurdles at the WTO—two on the export subsidy side and one on the import side:

  • Export subsidy: The DBCFT would be found to confer prohibited export subsidies under the Article 3 of the WTO Subsidies Agreement where (1) the tax is found to be a “direct tax,” which the Agreement defines as “taxes on wages, profits, interests, rents, royalties, and all other forms of income, and taxes on the ownership of real property” (VATs are a type of “indirect tax”); and (2) the “border adjustment” (i.e., tax exemption or rebate) for a company’s export sales is greater than the actual amount of tax due or collected.
  • Import discrimination: The DBCFT would violate the “national treatment” principle of GATT Articles II and III (on internal taxes) where it imposes a higher tax burden on an imported good than that imposed on an identical domestically produced product.

The concern among us trade lawyers rests in the deductions for labor and (maybe) land that a VAT doesn’t have but the DBCFT does—deductions that could generate violations of one or more of the aforementioned disciplines. This can be pretty difficult to see in the abstract, but the problems—as well as their absence for a normal VAT—become clearer through a simple hypothetical assessment of the tax’s effect on two identical US companies selling and exporting the same product, with one company selling only imported final goods and the other selling identical products with 100% US content. So let’s do that now, starting with a classic example used by the US Government Accounting Office to show how a standard subtraction-method VAT, which taxes corporations’ domestic (not export) sales revenue and permits one deduction for domestic (and thus taxable) input purchases, works in practice.


Why There Is No Fiscal Case for the Fed’s Large Balance Sheet

It is well known that the Federal Reserve System expanded its assets more than four-fold during and after the 2007-09 financial crisis by making massive purchases of mortgage-backed securities and Treasuries. The balance sheet has not returned to normal since. Total Fed assets stand today at $4.45 trillion, up from less than $1 trillion before the crisis. Whether, when, and how to normalize the size of the Fed’s balance sheet have been under discussion for years.

Economist-blogger David Andolfatto — not speaking for his employer the Federal Reserve Bank of St. Louis — now offers “a public finance argument” for “keeping the Fed’s balance sheet large.” Viewing the Fed as a financial intermediary, he observes that “The Fed transforms high-interest government debt into low-interest Fed liabilities (money),” and that this is a profitable business.

Curiously, Andolfatto omits to mention two important details: the Fed enjoys such a spread only because it is — for the first times in its history — (a) borrowing short and lending very long, also known as practicing “duration transformation” or “playing the yield curve,” and (b) heavily invested in mortgage-backed securities. The Fed is borrowing short by currently paying 0.75% (not 0.50% as Andolfatto reports) on zero-maturity bank reserves. It lends long by holding 10-year and longer Treasuries (paying 2.42% and up as of 17 Feb. 2017) and long-term mortgage-backed securities.

Not Just the Press

How can unelected judges limit the power of an elected official like the president? Two political scientists offer some answers in The Washington Post.

First, the public should broadly agree “about the basic legitimacy of the procedures used to review the powerful.” Second, the public needs “accurate information about the behavior of public officials.”

The authors say a free press should and does provide that information in various ways. That’s a good answer as far as it goes, but it does not go nearly far enough. Many other parts of our polity have the power and responsibility to provide information about government. To name a few: interest groups, bloggers, think tanks, professors, leakers, labor unions, trade associations, grassroots groups, and many others who might spring to mind with more reflection.

The media does not have a monopoly on informing the public. “The freedom of speech and of the press” belongs to all Americans. This diffusion of power seems especially valuable at a moment when the media lack credibility for so many Americans.

