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Government Spending Has Shrunk…When You Ignore 44 Percent of Government Spending

by Matt Mitchell on May 11, 2012

in Tax and Budget

Floyd Norris has made an astounding discovery. When you don’t count 44 percent of government spending, it appears that government spending has shrunk in recent years.

Writing in the New York Times, Mr. Norris asserts:

Spending by the federal government, adjusted for inflation, has risen at a slow rate under President Obama. But that increase has been more than offset by a fall in spending by state and local governments, which have been squeezed by weak tax receipts.

In the first quarter of this year, the real gross domestic product for the government — including state and local governments as well as federal — was 2 percent lower than it was three years earlier, when Barack Obama took office in early 2009.

The operative phrase here is “real gross domestic product for the government.” What Mr. Norris neglects to note is that real gross domestic product for the government is only about half of what governments actually spend. And when you look at total spending, it is actually up over the last three years, not down.

Let’s begin with government gross domestic product (GDP). This is the portion of government spending which is counted by the Bureau of Economic Analysis (BEA) when it tabulates national GDP. It consists of government consumption expenditures and gross investments. You can think of it as the tab for all items that the government buys on the open market: salaries of public employees, purchases of weapons for the military, investment in infrastructure, etc.

Among other things, however, government GDP does not include transfer payments such as Medicaid, Medicare, Social Security, Unemployment Insurance, Earned Income Tax Credits, Supplemental Nutritional Assistance, Housing Assistance, Supplemental Security Income, Pell Grants, Temporary Assistance to Needy Families, WIC, LIHEAP…you get the point.

It turns out that real spending on everything other than government consumption and gross investment is up about 19 percent since Obama took office. And this is more than enough to offset what’s going on with consumption and gross investment. Thus, total spending is up 7.7 percent in real terms.

You can see this in this chart*:

There’s nothing wrong with using government GDP figures. They are used all the time to estimate things like the government purchases multiplier. And they are also helpful in understanding whether government is growing faster or slower than the private sector. But Mr. Norris does his readers a disservice to casually conflate government GDP and total government spending. How many people reading his column would know that he left out 44 percent of what government spends? Or that when you include that 44 percent, total spending actually rose over the last three years?

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*Technical note: when the BEA calculates real government GDP, it uses chained 2005 dollars. It does not calculate real total spending, offering only the nominal figures in Table 3.1. I have therefore used 2005 inflation conversion factors found here to convert total spending from Table 3.1 and government GDP from Table 1.1.5 into real figures. When you do it this way, real government GDP actually rose slightly (0.41 percent) under Obama. In other words, the 2 percent drop in real government GDP looks like a slight increase if you use a different inflation conversion method.

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Principles of Pension Accounting Part 1

by Emily Washington on May 8, 2012

in Economic Policy, Pensions, Public Finance

Much of Eileen and Ben’s recent work has focused has focused on public defined benefit pensions and the problems that are common in public pension accounting. This post will explore some of the theoretical foundations that lie behind their arguments for reform. These principles might be foreign to people who haven’t studied economics or accounting, but all state taxpayers and public employees depend on responsible pension fund management. The second post in this short series will outline some of the incentives that policymakers face in managing pension funds.

Determining the amount of money that goes into a public pension fund requires an understanding of the time value of money, or an investment’s net present value. Because of the time value of money, funds in a savings account or invested in bonds earn interest; people prefer to have money now rather than later. In order to get a loan, borrowers must pay interest for the service, and conversely, savers are compensated for not spending their money today.

Net present value means that a fund’s outgoing payments and incoming payments must be adjusted to the present value. Calculating the net present value of pension obligations requires selecting an appropriate interest rate. This interest rate is called the discount rate.

In the case of public pensions, the appropriate discount rate to value fund liabilities, or outgoing payments is the risk-free discount rate. Unlike other retirement vehicles in which savers decide what level of risk they would like to take on, defined benefit pensions are typically guaranteed by the states and municipalities that provide them. As such, using any discount rate other than the risk-free rate unfairly transfers risk to taxpayers.

We can easily determine the risk-free discount rate by looking at the interest rate of Treasury bonds. The right bond to look at is the 15-year Treasury bond because this is the midpoint of the stream of cashflows that goes to pension fund beneficiaries. Currently, this rate is about 2.25%.

Unfortunately, defined benefit public pensions do not use this discount rate. Instead, they choose higher discount rates based on the return on investment that they hope their funds will earn. Most states assume a rate of return of around 8%. This higher discount rate leads states’ unfunded pension liabilities to appear smaller than they actually are, masking their true bill.

Assuming a lower discount rate leads to a lower Net Present Value of the fund and thus a higher liability. Elected officials and fund managers may view the risk-free discount rate as making retirement benefits cost more because it unveils the true size of unfunded liabilities. In reality though, the risk-free discount rate provides an honest assessment of how much funding these plans require.

