Tag Archives: reform

The Public Choice of Sustainable Tax Reform

Comprehensive tax reform has gotten a jump-start from Senators Max Baucus (D-MT) and Orrin Hatch (R-UT), the chairman and ranking Republican on the Senate Finance Committee.  The Senate’s two top tax writers announced a new “blank slate” approach to tax reform in a “Dear Colleague” letter issued last week.

The Senators describe their new, blank slate approach as follows:

In order to make sure that we end up with a simpler, more efficient and fairer tax code, we believe it is important to start with a “blank slate”—that is, a tax code without all of the special provisions in the form of exclusions, deductions and credits and other preferences…

However, under their framework, every current tax privilege has a chance to survive.  The Senators explain:

We plan to operate from an assumption that all special provisions are out unless there is clear evidence that they: (1) help grow the economy, (2) make the tax code fairer, or (3) effectively promote other important policy objectives.

This plan has drawn both praise and criticism, and rightly so.  Yes, this is a step in the right direction; however, this is unlikely to lead to any sustainable reforms for two reasons.

First, forcing Congress to defend tax privileges won’t be hard.  To become law, each privilege had a sponsor, and each sponsor had a rationale to defend it.  Each tax privilege was passed by Congress, and each was then signed into law.  It is difficult to see how privileges that have already survived this process won’t once again find a congressman willing to defend them.  So long as Congress has the power to create and protect tax privileges, it will be nearly impossible to simply wipe such privileges away.

Second, even if a blank slate were achieved, it is unlikely that a privilege-free tax code would last long under the current institutional framework.  This is best demonstrated by what happened in the aftermath of the Tax Reform Act of 1986 (TRA86).

James Buchanan, writing after the passage of TRA86, predicted that very little its reforms would remain intact.  Buchanan noted that “[t]o the extent that [political] agents do possess discretionary authority, the tax structure established in 1986 will not be left substantially in place for decades or even years.”

Buchanan was spot on.  From 1986 through 2005, the tax reform of 1986 suffered a death of 15,000 tweaks.  As reported by the President’s Advisory Panel on Federal Tax Reform in 2005, in the two decades after the 1986 tax reform bill was passed, nearly 15,000 changes were made to the tax code – equal to more than two changes per day for 19 years straight.

What insight did Buchanan have that allowed him to so aptly predict the demise of the Tax Reform Act of 1986?  Buchanan understood that institutions matter.  That is, he understood that no matter how many times the tax code was reformed, so long as the same institutions remain unchanged, political actors will continue to respond in predictable ways, and the result would be tax privileges creeping their way back into the code.  Buchanan explained:

The 1986 broadening of the tax base by closing several established loopholes and shelters offers potential rents to those agents who can promise to renegotiate the package, piecemeal, in subsequent rounds of the tax game. The special interest lobbyists, whose clients suffered capital value losses in the 1986 exercise, may find their personal opportunities widened after 1986, as legislators seek out personal and private rents by offering to narrow the tax base again. In one fell swoop, the political agents may have created for themselves the potential for substantially increased rents. This rent-seeking hypothesis will clearly be tested by the fiscal politics of the post-1986 years.

Going forward, if any sort of reforms are achieved in the tax code, this rent-seeking hypothesis will be tested again.

Senators Baucus and Hatch admit that a blank state “is not, of course, the end product, nor the end of the discussion.”  If Buchanan’s predictions remain true today, as they most certainly are, then the Senators are quite right in admitting that a blank slate is not, and will never be, an end product.  That is, of course, unless any reform in the tax code is paired with institutional reforms to ensure that special tax privileges do not creep back into the code.

The Economic Consequences of Misreading Statutes

When Congress adopted the Dodd-Frank financial reform law, it included a number of provisions that had nothing to do with financial markets.  One of these was a requirement that oil companies and other natural resources companies to report annually to the Securities and Exchange Commission payments they make to foreign governments in connection with extracting those countries’ natural resources.  Human rights advocates viewed the SEC’s disclosure system as a convenient tool for influencing how countries use their natural resource revenues.  The statute sets a bad precedent for using the SEC to accomplish goals unrelated to its mission.  To make matters worse, the SEC’s ruleinterpreted the statute in a way that would frustrate the SEC’s mission of protecting investors, fostering fair and well-functioning markets, and facilitating capital formation.   The rule was thrown out by a federal court today.

