Tag Archives: budget deficits

The cost disease and the privatization of government services

Many US municipalities are facing budget problems (see here, here, and here). The real cost of providing traditional public services like police, fire protection, and education is increasing, often at a rate that exceeds revenue growth. The graph below shows the real per-capita expenditure increase in five US cities from 1951 to 2006. (Data are from the census file IndFin_1967-2012.zip and are adjusted for inflation using the US GDP chained price index.)

real per cap spend

In 1951 none of the cities were spending more than $1,000 per person. In 2006 every city was spending well over that amount, with Buffalo spending almost $5,000 per person. Even Fresno, which had the smallest increase, increased per capita spending from $480 to $1,461 – an increase of 204%. Expenditure growth that exceeds revenue growth leads to budget deficits and can eventually result in cuts in services. Economist William Baumol attributes city spending growth to what is known as the “cost disease”.

In his 1967 paper, Baumol argues that municipalities will face rising costs of providing “public” goods and services over time as the relative productivity of labor declines in the industries controlled by local governments versus those of the private sector. As labor in the private sector becomes more productive over time due to increases in capital, wages will increase. Goods and services traditionally supplied by local governments such as police, fire protection, and education have not experienced similar increases in capital or productivity. K-12 education is a particularly good example of stagnation – a teacher from the 1950s would not confront much of a learning curve if they had to teach in a 21st century classroom. However, in order to attract competent and productive teachers, for example, local governments must increase wages to levels that are competitive with the wages that teachers could earn in the private sector. When this occurs, teacher’s wages increase even though their productivity does not. As a result, cities end up paying more money for the same amount of work. Baumol sums up the effect:

“The bulk of municipal services is, in fact, of this general stamp [non-progressive] and our model tells us clearly what can be expected as a result…inexorably and cumulatively, whether or not there is inflation, administrative mismanagement or malfeasance, municipal budgets will almost certainly continue to mount in the future, just as they have been doing in the past. This is a trend for which no man and no group should be blamed, for there is nothing than can be done to stop it.” (Baumol, 1967 p.423)

But is there really nothing than can be done to cure the cost disease? Baumol himself later acknowledged that innovation may yet occur in the relatively stagnant sectors of the economy such as education:

“…an activity which is, say, relatively stagnant need not stay so forever. It may be replaced by a more progressive substitute, or it may undergo an outburst of innovation previous thought very unlikely.” (Baumol et al. 1985, p.807).

The cure for the cost disease is that the stagnant, increasing-cost sectors need to undergo “an outburst of innovation”. But this raises the question; what has prevented this innovation from occurring thus far?

One thing that Baumol’s story ignores is public choice. Specifically, is the lack of labor-augmenting technology in the public-sector industries a characteristic of the public sector? The primary public sector industries have high rates of unionization and the primary goal of a labor union is to protect its dues-paying members. The chart below provides the union affiliation of workers for several occupations in 2013 and 2014.

union membership chart

In 2014, the protective service occupations and education, training, and library occupations, e.g. police officers and teachers, had relatively high union membership rates of 35%. Conversely, other high-skilled occupations such as management, computer and mathematical occupations, architecture and engineering occupations, and sales and office occupations had relatively low rates, ranging from 4.2% to 6.5% in 2014. Installation, maintenance, and repair occupations were in the middle at 14.6%, down from 16.1% in 2013.

The bottom part of the table shows the union membership rate of the public sector in general and of each level of government: federal, state, and local. The highest rate of unionization was at the local level, where approximately 42% of workers were members of a union in 2014, up from 41% in 2013. This is about 14 percentage points higher than the federal level and 12 percentage points higher than the state level. The union membership rate of the private sector in 2014 was only 6.6%.

In addition to the apathetic and sometimes hostile view unions have towards technological advancement and competition, union membership is also associated with higher wages, particularly at the local-government level. Economists Maury Gittleman and Brooks Piece of the Bureau of Labor statistics found that local-government workers have compensation costs 10 – 19% larger than similar private sector workers.

The table below shows the median weekly earnings in 2013 and 2014 for workers in the two most heavily unionized occupational categories; education, training, and library occupations and protective service occupations. In both occupation groups there is a substantial difference between the union and non-union weekly earnings. From the taxpayer’s perspective, higher earnings mean higher costs.

union median wage chart

There needs to be an incentive to expend resources in labor-saving technology for it to occur and it is not clear that this incentive exists in the public sector. In the public sector, taxpayers ultimately pay for the services they receive but these services are provided by an agent – the local politician(s) – who is expected to act on the taxpayer’s behalf when it comes to spending tax dollars. But in the public sector the agent/politician is accountable to both his employees and the general taxpayer since both groups vote on his performance. The general taxpayer wants the politician to cut costs and invest in labor-augmenting technology while the public-employee taxpayer wants to keep his job and earn more income. Since the public-employee unions are well organized compared to the general taxpayers it is easier for them to lobby their politicians/bosses in order to get their desired outcome, which ultimately means higher costs for the general taxpayer.

