Center for Business & Public Policy
Collaborative blog exploring the relationship between market forces and public policy.

Or, alternatively, “Why I Love Teaching”!  First, teaching lets me grandstand a bit, if that help students really think about the world around us.  Second, it lets me pretend to be an expert in fields other than economics, even fields such as philosophy (see below).  Third, trying to teach about a topic forces me to think hard about that topic myself!  A case in point is the standard lecture on “Justifications for Government Policy to Redistribute Income”, otherwise known as “Robin Hood”, otherwise known as government “theft” from the rich to give to the poor.   

One thing currently happening in the world around us is a heightened political debate about whether the top income tax rate is too low or too high.  See the diagram below.  So this “lecture topic” is not just textbook irrelevance.  It might even help YOU to think about what you read in the newspaper!  Then please decide for yourself.

I see four possible justifications, any one of which may or may not ring true to you.  If one or more justification is unconvincing, however, then perhaps a different justification is more appealing. 

1.)    As described below, some in the field of “moral philosophy” have found ethical justifications for extra help to the poor.

2.)    Even if the poor are not deemed special in that way, and all individuals receive equal weight, it may still be that a dollar from a rich person is relatively unimportant to that rich person, while a dollar to a poor person is very important to that poor person (higher marginal utility).  If so, then equal weights on everybody would still mean that total welfare could increase by taking from the rich in order to help the poor. 

3.)    If incomes are generally uncertain, so that any individual might do well in some years and not in other years, then government might actually make all of us happier by the provision of implicit “insurance” – taking premiums in good times in order to help any person who suffers bad times.

4.)    A reduction in income equality could be a “public good”, like the classic example of a lighthouse that benefits all ships whether they have helped to pay for it or not.  Everybody’s individual incentive is therefore not to pay (to “free ride”).  The private market never exists.  But government can raise welfare for all shippers by taxing all ships and using the funds to build and operate the lighthouse.  Similarly, if many people would LIKE to have more income equality in society, they could “free ride” on others who do give voluntarily to help the underprivileged. If so, then government could fix that market failure by taxing everybody and using the funds to improve income equality.

Having used up several paragraphs already, I will miss the chance to explain all four of these important points adequately in this one blog, and so I’ll save a few for the next blog.  Let’s just start with the first one.

In the field of moral philosophy, some libertarians such as Robert Nozick believe that theft itself is ethically wrong, that each person is morally entitled to the fruits of their own labor.  No person is allowed to steal from a rich neighbor, even to give to the poor, so why would government be allowed to do so?  If theft is morally wrong in itself, then government should not be redistributing from rich to poor, no matter how needy the poor nor how worthy the cause.  On the other hand, by the way, government steals from individuals through taxes in order to build highways and provide for national defense, and so one may wonder why theft is justified for some purposes and not others.  One way out of that problem is to decide that a tax for public purposes is not in fact “theft”.

In contrast, John Rawls argues that the moral choice is to help the poor.  Actually he has two important ideas.  One is that those who are already rich have no moral justification to argue for reducing taxes on the rich, just as those who are poor have no moral justification to argue for raising taxes on the rich.  Such positions are merely self-interested.  Therefore, a useful thought experiment is to put yourself in what Rawls calls the “Original Position”, at the beginning of the World, before places have been assigned in the wide distribution of incomes and well-being.  That is, suppose resources are limited, and that the world will inevitably have a distribution of different human abilities and disabilities.  You don’t yet know your IQ, or whether you will have any particular talents in music, sports, the arts, or management.  Our job in this “original position” is to write a constitution, a set of rules for government and human interaction.

The purpose of this thought experiment is to try to strip away self-interest and think about how rules “ought” to be designed.  And then, Rawls’ second idea is about what any of us would likely decide to do in such a position.  He argues that the only natural choice, indeed the only logical choice, is to be extremely risk averse.  We are not talking about twenty bucks you might lose at the Casino, where risk is fun.  Instead, we are talking about your entire life’s prospects, where risk is not fun.  It must be great to be Brad Pitt, but what if you end up with little talent or ability.  You could end up homeless, or worse.   Given that risk, he argues, one should design the rules such that society would take good care of those who are disadvantaged, unlucky, or disabled.  You might well be the person on the bottom of the totem pole.