The SEC’s rule mandated that company’s disclosures—which were required to be very granular—be publicly available.  Because the requirement applied only to companies that file with the Securities and Exchange Commission, it would—in the SEC’s words—“impose a burden on competition.”  The SEC explained that affected companies “could be put at a competitive disadvantage with respect to private companies and foreign companies that are not subject to the reporting requirements of the United States federal securities laws and therefore do not have such an obligation.”  Rules like these are costly to companies and consequently serve as a disincentive for companies to list in the United States.  Moreover, because some countries prohibit public disclosure of the sort the rule required, the SEC acknowledged that companies “may have to choose between ceasing operations in certain countries or breaching local law, or the country’s laws may have the effect of preventing them from participating in future projects.”  Not a great choice.

The SEC was sued for, among other things, interpreting the rule in a manner that was a lot more damaging to companies than Congress intended.  The court agreed and threw the rule out.  The court faulted the SEC for reading the statute to require that company’s filings be made available to the public, when it plainly did not contain such a requirement.  Moreover, the SEC “abdicated its statutory responsibility to investors” by failing to even consider whether an exemption from the rule would be appropriate for payments in countries that prohibit disclosure.

The SEC’s unwillingness to exercise discretion afforded to it by Congress is just one example of how a regulatory agency’s actions can have real effects on the competitiveness of American companies and the returns to investors in those companies.

Governors’ Priorities in 2013: Medicaid Funding, Pension Reform

As the month of March draws to a close, most governors have, by this point, taken to the podiums of their respective states and outlined their priorities for the next legislative year in their State of the State addresses. Mike Maciag at Governing magazine painstakingly reviewed the transcripts of all 49 State of the State addresses delivered so far (Louisiana, for some reason, takes a leisurely approach to this tradition) and tallied the most popular initiatives in a helpful summary. While there were some small state trends in addressing hot-button social issues like climate change (7 governors), gay rights (7 governors), and marijuana decriminalization (2 states), the biggest areas of overlap from state governors concerned Medicaid spending and state pension obligations.

Medicaid Spending

Judging from their addresses, the most common concern facing governors this year is the expansion of state Medicaid financing prompted by the Supreme Court’s ruling on the Affordable Care Act last year. While the ACA originally required states to raise their eligibility standards to cover everyone below 138 percent of the federal poverty level, the Supreme Court overturned this requirement and left up to the states whether or not they wanted to participate in the expansion in exchange for federal funding or politely decline to partake.  The governors of a whopping 30 states referenced the Medicaid issue at least once during their speech. Some of the governors, like Gov. Phil Bryant of Mississippi, brought up the issue to explain why they made the decision to become one of the 14 states that decided not to participate in the expansion. Others took to defending their decision to participate in the expansion, like Gov. John Kasich of Ohio, who outlined how his state’s participation would benefit fellow Buckeyes suffering from mental illness and addiction.

Neither the considerable amount of concern nor the markedly divergent positions of the governors are especially shocking. A recent Mercatus Research paper conducted by senior fellow Charles Blahous addresses the nebulous options facing state governments in their decision on whether to participate in the expansion. This decision is not one to make lightly: in 2011, state Medicaid spending accounted for almost 24 percent of all state budget expenditures and these costs are expected to rise by upwards of 150 percent in the next decade. The answer to whether a given state should opt in or opt out of the expansion is not a straightforward one and depends on the unique financial situations of each state. Participating in the Medicaid expansion may indeed make sense for Ohioans while at the same time being a terrible deal for Mississippi. However, what is optimal for an individual state may not be good for the country as a whole. Ohio’s decision to participate in the expansion may end up hurting residents of Mississippi and other states who forgo participating in the expansion because of the unintended effects of cost shifting among the federal and state governments. It is very difficult to project exactly who will be the winners or losers in the Medicaid expansion at this point in time, but is very likely that states will fall into one of either category.

Pensions

Another pressing concern for state governors is the health (or lack thereof) of their state pension systems. The governors of 20 states, including the man who brought us “Squeezy the Pension Python” himself, Illinois Gov. Pat Quinn, tackled the issue during their State of the State addresses. Among these states are a few to which Eileen has given testimony on this very issue within the past year.

