Tag Archives: CBO

We don’t need more federal infrastructure spending

Many of the presidential candidates on both sides of the aisle have expressed interest in fixing America’s infrastructure, including Donald Trump, Hilary Clinton, and Bernie Sanders. All of them claim that America’s roads and bridges are crumbling and that more money, often in the form of tax increases, is needed before they fall into further disrepair.

The provision of basic infrastructure is one of the most economically sound purposes of government. Good roads, bridges, and ports facilitate economic transactions and the exchange of ideas which helps foster innovation and economic growth. There is certainly room to debate which level of government – federal, state, or local – should provide which type of infrastructure, but I want to start by examining US infrastructure spending over time. To hear the candidates talk one would think that infrastructure spending has fallen of a cliff. What else could explain the current derelict state?

A quick look at the data shows that this simply isn’t true. A 2015 CBO report on public spending on transportation and water infrastructure provides the following figure.

CBO us infrastructure spending

In inflation adjusted dollars (the top panel) infrastructure spending has exhibited a positive trend and was higher on average post 1992 after the completion of the interstate highway system. (By the way, the original estimate for the interstate system was $25 billion over 12 years and it ended up costing $114 billion over 35 years.)

The bottom panel shows that spending as a % of GDP has declined since the early 80s, but it has never been very high, topping out at approximately 6% in 1965. Since the top panel shows an increase in the level of spending, the decline relative to GDP is due to the government increasing spending in other areas over this time period, not cutting spending on infrastructure.

The increase in the level of spending over time is further revealed when looking at per capita spending. Using the data from the CBO report and US population data I created the following figure (dollars are adjusted for inflation and are in 2014 dollars).

infrastructure spend per cap

The top green line is total spending per capita, the middle red line is state and local spending with federal grants and loan subsidies subtracted out, and the bottom blue line is federal spending. Federal spending per capita has remained relatively flat while state and local spending experienced a big jump in the late 80s, which increased the total as well. This graph shows that the amount of infrastructure spending has largely increased when adjusted for inflation and population. It’s true that spending is down since the early 2000s but it’s still higher than at any point prior to the early 90s and higher than it was during the 35-year-construction of the interstate highway system.

Another interesting thing that jumps out is that state and local governments provide the bulk of infrastructure spending. The graph below depicts the percentage of total infrastructure spending that is done by state and local governments.

infrastructure spend state, local as percent of total

As shown in the graph state and local spending on infrastructure has accounted for roughly 75% of total infrastructure spending since the late 80s. Prior to that it averaged about 70% except for a dip to around 65% in the late 70s.

All of this data shows that the federal government – at least in terms of spending – has not ignored the country’s infrastructure over the last 50 plus years, despite the rhetoric one hears from the campaign trail. In fact, on a per capita basis total infrastructure spending has increased since the early 1980s, driven primarily by state and local governments.

And this brings up a second important point: state and local governments are and have always been the primary source of infrastructure spending. The federal government has historically played a small role in building and maintaining roads, bridges, and water infrastructure. And for good reason. As my colleague Veronique de Rugy has pointed out :

“…infrastructure spending by the federal government tends to suffer from massive cost overruns, waste, fraud, and abuse. As a result, many projects that look good on paper turn out to have much lower return on investments than planned.”

As evidence she notes that:

“According to the Danish researchers, American cost overruns reached on average $55 billion per year. This figure includes famous disasters like the Central Artery/Tunnel Project (CA/T), better known as the Boston Big Dig.22 By the time the Beantown highway project—the most expensive in American history—was completed in 2008 its price tag was a staggering $22 billion. The estimated cost in 1985 was $2.8 billion. The Big Dig also wrapped up 7 years behind schedule.”

Since state and local governments are doing the bulk of the financing anyway and most infrastructure is local in nature it is best to keep the federal government out as much as possible. States are also more likely to experiment with private methods of infrastructure funding. As de Rugy points out:

“…a number of states have started to finance and operate highways privately. In 1995, Virginia opened the Dulles Greenway, a 14-mile highway, paid for by private bond and equity issues. Similar private highway projects have been completed, or are being pursued, in California, Maryland, Minnesota, North Carolina, South Carolina, and Texas. In Indiana, Governor Mitch Daniels leased the highways and made a $4 billion profit for the state’s taxpayers. Consumers in Indiana were better off: the deal not only saved money, but the quality of the roads improved as they were run more efficiently.”