If Baumol’s cost disease is the primary factor responsible for the increasing cost of municipal government then there is not an easy remedy in the current environment. If the policing, firefighting, and education industries are unreceptive to labor-augmenting technology due to their high levels of unionization and near-monopoly status, one potential way to cure municipalities of the cost disease is privatization. In their 1996 paper, The Cost Disease and Government Growth: Qualifications to Baumol, economists J. Ferris and Edwin West state “Privatization could lead to significant changes in the structure of supply that result in “genuine” reductions in real costs” (p. 48).

Schools, police, and fire services are not true public goods and thus economic efficiency does not dictate that they are provided by a government entity. Schools in particular have been successfully built and operated by private funds for thousands of years. While there are fewer modern examples of privately operated police and fire departments, in theory both could be successfully privatized and historically fire departments were, though not always with great success. However, the failures of past private fire departments in places like New York City in the 19th century appear to be largely due to political corruption, an increase in political patronage, poorly designed incentives, and the failure of the rule of law rather than an inherent flaw in privatization. And today, many volunteer fire departments still exist. In 2013 69% of all firefighters were volunteers and 66% of all fire departments were all-volunteer.

The near-monopoly status of government provided education in many places and the actual monopoly of government provided police and fire protection makes these industries less susceptible to innovation. The government providers face little to no competition from private-sector alternatives, they are highly unionized and thus have little incentive to invest in labor-saving technology, and the importance of their output along with the aforementioned lack of competition allows them to pass cost increases on to taxpayers.

Market competition, limited union membership, and the profit-incentive are features of the private sector that are lacking in the public sector. Together these features encourage the use of labor-augmenting technology, which ultimately lowers costs and frees up resources, most notably labor, that can then be used on producing other goods and services. The higher productivity and lower costs that result from investments in productive capital also free up consumer dollars that can then be used to purchase additional goods and services from other industries.

Privatization of basic city services may be a little unnerving to some people, but ultimately it may be the only way to significantly bring down costs without cutting services. There are over 19,000 municipal governments in the US, which means there are over 19,000 groups of citizens that are capable of looking for new and innovative ways to provide the goods and services they rely on. In the private sector entrepreneurs continue to invent new things and find ways to make old things better and cheaper. I believe that if we allow entrepreneurs to apply their creativity to the public sector we will get similar outcomes.

State Revenue Uncertainty

Yesterday the National Conference of State Legislatures released its State Budget Update for 2012, projecting that states’ revenues are approaching levels not seen since before the recession. This means that the budget deficits that have been common in most states over the past few years will hopefully be rare this fiscal year. As Reuters reports:

The situation is now turning around. Only California and the state of Washington currently are projecting deficits for fiscal 2012, according to NCSL. At the same time, resource-rich states like Alaska, Wyoming and North Dakota expect big balances for fiscal 2012, which ended on June 30 for most states.

For fiscal 2013, none of the states are projecting deficits, with 10 states and Washington, D.C., eyeing balances equal to 10 percent or more of general fund spending, the NCSL reported. However, year-end balances of just 0.1 percent to 4.9 percent are projected in nearly a quarter of the states.

Not everyone is as optimistic about state budgets in the coming year. This new report contrasts sharply with a study from the Center on Budget and Policy Priorities, which earlier this summer found that 31 states faced budget gaps in 2012, and that states face a combined $55 billion shortfall for 2013. However, if the NCSL findings are correct, this is very good news for states that have had to resort to midyear cuts and tax increases to balance budgets in the post-recession years.

If states can more easily meet their constitutionally required balanced budgets this year, policymakers should take this opportunity to look at their long-run debt challenges. As I wrote in a USA Today op ed last week, state debt levels are headed to levels that will threaten economic growth. Mounting interest costs will also mean that tax dollars increasingly go to pay for past services, rather than current services.

Whether or not states are in a better position for avoiding deficits in the current year, they need to address their debt levels for long run economic growth. Outspending current revenues is a constant temptation for elected officials who want to stay in office through public support of state programs. However, voters should demand responsible fiscal policy to address debt problems now, before this becomes even more difficult to do down the road.