In Montana, for instance, Gov. Steve Bullock promised a “detailed plan that will shore up [his state’s] retirement systems and do so without raising taxes.” While I was unable to find this plan on the governor’s website, two dueling reform proposals–one to amend the current defined benefit system, another to replace it with a defined contribution system–are currently duking it out in the Montana state legislature. While it is unclear which of the two proposals will make it onto the law books, let’s hope that the Montana Joint Select Committee on Pensions heeds Eileen’s suggestions from her testimony to them last month, and only makes changes to their pension system that are “based on an accurate accounting of the value of the benefits due to employees.”

A time when politicians tried to coax ‘the opposition’ to their view

Rostenkowski,danOn May 28, 1986, Ronald Reagan delivered an Oval Office speech calling for tax reform: a revenue-neutral plan to reduce marginal tax rates and close scores of loopholes that privileged particular firms, industries, and individuals. The Great Communicator lived up to his reputation, delivering a flawless speech that somehow managed to evoke lofty images (“Two centuries later, a second American revolution for hope and opportunity is gathering force again”) and yet grounded these images in relatable prose (“No other issue will have more lasting impact on the well-being of your families and your future.”)

Democratic House Speaker Tip O’Neill asked Ways and Means Chairman Dan Rostenkowski to deliver the Democratic response. The choice was controversial. Over the previous five years, the Democrats had flopped in just about every one of their responses to the president. Rostenkowski, famous for his mumbled delivery and mixed metaphors, seemed unlikely to do any better. Here is what the congressman said:

Good evening, I’m Dan Rostenkowski from Chicago. Let me read you something that pretty well explains what tax reform is all about, and what Democrats are all about.

[Reading from a book] “The continued escape of privileged groups from taxation violates the fundamental democratic principle of fair treatment for all and undermines public confidence in the tax system.” That was Harry Truman’s message to Congress thirty-five years ago.

Trying to tax people fairly: That’s been the historic Democratic commitment. Our roots lie with working families all over the country, like the Polish neighborhood I grew up in on the northwest side of Chicago. Most of the people in my neighborhood worked hard in breweries, steel mills, packing houses; proud families who lived on their salaries. My parents and grandparents didn’t like to pay taxes. Who does? But like most Americans they were willing to pay their fair share as the price for a free country where everyone could make their own breaks.

Every year politicians promise to make the tax code fair and simple, but every year we seem to slip further behind. Now most of us pay taxes with bitterness and frustration. Working families file their tax forms with the nagging feeling that they’re the biggest suckers and chumps in the world. Their taxes are withheld at work, while the elite have enormous freedom to move their income from one tax shelter to another. That bitterness is about to boil over. And it’s time it did.

But this time there’s a difference in the push for tax reform. This time, it’s a Republican president who’s bucking his party’s tradition as protectors of big business and the wealthy. His words and feelings go back to Roosevelt and Truman and Kennedy. But the commitment comes from Ronald Reagan and that’s so important and so welcome.

Because, if the president’s plan is everything he says it is, he’ll have a great deal of Democratic support. That’s the real difference this time. A Republican president has joined the Democrats in Congress to try to redeem this long-standing commitment to a tax system that’s simple and fair. If we work together with good faith and determination, this time the people may win. This time I really think we can get tax reform.

Then, he asked the audience to send letters of support:

Even if you can’t spell Rostenkowski, put down what they used to call my father and grandfather—Rosty. Just address it to R-0-S-T-Y, Washington, D.C. The post office will get it to me. Better yet, write your representative and your senator. And stand up for fairness and lower taxes.

This account comes from Jeffrey Birnbaum and Alan Murray’s classic history of the 1986 tax reform, Showdown at Gucci Gulch. They write:

When the speech was over, and the microphones were turned off, the camera crew did something Rothstein [Rostenkowski’s media consultant] had not seen before: they broke into applause. “That was my first clue we hit it over the fence,” Rothstein says.

The second clue was an ecstatic call from the White House. The third was the incredible response from the American people who deluged Washington with more than seventy-five thousand supportive letters addressed to “Rosty.”

I’m not one for nostalgia. I think many humans have a tendency to look at history through sepia-colored glasses that idealize our own political and cultural past.

But it is hard to read Rostenkowski’s speech without seeing the glaring contrast with today’s political rhetoric. The speech is still partisan in a way: He makes it seem as if Democrats had always wanted a simpler and fairer code and he congratulates Reagan for coming around to their view. This is, of course, ahistorical as both parties were at fault for a tax code riddled with loopholes. But the whole thrust of the speech seems designed to make the other side feel safe about moving towards Rostenkowski’s position.