It remains an open question as to exactly how much more money should be devoted to America’s infrastructure. But even if the amount is substantial it’s not clear that the federal government needs to get any more involved than they already are. Infrastructure is largely a state and local issue and that is where the taxing and spending should take place, not in Washington D.C.

 

 

Does an income tax make people work less?

Harry Truman famously asked for a one-handed economist since all of his seemed reluctant to decisively answer anything: “on the one hand,” they’d tell him, but “on the other…”

When asked whether an income tax makes people work more or less, the typical economist gives the sort of answer that would have grated on Truman like a bad music critic.

If, however, we change the question slightly and make it more realistic, it’s possible to give a decisive answer to the question. Income taxes do reduce overall labor supply. This is something that economists James Gwartney and Richard Stroup explained in the pages of the American Economic Review some 30 years ago. And last week, the CBO’s much-discussed report on the ACA and labor-force participation illustrated their point nicely.

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Don’t like the fiscal cliff? You’ll hate the fiscal future.

Absent an eleventh-hour deal—which may yet be possible—the Federal government will cut spending and raise taxes in the New Year. In a town that famously can’t agree on anything, nearly everyone seems terrified by the prospect of going over this fiscal cliff.

Yet for all the gloom and dread, the fiscal cliff embodies a teachable moment. At the risk of mixing metaphors, we should think of the fiscal cliff as the Ghost of the Fiscal Future. It is a bleak lesson in what awaits us if we don’t get serious about changing course.

First, some background. Over the last four decades, Federal Government spending as a share of GDP has remained relatively constant at about 21 percent. This spending was financed with taxes that consumed about 18 percent of GDP and the government borrowed to make up the difference.

After a decade of government spending increases and anemic economic growth, federal spending is now about 24 percent of GDP (a post WWII high, exceeded only by last year’s number) and revenues are about 15 percent of GDP (the revenue decline can be attributed to both the Bush tax cuts and to the recession).

But the really telling numbers are yet to come.

The non-partisan Congressional Budget Office now projects that, absent policy change, when my two-year-old daughter reaches my age (32), revenue will be just a bit above its historical average at 19 percent of GDP while spending will be nearly twice its historical average at 39 percent of GDP. This is what economists mean when they say we have a spending problem and not a revenue problem: spending increases, not revenue decreases, account for the entirety of the projected growth in deficits and debt over the coming years.

Why is this so frightful? The Ghost of the Fiscal Future gives us 3 reasons:

1) As spending outstrips revenue, each year the government will have to borrow more and more to pay its bills. We have to pay interest on what we borrow and these interest payments, in turn, add to future government spending. So before my daughter hits college, the federal government will be spending more on interest payments than on Social Security.

2) When the government borrows to finance its spending, it will be competing with my daughter when she borrows to finance her first home or to start her own business. This means that she and other private borrowers will face higher interest rates, crowding-out private sector investment and depressing economic growth. This could affect my daughter’s wages, her consumption, and her standard of living. In a vicious cycle, it could also depress government revenue and place greater demands on the government safety net, exacerbating the underlying debt problem.

This is not just theory. Economists Carmen Reinhart and Kenneth Rogoff have examined 200-years’ worth of data from over 40 countries. They found that those nations with gross debt in excess of 90 percent of GDP tend to grow about 1 percentage point slower than otherwise (the U.S. gross debt-to-GDP ratio has been in excess of 90 percent since 2010)

If, starting in 1975, the U.S. had grown 1 percentage point slower than it actually did, the nation’s economy would be about 30 percent smaller than it actually is today. By comparison, the Federal Reserve estimates that the Great Recession has only shrunk the economy by about 6 percent relative to its potential size.

3) Things get worse. The CBO no longer projects out beyond 2042, the year my daughter turns 32. In other words, the CBO recognizes that the whole economic system becomes increasingly unsustainable beyond that point and that it is ludicrous to think that it can go on.

What’s more, if Congress waits until then to make the necessary changes, it will have to enact tax increases or spending cuts larger than anything we have ever undertaken in our nation’s history. As Vero explains:

By refusing to reform Social Security, lawmakers are guaranteeing automatic benefit cuts of about 20-something percent for everyone on the program in 2035 (the Social Security trust fund will be exhausted in 2035, the combined retirement and disability trust funds will run dry in 2033, and both will continue to deteriorate).

In other words, if we fail to reform, the fiscal future will make January’s fiscal cliff look like a fiscal step. I’ve never understood why some people think they are doing future retirees a favor in pretending that entitlements do not need significant reform.