Is Cutting the Deficit an Electoral Loser?

Here is an NBER article I hope all presidential candidates read:

The conventional wisdom regarding the political consequences of large reductions of budget deficits is that they are very costly for the governments which implement them: they are punished by voters at the following elections. In the present paper, instead, we find no evidence that governments which quickly reduce budget deficits are systematically voted out of office in a sample of 19 OECD countries from 1975 to 2008.  We also take into consideration issues of reverse causality, namely the possibility that only “strong and popular” governments can implement fiscal adjustments and thus they are not voted out of office “despite” having reduced the deficits.  In the end we conclude that many governments can reduce deficits avoiding an electoral defeat.

Alesina described similar findings in his 2010 Mercatus Working paper. There he wrote:

One of the most striking results of Alesina and Ardagna (2010) is that fiscal adjustments (reductions) on the spending side are almost as likely to be associated with high growth (i.e. a successful episode) as fiscal expansions on the spending side,

Pension costs rising in local governments

Long Island villages are contending with increasing contributions to the state pension system. They expect to be billed $1.2 billion this fiscal year for school district employees, public workers, police and firefighters. Maryland counties can expect to begin footing part of the pension tab for teachers in a cost-sharing plan put forth by Governor O’Malley. And Rhode Island municipalities are asking the governor for increased state aid to fill their pension shortfalls and budget deficits.

What is worth noting in all of these cases is how this funding crisis highlights both the importance of accurate accounting, and the fiscal relationship between the state and local governments. Where localities participate in the state plan but do no make annual contributions (as in Maryland), there is a tendency for fiscal illusion to take over. The plans seem inexpensive and thus counties may end up expanding other parts of the county budget. Billing local governments for their portion of the pension tab makes for good fiscal discipline and transparency.

In the case of Long Island, the costs are already shared between the state and local governments. Rhode Island municipalities participate in the state run plan and in many cases operate their own local plans. Here the problem is the same as it is across the country – pension promises have been undervalued and thus underfunded. Costs are rising fast. State and local governments are going to be sharing in the growing burden in the form of higher taxes, service cuts and/or increased debt. Pension plans will be reformed and restructured. But the first step must be an accurate accounting as we found in our recent research on New Jersey.

In New Jersey pension costs are shared between the local and state governments. As with all plans the costs are obscured for the purposes of accounting leaving a good portion of the mounting expense off the books. Accounting choices that push costs forward or hide them altogether have turned pension funding into a looming nightmare for city governments, public sector workers and taxpayers across the country.

Why Do Some States Face Steep Borrowing Costs?

One of the interesting—and alarming—developments in state finance over the last few years is the spread between borrowing costs among the states. Unsurprisingly, the borrowing costs of all states jumped during the financial crisis and recession. But as the (anemic) recovery began, the borrowing costs of many states eased while those of some states like California and Illinois remained high.

A paper by Daniel Nadler and Sounman Hong of the Harvard Kennedy School offers one explanation:

Political-institutional factors—such as the political composition of state legislatures, and interstate variations in public sector labor environments, such as union strength, and collective bargaining rights—can explain a significant proportion of interstate variation in bankruptcy risk. We find that, controlling for multiple economic variables, states with weaker unions, weaker collective bargaining rights, and fewer Democratic state legislators pay less in borrowing costs absolutely, and less in borrowing costs at similar levels of unexpected budget deficits, than do states with stronger unions and a higher proportion of Democrats.

As this summary puts it:

According to the study, a 20 percentage point difference in the share of the public-sector workforce that is unionized is associated with an additional increase in state borrowing costs of 40.4 basis points.

Do More Revenues Lead to More or Less Spending?

This, I think, is (literally) the trillion dollar question.

As you can see from the animated chart below, ours really is a spending problem in the sense that revenue is set to remain fairly constant while non-interest spending is set to skyrocket.  That, in turn, causes interest payments to skyrocket, adding to the amount we spend and causing the whole thing to go to…you get the drift.

One hopes that at least some of the members of the Super-Committee recognize this. If so, they will draw a hard line in the sand demanding meaningful spending reforms in the entitlement programs that are at the heart of the long-term problem.

But a question remains: should they also draw a hard line in the sand against any and all revenue increases?  I believe this question turns on the one above: do more revenues lead to more spending?

If the answer is yes, then a hard line in the sand against revenue increases may be warranted.  But if the answer is no, then negotiators would be wise to focus all of their energies on reforming entitlement spending and should perhaps be willing to give some ground on revenue if it buys more support for spending cuts.  Interestingly, there are good “free market” economists on both sides of this debate.