As an economist, I’m accustomed to thinking about human interaction as exchange: when two people meet, there is almost always an opportunity for mutually beneficial exchange (though transactions costs mean that many of these opportunities are unrealized). And the more different these people are in their tastes and in their productive abilities, the greater the opportunity for exchange.

It is interesting that more politicians don’t see their task as one of getting “the other side” to feel comfortable about abandoning its position and moving toward the middle. Instead, politicians seem to increasingly address themselves to their own base. Unfortunately, what draws the base in often pushes the other side away.

In a follow-up post, I’ll address some possible explanations for this.

Why did the ratings agencies mess up so badly?

When companies or countries issue debt, ratings agencies assign grades based on how creditworthy the issuers are believed to be. Low grades can cost the issuers dearly.

But during the housing crisis, the major ratings firms gave the highest grades to mortgage-based securities that proved worthless. This month, the government sued one of the three dominant agencies, Standard & Poor’s, saying its evaluations of some of those securities were fraudulent.

What should be done to reform the ratings industry?

That is the introduction to the latest New York Times Room for Debate forum. There are contributions from:

Reggie Middleton: “The root cause of the agencies’ problems is the outrageous conflict created by having their primary revenue sources be the entities they rate, or the agents of those entities.”

Lawrence J. White: “The Dodd-Frank Act of 2010 instructed federal regulators to eliminate their mandated reliance on ratings, and some bank regulators have done so. But, maddeningly, for money market funds and broker-dealers, the Securities and Exchange Commission continues to mandate reliance on ratings.”

James H. Gellert: “The poor work of credit rating agencies undoubtedly played a role in the subprime mortgage crisis. But the government’s lawsuit against Standard & Poor’s is freighted with unintended consequences.”

Claire A. Hill: “Ideally, ratings would matter less. Fewer and less precipitous actions would be taken solely because of ratings. A money manager should not be able to justify having purchased a badly performing investment by saying that he relied on the rating agencies.”

And yours truly: “Since the days of Adam Smith, economists have known that a tightly restricted market will often result in higher prices and lower quality. So it was—and continues to be—with the ratings industry.”

 

When politicians can’t see their own loopholes

TaxesAccording to a 2008 IRS report, the Federal Tax Code “has grown so long that it has become challenging even to figure out how long it is.”

A search of the Code conducted in the course of preparing this report turned up 3.7 million words. A 2001 study published by the Joint Committee on Taxation put the number of words in the Code at that time at 1,395,000. A 2005 report by a tax research organization put the number of words at 2.1 million, and notably, found that the number of words in the Code has more than tripled since 1975.

In last night’s State of the Union, President Obama spoke eloquently about the need for tax reform to clean up the code:

To hit the rest of our deficit reduction target, we should do what leaders in both parties have already suggested, and save hundreds of billions of dollars by getting rid of tax loopholes and deductions for the well-off and well-connected.  After all, why would we choose to make deeper cuts to education and Medicare just to protect special interest tax breaks?  How is that fair?  How does that promote growth?

Now is our best chance for bipartisan, comprehensive tax reform that encourages job creation and helps bring down the deficit.

The American people deserve a tax code that helps small businesses spend less time filling out complicated forms, and more time expanding and hiring; a tax code that ensures billionaires with high-powered accountants can’t pay a lower rate than their hard-working secretaries.

Amen. Unfortunately, a few minutes later, the President said:

Through tax credits, grants, and better loans, we have made college more affordable for millions of students and families over the last few years.

And a few lines after that:

We’ll give new tax credits to businesses that hire and invest.

The tax code didn’t get to be as complicated as it is by accident. Every complication; every loophole; every deduction, exemption, and credit got there because some elected official had a clever idea. It got there because someone dreamed up an innovative scheme to use the tax code as a way to encourage some sort of behavior.

The code is the way it is because politicians who decry loopholes and special-interest privileges can’t see that their own clever schemes are part of the problem.

The battle of the taxes

In my last post, I discussed several exciting tax reforms that are gaining support in a handful of states. In an effort to improve the competitiveness and economic growth of these states, the plans would lower or eliminate individual and corporate income taxes and replace these revenues with funds raised by streamlined sales taxes. Since I covered this topic, legislators in two more states, Missouri and New Mexico, have demonstrated interest in adopting this type of overhaul of their state tax systems.