His treatise, called “A Theory of Justice” is 600 pages, so I haven’t even read it all!  So I won’t try to explain all the reasoning, but the interesting point is the connection between risk aversion and redistribution.  Rawls himself is extremely risk averse, saying we ought to maximize the welfare of the poorest person with the minimum income – the “maximin” strategy.  That does not mean perfect equality, as he points out that the poorest person’s welfare might be improved by giving the most talented individuals plenty of incentive to work hard and invent new technology that generates plenty of profits, market success, and economic growth.  But cutting the tax rate on the rich is only justified for Rawls if that really does improve the welfare of the poorest.

Well, out of space for today, so I’ll save the other justifications for next time.  But in case you don’t like the justifications of Rawls, those other justifications (#2 through #4) are completely different!

Yes, I’ve written about the budget before, and perhaps I’m getting repetitive.  But it’s important, and surprising, so I’ll give it another go.  But nevermind President Obama’s recent release of a proposed budget for next year.  That document is already irrelevant!  Let’s start with the current budget. 

Current federal spending now is over  $3 trillion per year.  The deficit is $1.6 trillion.  The U.S. House of Representatives approved a plan to cut spending by $60 billion.  The Republicans chose not to change spending on defense and homeland security, nor entitlement programs like Social Security, Medicare, and Medicaid.  The problem is that then other discretionary spending must be cut for some government agencies by as much as 40%.  And yet that total $60 billion cut is only a drop in the bucket.  It cuts the annual deficit only from $1.6 trillion to 1.54 trillion!

My point is that you can’t get there from here.  First of all, it’s not wise to cast such a wide net, without thinking, making cuts of 40% or more to discretionary programs simply because they are called discretionary.  It means cuts to national parks, environmental programs, and federal employees who provide many public services people want.

Second, who says we need to leave defense and entitlements untouched?   Within just a few years, Medicaid will cost about $300 billion per year, Medicare will cost $500 billion, and Social Security will cost $800 billion, and defense $800 billion.  ALL of domestic discretionary spending will be only $400 billion.  By those round numbers, $60 billion from that last category is a 15% cut.   The same $60 billion cut proportionally from all of those categories would be only a 2% cut.  That’s what I mean by a drop in the bucket.

Anyway, that plan would still cut the deficit only from $1.6 trillion to $1.54 trillion.  The ONLY way to make any sizeable dent in the huge $1.6 trillion deficit is to look at all the current spending, not just at $400 billion of domestic discretionary spending, but at the $800 billion of defense spending, $800 billion of social  security, $500 billion of Medicare, and/or $300 billion of Medicaid.

And who says taxes are sacrosanct?  A $1.6 trillion deficit means we are spending more than our income, so one just MIGHT think that problem can be approached from both ends.

For the U.S. Federal Government, estimated receipts for the fiscal year 2010 are $2.381 trillion.  President Obama’s budget for 2010 adds up to $3.55 trillion; a difference in spending of $1.17 trillion.  That annual deficit is 49.2% of receipts!  Now that’s scary.  We’ve got to do something.  What we hear of course, is that we need to cut waste, fraud, and abuse.  No doubt about it; nobody in their right mind LIKES waste, fraud, and abuse.

So I went to find out how much of U.S. Federal government spending is on waste, fraud, and abuse.  For that purpose, of course, I turn to the best source for information that is accurate, unbiased, and objective.  I mean Wikipedia, of course.   On the Wikipedia entry for “2010 United States federal budget”, I see a breakdown for $2.184 trillion worth of “Mandatory Spending”:

• $677.95 billion – Social Security
• $571 billion – Other mandatory programs
• $453 billion – Medicare
• $290 billion – Medicaid
• $164 billion – Interest on National Debt
• $11 billion – Potential disaster costs

That $2.184 trillion of mandatory spending is 61.5% of the total $3.55 trillion of spending!   That MUST be spent, by law.  We can’t just renege on promised social security benefits or interest payments on the national debt.   And if it’s mandatory, it can’t include any waste, fraud and abuse.  So let’s keep looking for where to cut that waste, fraud, and abuse.  Here are some of the top categories for the remaining $1.368 trillion of spending, called “discretionary spending.”