You might think that we could tax our way out of this mess. But taxes, like debt, are also bad for economic growth.

But it is not too late. Like Scrooge, we can take ownership of the time before us. We can make big adjustments now so that we don’t have to make bigger adjustments in a few years. There is still time to adopt meaningful entitlement reform, to tell people my age to adjust our expectations and to plan on working a little longer, to incorporate market incentives into our health care system so that Medicare and Medicaid don’t swallow up more and more of the budget.

Some characterize these moves as stingy. In reality, these types of reforms would actually make our commitments more sustainable. And the longer we wait to make these inevitable changes, the more dramatic and painful they will have to be.

For all the gloom and dread, the Ghost of Christmas Yet to Come was Scrooge’s savior. In revealing the consequences of his actions—and, importantly, his inactions—the Ghost inspired the old man to take ownership of the “Time before him” and to change his ways.

Let us hope that Congress is so enlightened by the Ghost of the Fiscal Cliff.

Maybe We Need a Super Democrat?

The Super Committee has failed. What now?

As I have said before, it is very difficult to look at the long-run fiscal projections and conclude that the impending debt crisis is anything but a major spending problem. According to the CBO, when my daughter graduates from college, federal revenue will be right at its historical average of 18.4 percent of GDP. At the same time, federal spending will consume more than 35 percent of GDP—more than 15 percentage points above the 20 percent average that has prevailed my entire life.

So the long-run explosion in spending—which is driven almost entirely by entitlements and interest payments—must be arrested. How?

In my view, it takes a Democrat.

Only Nixon could go to China. Only Carter could deregulate. Only Reagan could sign the first arms reduction treaties. Only Clinton could sign welfare reform. Lasting and meaningful reforms often require politicians to cross the ideological divide. Given the partisan divide right now, it is very difficult for me to imagine that any Republican president would be successful in reducing entitlement spending. But a Democrat could do it.

And one piece of evidence for this is a 2004 paper in the Journal of Public Economics by the economist José Tavares. He writes:

In a panel of large fiscal adjustments in OECD countries during the last 40 years, we find evidence that left-wing and right-wing cabinets are partisan: the left tends to reduce the deficit by raising tax revenues while the right relies mostly on spending cuts. Our testable hypothesis is that cabinets can signal commitment by undertaking fiscal adjustments in ways that are not favored by their constituencies. In other words, the left gains credibility when it cuts spending while the right becomes more credible when it increases tax revenues. Probit estimates of the determinants of persistence in fiscal adjustments confirm that spending cuts by the left and tax increases by the right are associated with persistent adjustments.

So if it is spending cuts that we need, then these cuts are likely to be more sustainable (“persistent”) if they are executed by a left-leaning government.

Unfortunately, I don’t see much evidence that President Obama is keen to follow this course. His best shot at it came when his own deficit-reduction panel (the Bowles-Simpson Commission) endorsed a mostly-spending-cuts approach. He ignored them.

An Unbalanced Budget: Fiscal Pollution

Yesterday I appeared before the House Judiciary Committee to talk about a balanced budget amendment to the U.S. Constitution. The other witnesses were Former Governor and Attorney General Richard Thornburgh, Former CBO Director and current president of the American Action Forum, Douglas Holtz-Eakin, and Professor Philip Joyce of the University of Maryland.

I began by pointing out the enormity of the problem: CBO projects that absent policy change, the nation’s debt will be 90 percent of GDP in just seven years. This is an important figure because research suggests that when national debt levels get much above this point, their growth rates tend to slow. In the median case, they slow by 1 percentage point and in the mean case, their growth rates are cut in half.

This may not sound like much, but to put it in perspective, I used the following chart.

What would current national income be if—in 1975—the U.S. had accumulated the sort of debt that we are about to accumulate and the nation’s growth rate had slowed by 1 percentage point? This is indicated by the dashed line in the middle. Today’s GDP would be about 1/3rd smaller than it actually is. And what would national income be if we had grown at half our actual pace? This is indicated in the bottom line. Today’s income would be 45 percent smaller than it actually is. To get a feel for this magnitude, notice the blip in the top right corner of the actual GDP line. That is the Great Recession that began in 2008. As I told the Judiciary Committee:

The most calamitous economic contraction in decades pales in comparison to the lost income associated with persistently anemic economic growth from too much debt.