At the same time, policymakers in other states across the country are likewise taking advantage of their majority status by pushing their preferred tax plans through state legislatures and state referendums. These plans provide a sharp contrast with those proposed by those states that I discussed in my last post; rather than prioritizing lowering income tax burdens, leaders in these states hope to improve their fiscal outlooks by increasing income taxes.

Here’s what some of these states have in the works:

  • Massachusetts: Gov. Deval L. Patrick surprised his constituents last month during his State of the State address by calling for a 1 percentage point increase in state income tax rates while simultaneously slashing state sales taxes from 6.25% to 4.5%. Patrick defended these tax changes on the grounds of increasing investments in transportation, infrastructure, and education while improving state competitiveness. Additionally, the governor called for a doubling of personal exemptions to soften the blow of the income tax increases on low-income residents.
  • Minnesota: Gov. Mark Dayton presented a grab bag of tax reform proposals when he revealed his two-year budget plan for the state of Minnesota two weeks ago. In an effort to move his state away from a reliance on property taxes to generate revenue, Dayton has proposed to raise income taxes on the top 2% of earners within the state. At the same time, he hopes to reduce property tax burdens, lower the state sales tax from 6.875% to 5.5%, and cut the corporate tax rate by 14%.
  • Maryland: Last May, Maryland Gov. Martin O’Malley called a special legislative session to balance their state budget to avoid scheduled cuts of $500 million in state spending on education and state personnel. Rather than accepting a “cuts-only” approach to balancing state finances, O’Malley strongly pushed for income tax hikes on Marylanders that earned more than $100,000 a year and created a new top rate of 5.75% on income over $250,000 a year. These tax hikes were signed into law after the session convened last year and took effect that June.
  • California: At the urging of Gov. Jerry Brown, California voters decided to raise income taxes on their wealthiest residents and increase their state sales tax from 7.25% to 7.5% by voting in favor of Proposition 30 last November. In a bid to put an end to years of deficit spending and finally balance the state budget, Brown went to bat for the creation of four new income tax brackets for high-income earners in California. There is some doubt that these measures will actually generate the revenues that the governor is anticipating due to an exodus of taxpayers fleeing the new 13.3% income tax and uncertain prospects for economic growth within the state. 

It is interesting that these governors have defended their proposals using some of the same rhetoric that governors and legislators in other states used to defend their plans to lower income tax rates. All of these policymakers believe that their proposals will increase competitiveness, improve economic growth, and create jobs for their states. Can both sides be right at the same time?

Economic intuition suggests that policymakers should create a tax system that imposes the lowest burdens on the engines of economic growth. It makes sense, then, for states to avoid taxing individual and corporate income so that these groups have more money to save and invest. Additionally  increasing marginal tax rates on income and investments limits the returns to these activities and causes people to work and invest less. Saving and investment, not consumption, are the drivers of economic growth. Empirical studies have demonstrated that raising marginal income tax rates have damaging effects on economic growth. Policymakers in Massachusetts, Minnesota, Maryland, and California may have erred in their decisions to shift taxation towards income and away from consumption. The economies of these states may see lower rates of growth as a result.

In my last post, I mused that the successes of states that have lowered or eliminated their state income taxes may prompt other states to adopt similar reforms. If the states that have taken the opposite approach by raising income taxes see slowed economic growth as a result, they will hopefully serve as a cautionary tale to other states that might be considering these proposals.

States Aim to Eliminate Corporate and Individual Income Taxes

Although the prospects of fundamental tax reform on the federal level continue to look bleak, the sprigs of beneficial tax proposals in states across the US are beginning to grow and gain political support. Perhaps motivated by the twin problems of tough budgeting options and mounting liability obligations that states face in this stubborn economy, the governors of several states have recommended a variety of tax reform proposals, many of which aim to lower or completely eliminate corporate and individual income taxes, which would increase state economic growth and hopefully improve the revenues that flow into state coffers along the way.