• $663.7 billion – Department of Defense (including Overseas Contingency Operations)
• $78.7 billion – Department of Health and Human Services
• $72.5 billion – Department of Transportation
• $52.5 billion – Department of Veterans Affairs
• $51.7 billion – Department of State and Other International Programs
• $47.5 billion – Department of Housing and Urban Development
• $46.7 billion – Department of Education
• $42.7 billion – Department of Homeland Security
• $26.3 billion – Department of Energy
• $26.0 billion – Department of Agriculture
• $23.9 billion – Department of Justice
• $18.7 billion – National Aeronautics and Space Administration
• $13.8 billion – Department of Commerce
• $13.3 billion – Department of Labor
• $13.3 billion – Department of the Treasury
• $12.0 billion – Department of the Interior
• $10.5 billion – Environmental Protection Agency

The biggest item ($663.7 billion) is defense spending, and we certainly can’t cut that during a war.  And that is 48.5% of all discretionary spending.  All of the rest of discretionary spending adds up to $704 billion, which is only 60.2% of the total $1.17 trillion of deficit.  In other words, even if we completely eliminated ALL discretionary spending other than defense, we’d still be stuck with 40% of the current deficit ($466 billion, or half a trillion dollars per year).  And that would mean zero spending on health and human services, zero on transportation, zero on veterans affairs, etc.

Still, however, it seems like we ought to be able to eliminate SOME of that spending, at least the spending on waste, fraud, and abuse.   So let’s look for that category.  Hmmm.  As I look down that entire list, I don’t SEE a category for waste, fraud, and abuse!

Okay, I’ll stop being sarcastic, but this does have a point.  Some very careful analysts might in fact be able to find some waste, fraud and abuse.  But that is much easier said than done, and it will be a tiny fraction of the deficit.  Any plan to get serious about cutting federal spending must make serious cuts in programs that are important to people, like welfare and transportation.  To eliminate the deficit will require changes in entitlements like Social Security and Medicare.

Moreover, we can’t substantially cut the deficit with only cuts in spending.  The categories listed above just cannot be cut enough to dent the deficit.  To eliminate the deficit, the only alternative is a combination of spending cuts and tax increases.  The new Congressional leaders do not want to increase taxes, of course, and I’m not saying they must.  Maybe we won’t close the deficit.  But just don’t tell me you’ll eliminate the federal deficit by cutting waste, fraud, and abuse.

It was just a matter of time until the comparisons of Illinois to Greece started flowing like the waters of the Agean.  Yesterday I came across this story on CNN/Money entitled “Illinois: Our Very Own Greece.”  Luckily, Businessweek says that things aren’t quite that bad. 

“The statement that any U.S. state is the next Greece, meaning a near default on their bonds, is not based on fact,” said Judy Wesalo Temel, a principal and director of credit research at Samson, which manages $7 billion. “Comparing the Greek debt crisis to state and local governments is not valid and is distracting from the real concerns about budgets.”

While that’s encouraging, I couldn’t help but notice that the article spends an awfully long time explaining why Illinois is not Greece.  So, the message seems to be that, while we are not Greece, we are the state most in need of an explanation why we’re not Greece.

The New York Times ran a long piece last week about Illinois’ budget problems.  We are dangerously close to passing California as the biggest fiscal mess in the country, if we haven’t already.  Virtually everything is scary, but I found this to be most disturbing:

The state’s income tax burden is not terribly high — Illinois ranks in the bottom half of states — and its government is not terribly large. (The budgets in New York and California, per capita, are much larger).