In my view, the nation’s fiscal problems owe much to the incentives that politicians face. Around 1:27:45 I make this point:

The basic problem here is one of externalities. This is a problem that is familiar to environmental economists.  If a factory…in the process
of making a product for consumers, is allowed to bilge smoke into the air, that’s an externality. And they will make too much of the product unless it is internalized. So here, what’s happening is that this current generation is allowed to externalize the costs of government onto the next generation….The costs of reform, the costs of avoiding this kind of economic contraction that we are staring at will be borne by people like me, the median voter. But the costs of the status quo will be borne by my daughter. She cannot vote. Until we can internalize that externality, I think we are going to continue to make the wrong choice because none of you have the incentive to make the right choice. It’s not your fault; you are all good people, you are servants of the public and you are listening to what your constituents and your median voters are saying. But the incentives that they offer you are not right.

A balanced budget amendment, by internalizing this externality, would correct these misaligned incentives. Simply put, it would “make each generation that benefits from government services pay for the costs of producing them.”

The video is here (my testimony begins at 54:30). Here is my written statement.

Unfortunately, despite the ardent wishes of my 7th grade civics teacher, these sorts of hearings are not, primarily, about weighing the evidence and changing minds. Instead, they have much more to do with scoring political points and solidifying already-hardened positions. Nevertheless, I found that most of the Congress-people who disagreed with me were polite. And I hope that this leads to opportunities for more fruitful exchanges down the line.

When Does Each State’s Debt Reach 90 Percent of GDP?

Few economic studies have received as much attention as Carmen Reinhart and Kenneth Rogoff’s “Growth in a Time of Debt.” The attention is well-deserved. Reinhart and Rogoff have painstakingly assembled data on debt from over 40 countries covering 200 years, making it the largest dataset of its kind. They then examine the way debt impacts economic growth and find that as nations’ debt-to-GDP ratios go from 30 to 90 percent, their growth rates decline markedly. In the best case, their real average annual growth rates decline by about 1 percentage point; in the worst case, the growth rate is halved.

To put this in perspective, if in 1975, the US growth rate had slowed by 1 percentage point, our current economy would be about 30 percent smaller than it actually is. And if our growth rate had been cut in half, then the current economy would be nearly 43 percent smaller than it actually is. In other words, an entire generation’s worth of economic growth would not have occurred.

Absent policy change, the CBO is projected that federal debt held by the public will be 90 percent of GDP within 7 years.

But what about the states? They, too, face a grim fiscal future. Harvard economist Jeffrey Miron recently examined this question for the Mercatus Center. In it, he concludes:

[S]tate government finances are not on a stable path; if spending patterns continue to follow those of recent decades, the ratio of state debt to output will increase without bound.

Miron then calculates the year at which each state’s debt will exceed the fateful 90 percent mark identified by Reinhart and Rogoff. To help visualize Miron’s work, I have created a short YouTube video that shows the states whose debt levels exceed 90 percent of state GDP at certain time periods. Absent policy change, debt in every state of the union will be greater than 90 percent by 2070. But many of us don’t have to wait that long. In a number of states, the day of reckoning will come much sooner.

 

Read Miron’s entire, informative, analysis here.

How markets responded on Monday morning to the S&P downgrade

“S&P doesn’t know anything investors don’t know already…” is how Martin Feldstein of Harvard described the market’s possible Monday reaction to S&P’s downgrade of US debt on Friday night.  And indeed, the yield on 10-year Treasuries dropped on Monday morning from 2.56 percent to 2.47 percent, a sign that Treasuries are still a hedge against riskier investments in equities.

The Wall Street Journal’s opinion: they aren’t admirer’s of the credit ratings agencies (since ratings agencies don’t make distinctions among policy actions and their impacts, but just look at the balance sheet), yet the editors stress it’s important to not, “shoot the messenger.” Debt as a percentage of GDP has, and will continue to rise, dramatically.

The future is far from bright. According to Vernonique de Rugy without any policy changes debt held by the public will rise from $9.7 trillion (69 percent of GDP) this year to $18 trillion in 2021 (a mere decade from now).

de Rugy uses the CBO’s own data to chart the picture.

 

 

Spending Projections and Spending Reality

The President’s budget was released this week. Since 2009, spending as a share of the economy has been at an all-time, post-WWII high. As a share of the economy, spending averaged 20.8 percent from 1970 to 2010. In FY2011, it is projected to be 25.3 percent (or 22 percent above average). According to the CBO’s alternative fiscal scenario, it will reach 35.2 percent by 2035.