Milton Friedman exemplifies the view that more revenue will only encourage more spending (see “The Limitations of Tax Limitation,” 1978; I wasn’t able to find a link).  Those who subscribe to his view may point to Reagan’s 1982 “TEFRA” deal with Democrats.  The president agreed to raise some tax revenue, mostly by closing loopholes, in exchange for spending cuts.  But, say critics, the tax increases materialized while the spending cuts never did.

On the other hand, James Buchanan, another Nobel-laureate with free market bona fides, takes the opposite view.  He argues that the ability to deficit spend biases policy makers to favor more spending.  He believes that if you make policy makers charge current taxpayers for what they spend, the current taxpayers will demand less spending.  Ironically, this leads to the conclusion that revenue increases will lead to less spending.  Advocates of this view might point to the 1990s.  Then, revenues as a share of GDP rose while spending as a share of GDP actually fell for the first time in post-WWII history.

As an empirical matter, I don’t think this is settled.  James Payne (2003) has studied the issue at the state level and has concluded that, at least in a plurality of states, spending does seem to respond to revenue, corroborating the Friedman view.  Thus, he concludes that, “any policy to reduce budget deficits via revenues may not result in deficit reduction.”

On the other hand, Andrew Young has studied the matter at the federal level and concludes:

Perhaps counter-intuitively, the findings suggest that tax increases—even temporary—may serve to decrease expenditures by forcing the public to reckon with the cost of government spending.  The findings suggest that the electorate has to be clearly presented with the bill to recognize the cost of government, rather than being allowed to run up a tab.

It makes some sense that the Friedman view would be corroborated at the state level while the Buchanan view would hold at the federal level.  Most states have an obligation to balance their books (more or less), while the Feds have no obligation whatsoever.  Thus, current state taxpayers tend to be the ones to pay for current state spending while current federal taxpayers can more-easily foist their costs onto the next generation.

If you do subscribe to the Buchanan view, what sort of revenue increases should be on the table?  The answer is almost certainly not rate increases on those who are current taxpayers.  They, presumably, are already resistant to more spending (we also know that these are the most inefficient sorts of tax increases).  Instead, revenue increases ought to be focused on closing loopholes and broadening the tax base (about half of all Americans have no income tax liability).  In a new Mercatus working paper, economists Jody Lipford and Bruce Yandle examine what happens to spending when large numbers of Americans have little or no income tax liability, leaving the rest (and future generations) to pick up the tab.

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Update: Josh Barro rightly noted that large numbers of Americans don’t have an income tax liability; they still pay other taxes including payroll taxes.

Governors set a new tone for FY 2012

Governors in many states are beginning the calendar year with sobering rhetoric. The New York Times reports there is a consensus emerging among governors of both parties that the only way out of persistent budget deficits is to, “Slash spending. Avoid tax increases. Tear up regulations that might drive away businesses and jobs. Shrink government, even if that means tackling the thorny issues of public employment and their pensions.”

There are a few exceptions. Governor Pat Quinn of Illinois spoke vaguely about “stabilizing the budget” and then increased the state’s income tax. Minnesota Governor Mark Dayton proposes to close his state’s $6.2 billion deficit with tax increases.

Forty states anticipate budget gaps totaling $140 billion in FY 2012. New Jersey’s gap is projected to be $10.5 billion, one third of the budget. Governor Christie addressed one remark to the Republican-led Congress reminding them that another round of bailouts only papers over the problems facing state budgets, “It’s time to make some tough decisions.”

Bailouts are indeed a bad idea.  As Thomas Sowell writes, they merely conceal what bankruptcy reveals.

Assorted Links

Jeff Dircksen at the National Taxpayers Union writes about a new ranking of state governments:

There’s a new ranking that looks at how well states are run, or in some cases not so well run.  According to its web site, “24/7 Wall St. has completed one of the most comprehensive studies of state financial management ever performed by the mainstream media. It is based on evaluation principles used in the award-winning Best Run States In America ratings published by the Financial World Magazine during the 1990s. These studies were used by state governments to evaluate the efficiency of their own operations. The new 24/7 Wall St. study is meant to help businesses and individuals examine state operation with an unbiased eye.”

Take a look and see how your state does.  Spoiler alert:  Wyoming is the best and Kentucky is the worst.