War of the Worst Case Scenarios

A few nightmare scenarios haunt the dreams of civil libertarians—scenes drawn from our long and ignominious history of intelligence abuses.   One—call it the Nixon scenario—is that the machinery of the security state will fall into the hands of an autocratic executive, disdainful of the rule of law, who equates “national security” with the security of his own grip on political authority, who is all too willing to turn powers meant to protect us from foreign adversaries against his domestic political opponents, and who lacks any qualms about quashing inquiries into his own illegal conduct or that of his allies.  Another—call it the Hoover scenario—is that the intelligence agencies anxious to protect their own powers and prerogatives will themselves slip the leash, using their command of embarrassing secrets to intimidate (and in extreme cases perhaps even select) their own nominal masters.  As the American surveillance state has ballooned over the past 15 years, we’ve often invoked those scenarios to argue out that the slippery slope from a reasonable-sounding security measure a tool of anti-democratic repression is disquietingly short and well-oiled. You may trust that some new authority will only be used to monitor terrorists today, but under a more authoritarian administration, might it be used to suppress dissent—as when civil rights and anti-war activists became the targets of the FBI’s notorious COINTELPRO?  You may be reassured by all the rigid rules and layers of oversight designed to keep the Intelligence Community accountable, but will those mechanisms function if the intelligence agencies decide to use their broad powers to cow their own overseers?

We are now, it seems, watching both scenarios play out simultaneously.  Perhaps surprisingly, however, they’re playing out in opposition to each other—for the moment. Whatever the outcome of that conflict, it seems unlikely to bode well for American liberal democracy.

On the one hand we have Donald Trump, whose thin-skinned vindictiveness and contempt for judicial checks on his whims are on daily display, and who during his presidential campaign revealed a disturbing instinct for lashing out at political opponents with threats to disclose embarrassing personal information. (Recall his tweets promising to “spill the beans” on Heidi Cruz, wife of primary opponent Ted, or his warning that the Ricketts family, which funded ads opposing him, had “better be careful” because they “have a lot to hide”.) As a private citizen, Trump treated the legal system as a tool to harass people who wrote unflattering things about him; as a candidate, he thought nothing of offhandedly suggesting he could use the power of the Justice Department to jail his opponent. Even before taking the Oval Office, then, Trump had provided civil libertarians and intelligence community insiders with a rare point of consensus: Both feared that with control of both the intelligence agencies and the institutional checks on those agencies within the executive branch, Trump would fuse a disposition to abuse power with an institutionally unique ability to get away with it.  On the flip side, Trump’s dismissive attitude toward the intelligence consensus that Russia had intervened to aid him in the election; his frankly bizarre, fawning posture toward Russia’s strongman leader; and his insistence on defying decades of political norms to shield his finances from public scrutiny signaled that inquiries into illicit conduct by himself or his allies and associates would be likely to wither on the vine once Trump loyalists had been installed at the heads of law enforcement agencies. As Nixon scenarios go, to steal a turn of phrase from my colleague Gene Healy, Trump is a civil libertarian’s grimmest thought experiment come to life.

Court: IRS, Unlike Caligula, May Punish Only Under Well-Proclaimed Law

Judge Jeffrey Sutton, writing for a Sixth Circuit panel, has reversed a Tax Court ruling in an opinion [Summa Holdings v. Commissioner of Internal Revenue] beginning thus:

Caligula posted the tax laws in such fine print and so high that his subjects could not read them. Suetonius, The Twelve Caesars, bk. 4, para. 41 (Robert Graves, trans., 1957). That’s not a good idea, we can all agree. How can citizens comply with what they can’t see? And how can anyone assess the tax collector’s exercise of power in that setting? The Internal Revenue Code improves matters in one sense, as it is accessible to everyone with the time and patience to pore over its provisions.

In today’s case, however, the Commissioner of the Internal Revenue Service denied relief to a set of taxpayers who complied in full with the printed and accessible words of the tax laws. The Benenson family, to its good fortune, had the time and patience (and money) to understand how a complex set of tax provisions could lower its taxes.

And taking issue with the IRS Commissioner’s decision to disallow the combined use of two Congressionally approved devices, the Roth IRA and DISC (domestic international sales corporation), in a way said to trigger the so-called substance-over-form doctrine:

Each word of the “substance-over-form doctrine,” at least as the Commissioner has used it here, should give pause. If the government can undo transactions that the terms of the Code expressly authorize, it’s fair to ask what the point of making these terms accessible to the taxpayer and binding on the tax collector is. “Form” is “substance” when it comes to law. The words of law (its form) determine content (its substance). How odd, then, to permit the tax collector to reverse the sequence—to allow him to determine the substance of a law and to make it govern “over” the written form of the law—and to call it a “doctrine” no less.

[cross-posted from Overlawyered]