The Tax Foundation ranks Illinois’ total state and local tax burden (2008) as 30^th highest out of the 50 states and Washington DC.  Federal government data (2009) ranks Illinois 22^nd highest in terms of state and local spending per capita, 12^th highest in terms of debt per capita, and 17^th in terms of GDP per capita.   Relative to other states, we have a very large unfunded pension liability, and as Jeff has pointed out, it is probably even larger than the official numbers show.  And, there are reasons to think that the unfunded pension liability is a symptom of the problem rather than its cause.  Unemployment is high here, but arguably our problems predated the current recession.

Which brings us to the big question.  How did we get into the state we’re in?  If we had an unsually high, or low tax burden, then maybe that would be the cause, and moving taxes in the other direction would help.  If we had an unusually large government, maybe trimming the size of government would be the solution.  But, none of these indicators point to why our state is doing so much worse than others.  The Times article suggests the following:

More broadly, Illinois is caught between blue state convictions about social safety nets and a red state aversion to taxes. For years, the Democratic-controlled legislature has passed budgets that are, in effect, in deficit. Lawmakers routinely skip around the state’s balanced-budget law, with few consequences. (Republicans are near monolithic in voting against any tax increases and borrowings. When one broke ranks to try to keep the pension solvent, he was stripped of a committee position, reducing his pay and pension.)

Hollywood is abuzz today with the news of the 2010 Academy Award nominations.  If there were a category for “Most Frightening,” surely the newly released 2011 federal budget would be the odds-on favorite.  Released yesterday, the budget contains some difficult-to-swallow news about the difficult choices ahead of us.  

 Let me just highlight some of the more frightening numbers – all of which can be found in the proposed budget.  

• Even with the President’s proposed tax increases and spending cuts, the projected single-year deficit never falls below $706 billion (that, in year 2014).  Indeed, it starts with a projected FY 2011 deficit of $1.566 trillion, and ends in 2020 with a $1 trillion deficit.
• The debt held by the public is projected to roughly double over the next decade, from $9.3 trillion in 2010 to $18.57 trillion by 2020.
• Of course, the economy is growing over this time (at least we all hope), so more meaningful numbers are relative to GDP.
  • The 2011 deficit is projected to be 8.3% of GDP
  • The debt held by the public will rise from 63.6% of GDP to 77.2% of GDP over the next decade.

 Of course, this may be a best-case scenario (in terms of deficits) because it assumes the President gets what he wants, including (as reported in today’s Wall Street Journal):

• $175 billion rise in personal income taxes
• $117 billion rise in corporate income taxes

 I’ve written previously about why deficits matter, primarily because they serve as a drag on long-term economic growth.  President Obama’s very talented budget director Peter Orszag understands this as well as anyone.

 But as bad as things look over the next few years, we need to recognize that the really long-term budget forecasts are far worse.  

 It is no secret that the biggest drivers of increased government spending over the long-run are the “Big Three” (meaning entitlements, not the auto-makers).  Growth in spending on Medicare, Medicaid and Social Security are projected to outpace overall economic growth for as far as the eye can see.  Unless these programs undergo structural change to rein in costs, the implications for our economy are enormous.

Consider this: for most of the last 50 years, government spending has stood around 20% of GDP (yes, it is higher now, but I am taking a longer-term view).  According to the Congressional Budget Office, by the year 2035 (about the time today’s newborn children are starting their own households, when today’s college graduates are in their middle ages, and when today’s middle-agers are set to retire), spending on Medicare, Medicaid and Social Security will be 16% of GDP all by themselves.  By 2080 (when today’s newborns are retiring), these programs will comprise nearly a quarter of GDP – a higher fraction than ALL government spending today.  So unless we change these programs, the rest of the government would need to cease operation, tax rates will have to skyrocket, or we are going to watch our debt grow to unprecedented levels relative to GDP.

The main drivers of these trends are rising per capita health care costs and population aging.  We have so far been woefully unsuccessful at dealing with the first, and we may not want to do anything about the second (after all, most of us like living longer).