By banking on higher returns than the risk-free discount rate, fund managers opened the door for the possibility that they are now experiencing: large unfunded liabilities. Both the net present value of pension funds and of pension liabilities must be valued with the appropriate risk-free discount rate for states and municipalities to get out of the current funding gap and to ensure that the problem is avoided in the future. Without proper accounting methodology, defined benefit pension funds expose taxpayers and beneficiaries to high levels of risk, as these benefits are supposed to be guaranteed by the government, putting taxpayers on the hook.

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Behold the Savage Austerity

by Matt Mitchell on May 7, 2012

in Austerity

If you are a journalist or a commentator and you have ever uttered or written the word “austerity,” I hope you spend some time with this chart:

Vero offers some excellent comments here:

These countries still spend more than pre-recession levels

France and the U.K. did not cut spending.

In Greece, and Spain, when spending was actually reduced — between 2009–2011 — the cuts have been relatively small compared to the size of bloated European budgets. Also, meaningful structural reforms were seldom implemented.

As for Italy, the country reduced spending between 2009 and 2010 but the data shows [an] uptick in spending 2011. The increase in spending represents more than the previous reduction.

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Pension Reform in Pennsylvania and a book recommendation

by Eileen Norcross on May 7, 2012

in Debt, Pensions, Public Finance

Last week I testified before the Pennsylvania General Assembly on their pension reform efforts. In my testimony I covered the valuation problem. While the state reports an unfunded liability of $39.5 billion. I calculate it is $116 billion. Like many other state and local pension systems, the mis-valuation problem caused Pennsylvania lawmakers to undertake a series of measures over the past several decades that further weakened the system. These include benefit enhancements when the market was booming and creating a “funding collar” which capped annual contributions to the pension plan effectively pushing that bill forward. to the present

Pennsylvania has run out of time and costs are rising rapidly. In my testimony I cite the work of M. Barton Waring, whose book, Pension Finance, I highly recommend as an analysis of why economic valuation matters to the very existence of defined benefit plans. Without it, plans are subject to often questionable and arbitrary accounting choices. His analysis is well-grounded, consistent with theory and cogently explained.

He states his findings as a series of propositions that should guide how defined benefit plans are structured, valued and funded.

Proposition 1: Measures of the pension plan based on conventional accounting methods will always follow measures based on economic accounting sooner or later, even with a lag. The accounting will follow the economics sooner or later.

I think that proposition can been seen in the funding schedule for Pennsylvania’s two main pension plans: SERS and PSERS. As a result of artificially capping the state’s annual contribution to the plan, future contributions are slated to increase by 267 percent in the next five years. (And that is an underestimation since it is working off of the misvalued liability). Lawmakers know there is a serious hole ahead and as Waring’s book shows that is something that could have been avoided if plans had used economic valuation from the start.

 

 

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The Appearance of Fiscal Prudence in Maryland discussed on WBAL-TV

May 4, 2012

Yesterday I did an interview with David Collins of  WBAL-Baltimore on my recently published paper co-authored with Benjamin VanMetre in Maryland Journal on Maryland’s Spending and Affordability Committee (SAC). Set up in 1983, the SAC was put in place to help legislators control the growth of spending. Over the interim, spending has grown beyond the [...]

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More On UK “Austerity”

May 2, 2012

There have been a lot of good things written about UK austerity since my post last week. Here is a quick round-up: Yesterday, Veronique noted that the meanings of words often get jumbled when politicians and pundits talk about austerity. Tax increases, spending cuts, and structural reforms all fall under the label “austerity.” But only [...]

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Does UK Double-Dip Prove that Austerity Doesn’t Work?

April 26, 2012

The U.K. has slipped back into recession and Paul Krugman thinks this is evidence that austerity doesn’t work. Is it? There are three questions with austerity: Will it work? Will it actually cut the debt? Will it hurt? Will it harm the economy or might it actually be stimulative? What mix of spending cuts and [...]

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To Cut Spending, Focus on the Rules of the Game, Not the Players

April 25, 2012

It might seem that the natural solution is to elect politicians committed to reining in spending, especially on the entitlement programs and pensions at the heart of state and federal overspending. The problem, however, is that even fiscally conservative politicians face significant perverse incentives to spend beyond their constituents’ means. And even if they do [...]

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Governor Quinn’s pension reforms: constitutionally bold, but is it enough?

April 24, 2012

  On Friday, Governor Quinn proposed the most drastic pension reforms to date in Illinois. To meet the funding gap in the pension system, which on an actuarial basis is reported at $83 billion, the Governor will offer workers a choice between higher annual contributions to the system or the loss of health care benefits [...]

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Proposed changes to Illinois’ pension benefits

April 24, 2012

Illinois Governor Pat Quinn proposed several changes to the state’s pension plan last week designed to shore up the state’s fund that has one of the nation’s largest unfunded liabilities. The Chicago Tribune summarizes the potential changes: Illinois’ unfunded pension liability has grown to a huge $83 billion after the state skimped on funding for [...]

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