Here is a sampling of the proposals:

  • Nebraska: During his State of the State address last week, Gov. Dave Heineman outlined his vision of a reformed tax system that would be “modernized and transformed” to reflect the realities of his state’s current economic environment. His bold plan would completely eliminate the income tax and corporate income tax in Nebraska and shift to a sales tax as the state’s main revenue source. To do this, the governor proposes to eliminate approximately $2.8 billion dollars in sales tax exemptions for purchases as diverse as school lunches and visits to the laundromat. If the entire plan proves to be politically unpalatable, Heineman is prepared to settle for at least reducing these rates as a way to improve his state’s competitiveness.
  • North Carolina: Legislative leaders in the Tar Heel State have likewise been eying their individual and corporate income taxes as cumbersome impediments to economic growth and competitiveness that they’d like to jettison. State Senate leader Phil Berger made waves last week by announcing his coalition’s intentions to ax these taxes. In their place would be a higher sales tax, up from 6.75% to 8%, which would be free from the myriad exemptions that have clogged the revenue-generating abilities of the sales tax over the years.
  • Louisiana: In a similar vein, Gov. Bobby Jindal of Louisiana has called for the elimination of the individual and corporate income taxes in his state. In a prepared statement given to the Times-Picayune, Jindal emphasized the need to simplify Louisiana’s currently complex tax system in order to “foster an environment where businesses want to invest and create good-paying jobs.” To ensure that the proposal is revenue neutral, Jindal proposes to raise sale taxes while keeping those rates as “low and flat” as possible.
  • Kansas: Emboldened by the previous legislative year’s successful income tax rate reduction and an overwhelmingly supportive legislature, Kansas Gov. Sam Brownback laid out his plans to further lower the top Kansas state income tax rate from the current 4.9% to 3.5%. Eventually, Brownback dreams of completely abolishing the income tax. “Look out Texas,” he chided during last week’s State of the State address, “here comes Kansas!” Like the other states that are aiming to lower or remove state income taxes, Kansas would make up for the loss in revenue through an increased sales tax. Bonus points for Kansas: Brownback is also eying the Kansas mortgage interest tax deduction as the next to go, the benefits of which I discussed in my last post.

These plans for reform are as bold as they are novel; no state has legislatively eliminated state income taxes since resource-rich Alaska did so in 1980. It is interesting that the aforementioned reform leaders all referenced the uncertainty and complexity of their current state tax systems as the primary motivator for eliminating state income taxes. Seth Giertz and Jacob Feldman tackled this issue in their Mercatus Research paper, “The Economic Costs of Tax Policy Uncertainty,” last fall. The authors argued that complex tax systems that are laden with targeted deductions tend to concentrate benefits towards the politically-connected and therefore result in an inefficient tax system to the detriment of everyone within that system.

Additionally, moving to a sales tax model of revenue-generation may provide state governments with a more stable revenue source when compared to the previous regime based on personal and corporate income taxes. As Matt argued before, the progressive taxation of personal and corporate income is a particularly volatile source of revenue and tends to suddenly dry up in times of economic hardship. What’s more, a state’s reliance on corporate and personal income taxes as a primary source of revenue is associated with large state budget gaps, a constant concern for squeezed state finances.

If these governors are successful and they are able to move their states to a straightforward tax system based on a sales tax, they will likely see the economic growth and increased investment that they seek.

Keep an eye on these states in the following year: depending on the success of their reforms and tax policies, more states could be soon to follow.

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.

Illinois conjures Squeezy the Pension Python

Illinois Office of the Governor has released a video aimed at school kids. It’s subject: the importance of paying workers their government pensions. It’s meant to get Illinoisans excited about pension reform. Illinois has the worst pension system in the country. The pension liability grew by $12 billion this year. According to Illinois official accounting the unfunded liability is $100 billion. Under market valuation the unfunded liability is over $200 billion. The Civic Federation calls the system, “Unfixable.”

Enter, Squeezy the Pension Python.

Cute.

There’s some history about the Romans, the American Revolution, and World War I. There’s a basic message about why we (i.e. government on your behalf)  should make sure promises are kept. But, not surprisingly, this video totally misdiagnoses why the pension fund is running on empty. I didn’t expect it to contain much in the way of discount rates. Instead the blame is shifted to yesterday’s politicians and the 2008 Wall Street crash (and the fact that people live longer). There is barely a mention of why the economic assumptions that drive the valuation and accounting really matter. Sure, it’s not easy to explain arbitrage, present value, discounting, or the time value of money to second graders. So, instead the video makes the case for how the buck has been passed time and time again, for the children.

Reactions to the video have been decidedly mixed.