Not to worry, though, the White House Office of Management and Budget projects that—starting around 2012—things will turn around. Through a combination of rapid economic expansion (they assume nominal GDP will grow at an average annual rate of 5.6 from 2012 to 2016) and “responsible” budget cuts, they plan to get spending as a share of the economy down to around 22.5 percent by 2013. (They do not foresee spending ever returning to its historical average).

What are the odds they will succeed?

As one data point, the curious may want to see what the OMB was projecting two years ago when the spending spree began. My colleague, Jakina Debnam, and I do just that with this chart. Two years ago, they were promising that the spending increase would be “timely, targeted, and temporary.” As such, they projected that in 2011, spending as a share of the economy would already have fallen to 23.4 percent.

This is nearly 2 percentage points lower than they now are willing to countenance.

The Wrong Line in the Sand

There are many in policy circles these days who believe that newly-empowered House Republicans – especially those that were elected with Tea Party backing – ought to draw a line in the sand on raising the debt ceiling. This is the wrong line in the sand. Excessive debt is indeed bad. But it is a symptom of the disease, not the disease itself. To treat the real disease, I believe we need to get serious about addressing the spending problem.  

What is Wrong With Debt?

It used to be that Republicans focused almost-exclusively on taxes instead of on their root cause: spending. This, of course, biased policy in favor of huge deficits. When deficits are large but manageable, they drive up interest rates and crowd-out private investment. And when deficits are large and unmanageable, they can up-end a country’s entire economy.

Economists Carmen Reinhart and Kenneth Rogoff examined the implications of debt in 44 countries over a 200 year period. They found that in economically-advanced countries, when debt-to-GDP ratios moved from around 30 percent of GDP to 90 percent or more, economic growth rates tended to halve. Now the US isn’t a typical country and investors may be willing to let our government get away with debt-to-GDP ratios that are higher than 90 percent.

But certainly they are not going to let us get away with debt-to-GDP ratios of 200+ percent (which is what the CBO projects for 2035), let alone 300+ percent (2047) or 800 percent (2078).

At some point, the federal government will have accumulated too much debt for investors to feel comfortable lending at current rates. At that point, they will demand higher interest rates which will undermine economic growth.

In a best-case scenario, we will join the list of countries that have seen excessive debt severely hamper their economic growth rates. In a worst-case-scenario, the increased interest-cost will further add to the government tab, consuming the whole budget and causing the whole edifice to collapse under its own weight.   

What is Wrong with Taxes?

Now you might think we ought to draw a line in the sand and not borrow anymore. The problem is that if we refuse to raise the debt limit, it might cause the government to default on its existing debt, hastening the day when investors will lose confidence in the full faith and credit of the government.

An even more-likely scenario is that a refusal to raise the debt limit will trigger a massive tax increase. Some critics, of course, have blithely suggested that a tax increase is just what we need. The problem here is that taxes can also inflict great economic harm. Economists Christina and David Romer examined over 60 years of U.S. data to understand the impact of taxes on GDP. They carefully disentangled the tax-effect from other effects, and concluded that a tax increase of 1 percent of GDP lowers real GDP by almost 3 percent.

The CBO projects that if we were to meet our current long-term spending promises without more borrowing, all taxes would need to roughly double. If the Romers’ estimate is anywhere near accurate, a doubling of all tax rates would trigger one of the worst economic contractions in US history.  

So what should we do? I’d say the first thing we need to do is focus on spending. Its two symptoms — excessive debt and excessive taxation — are both economically damaging. Only by focusing on the disease can we avoid both symptoms.

Spending is where the line should be drawn.

There is Nothing So Permanent as Temporary Stimulus

It is interesting to note that not even the most-ardent Keynesians are willing to claim that permanent fiscal stimulus makes any sense whatsoever. That is, the stimulative effects of debt-financed spending—whatever they may be—are only fleeting. Hence, the perennial Keynesian calls for ”temporary, targeted and timely” stimulus spending. But is that the way it happens? 

Last summer, the Congressional Budget Office issued a report showing federal spending as a share of GDP skyrocketing well above its 40-year average. At the time, the CBO projection seemed to indicate that the spending would, indeed, be temporary. By 2013, the report claimed, spending as a share of GDP would be within a few percentage points of the 40-year average (though still above it).

One year later, CBO has issued another report. This one shows spending as a share of GDP remaining will above its 40-year average for the foreseeable future. Note, however, that they still show spending as a share of GDP declining somewhat in the coming years. Below, I show both projections on the same graph (click on the graph to make it larger). I plan to update this graph next summer.