On an unrelated note, Joe Henchman at the Tax Foundation cautions against the use of the Center on Budget and Policy Priorities’ state budget gap data (note: I used this data in my paper on budget gaps—in part because it was timely and because it is so commonly cited). Joe writes:

The number is probably accurate from their methodology, but is ultimately meaningless. Here’s why:

  • A state “budget deficit” is the revenue projected (usually by the Governor’s office) minus hoped-for spending according to some formula, in the initial budget plan. For instance, say a state raised and spent $10 billion this year, but wants to spend $20 billion next year, projecting $11 billion in revenues. Ultimately they settle on spending $11 billion. That state has “closed a $9 billion budget deficit” even though revenues and spending are up from the previous year.
  • The exact method of estimating next year’s spending varies by state, with some starting with last year’s budget while others throw in additional wish list programs. Adding up all the states’ numbers is adding apples and oranges.
  • States must balance their budgets so there really is no cumulative state budget deficit in the end, at least on paper.
  • It’s routine for states to want to spend more than they actually can, at least at first, and having a deficit in the initial plan happens even in flush times. Thus, CBPP’s numbers overestimate the scope of actual state budget deficits.
  • CBPP also presents the deficits as a percent of each state’s general fund. While the general fund is usually the largest and most important part of a state’s budget, in many states it can represent less than half of the total budget. This number thus exaggerates the seriousness of a budget deficit.
  • A budget deficit could exist because of overly ambitious spending plans that are whittled down to reality, overly optimistic revenue projections, fiscal irresponsibility, or structural imbalance. CBPP’s tale of the recession causing everything and federal aid being the only salvation doesn’t fit the facts. For instance, California’s deficit this year includes unpaid bills kicked over from last year, so it’s the same money being double-counted. This irresponsibility is glossed over in CBPP’s report.

Stadium Debt and Monopoly Power

The old Giants Stadium was demolished this spring. The New York Times reports all that remains is a parking lot carrying $110 million in debt. This Sunday, the New York Giants will play their first game of the season in the new stadium, while New Jersey taxpayers will continue to pay the remaining principal and interest on $266 million in bonds issued to finance the original (1976) Meadowlands Sports Complex.

What went wrong? As the NYT notes, in the beginning the Meadowlands was successful. But by the 1980s, interest in horse racing started to decline. The NJ Devils and the Nets went to Newark. Revenues fell. Instead of responding to these signals the New Jersey Sports and Exposition Authority expanded operations.

The hypnotic fascination that sporting and entertainment facilities hold over local politicians dates to the 1960s and is a universal phenomenon. (The Olympic Games are a prime example, as is The World Cup). During this period, the definition of infrastructure changed to include not just roads and bridges but also stadiums and convention centers. Keynesian economic theories held sway. The idea that publicly financed sporting facilities would reap economic benefits for host cities continues to be the leading rationale for public investment in what should be privately financed ventures.

Economist Stefan Szymanski writes in his book, Playbooks and Checkbooks, “in recent years [major league sports franchises in the U.S.] have found a way to exploit their monopoly power.”During the early years of professional sports, team owners would build their own stadiums. With a shortage of major league teams, owners discovered they didn’t have to foot the bill, cities would gladly bid for the privilege. He estimates that over the last 20 years more than 60 publicly financed stadiums and arenas have been built in the U.S. totaling $20 billion. All a team must do is hint at leaving town to “extort a subsidy from the incumbent city.”

The problem is once the thrill is gone and attendance drops off the taxpayer is stuck with decades of debt. This “honeymoon effect” is well-understood. But even when put on ballot referendums in many cases voters still O.K. stadium debt. That may change in the near term with cities and states desperate to close budget deficits.  Another good sign: the Jets and the Giants financed the new stadium, one of the most expensive ever built at $1.6 billion. It’s probably not enough to convince politicians that they should stop committing the public purse to subsidizing ventures that are purely private goods.

The Fallout: Short-term Thinking in State Budgets

Reliance on fiscal gimmicks and stimulus funds have done no favors for state budgets. FY 2010 promises to be worse than last year. The National Governors Association reports states face budget deficits amounting to $134 billion over the next three years. Bob Williams writes only three governors appear to showing leadership on the issue: Indiana Governor Mitch Daniels, Virginia Governor Bob McDonnell, and New Jersey Governor Chris Christie. The reverse can be said for California. Governor Arnold Schwarzenegger has praised the stimulus for creating 150,00 new jobs in his state. As Veronique de Rugy points out, those are primarily taxpayer supported public sector jobs. For economic recovery to occur jobs must be created in the private sector. And there has been very little of that. California’s unemployment rate remains at 12.4 percent.