In short, as bad as the short-term budget outlook is, the longer-term budget outlook is even worse. 

Sorry to be so pessimistic … but sometimes the facts speak for themselves.

I happened to spot a USA Today in the coffee shop where I was working today (think of it as practice for my upcoming furlough days) and noticed a headline in the “Money” section entitled “How do we dig out from under $12 trillion in debt?”  It reminds readers of the very salient fact that our national debt-to-GDP ratio (now at 70.4 percent of GDP) is the highest it has been since the post WWII period.  Importantly, this figure substantially under-states the sad state of the U.S. fiscal position because it ignores the massive unfunded obligations facing our “big three” entitlement programs – Medicare, Medicaid and Social Security. 

While this is not good news, I was pleased to see one of the nation’s widely read newspapers addressing the issue.  And I thought it was worth a brief post about why deficits matter. 

There is some public confusion around this issue, not least because neither party seems to do much about it.  Whatever you like or dislike about the Bush Administration (disclosure: I worked for President Bush in 2001-02, participated in the Social Security reform tour with him and 2005, and received a Presidential appointment to the Social Security Advisory Board in 2006), it is near impossible to make a credible case that his Administration took deficit or debt reduction seriously. 

 Thus far, the Obama Administration has an even worse record of fiscal discipline.  Yes, yes, I know – the midst of a deep recession is not the best time to cut federal spending (or increase taxes) in an attempt to close the fiscal gap.  But despite the significant lip service that the Obama Administration gives to deficit reduction, there is so far scant little evidence that they are serious about reducing it even after the economy improves.  Most of their calls for increasing taxes are accompanied by new ideas for growing the size of government, such as paying for health care reform. 

 Leaving politics aside, do deficits matter?  V.P. Cheney famously quipped that they do not.  But most economists agree that they do.  The standard textbook analysis is that deficits reduce national saving and drive up long-term interest rates, thus reducing private investment and thus sacrificing long-term economic growth. 

 There is plenty of empirical evidence to support this.  Indeed, President Obama’s own budget director Peter Orszag, a distinguished economist and fiscal policy expert (another disclosure: Peter is a good friend and co-author of mine, despite our policy disagreements) has an influential paper on this topic.  The full paper (with Bill Gale) appeared in the Brookings Papers on Economic Activity, but a more reader-friendly summary is available from their piece in the Economist’s Voice. 

 Keep in mind that this article was written in 2004, back when annual deficits were projected to run 3.5 percent of GDP.  In contrast, current deficits are running about double that (although, admittedly, no one expects the current level of deficit spending to persist once the economy improves and we stop spending like drunken sailors in an attempt to stem the decline). 

 Here is what Gale and Orszag said then: 

 “Under reasonable projections, the unified budget deficits over the next decade will average 3.5 percent of GDP. Compared to a balanced budget, the unified budget deficits will reduce annual national income a decade hence by 1 to 2 percent (or roughly $1,500 to $3,000 per household per year, on average), and raise average long-term interest rates over the next decade by 80 to 120 basis points. Looking out beyond the next decade, the budget outlook grows steadily worse. Over the next 75 years, if the tax cuts are made permanent, this nation’s fiscal gap amounts to about 7 percent of GDP. The main drivers of this long-term fiscal gap are, in order, the spending growth associated with Medicare and Medicaid, the revenue losses from the 2001 and 2003 tax cuts, and increases in Social Security costs. The nation has never before experienced such large long-term fiscal imbalances. They will gradually impair economic performance and living standards, and carry with them the risk of a severe fiscal crisis.”

 I am heartened that OMB Director Orszag understands the serious long-term consequences of our nation’s fiscal imbalance.  Of course, Peter and I will likely disagree on how to fix the problem (he will want to rely primarily on taxes, whereas I would prefer to first go after spending).  But future generations had better hope that our elected officials find a way to compromise, do some of both, and get this nation back on a sustainable fiscal path.