Tag Archives: Social Security

State government spending hits new heights

There is a large literature in macroeconomics that examines the extent to which federal spending “crowds out” investment in the private sector. Basic theory and common sense lead to the conclusion that government spending must replace some private sector spending. After all, dollars are scarce – if the government taxes Paul and uses his money to build a road Paul necessarily has less money to invest in his landscaping business. In theory government spending on public goods like roads could be a net gain. This would occur if the additional value produced by spending one more dollar on roads was greater than the additional value produced by investing one more dollar in Paul’s landscaping business. But even in this scenario, Paul himself may be worse off – he’s one dollar poorer and he may not use the new road – and there is still a dead-weight loss due to the tax.

In reality, the federal government does a lot more than build roads, especially productive ones. In 2014, only 1.9% of federal income tax revenue was spent on transportation. And most of the other stuff that the government does is way less productive, like shuffling money around via entitlement programs – Medicare, Medicaid, and Social Security – and investing in businesses that later go bankrupt like Solyndra. So while it is possible that a dollar spent by the government is more productive than a dollar spent by a guy like Paul, in a country with America’s spending habits it’s unlikely to be the case.

The same crowding out that occurs at the federal level can occur at the state level. In fact, in many states state spending as a percentage of gross state product (GSP) exceeds federal spending as a percentage of GDP. The graph below shows state spending as a percentage of GSP for all 50 states and Washington D.C. in 1970, 1990, and 2012 (data). The red, dashed line is federal spending as a percentage of GDP in 2012 (21.9%).

state spending gsp graph

As shown in the graph, nearly every state increased their spending relative to GSP from 1970 – 2012 (triangles are above the X’s). Only one state, South Dakota, had lower spending relative to GSP in 2012 than in 1970. In 2012, 15 of the 50 states spent more as a percentage of GSP than the federal government spent as a percentage of GDP (states where the triangle is above the red, dashed line). In 1990 only two states, Arizona and Montana, spent at that level.

It used to be the case that state and local spending was primarily focused on classic government services like roads, water/sewer systems, police officers, firemen, and K-12 education. But state spending is increasingly looking similar to federal spending. Redistributive public welfare expenditures and pension expenditures have increased substantially since 1992. As an example, the tables below provide a breakdown of some key spending areas for two states, Ohio and Pennsylvania, in 1992 and 2012 (1992 data here, 2012 data here). The dollar per capita amounts are adjusted for inflation and are in 2009 dollars.

ohio spending table

penn spending table

As the tables show, spending on public welfare, hospitals, and health increased by 120% in Ohio and 86% in Pennsylvania from 1992 to 2012. Pension expenditures increased by 83% and 125% respectively. And contrary to what many politicians and media types say, funding for higher education – the large majority of state education spending is on higher education – increased dramatically during this time period; up 250% in Ohio and 199% in Pennsylvania. Meanwhile, funding for highways – the classic public good that politicians everywhere insist wouldn’t exist without them – has increased by a much smaller amount in both states.

The state spending increases of the recent past are being driven in large part by public welfare programs that redistribute money, pensions for government employees, and higher education. While one could argue that higher education spending is a productive public investment (Milton Friedman didn’t think so and I agree) it is hard to make a case that public welfare and pension payments are good investments. This alone doesn’t mean that society shouldn’t provide those things. Other factors like equity and economic security might be more important to some people than economic productivity. But this does make it unlikely that the marginal dollar spent by a state government today is as economically productive as that dollar spent in the private sector. Like federal spending, state spending is likely crowding out productive private investment, which will ultimately lower output and economic growth in the long run.

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.

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

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

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

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

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

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

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

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

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

You can see this in this chart*:

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

—————————

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

Comparative study of state and local pension plans

The Wisconsin Legislative Council has released their  survey of state pensions for 2010. It is a comparative study of 87 state and local pension plans and contains some interesting statistics. The ratio of active employees to retired employees is falling. In 2010 the ratio is 1.87, down from a ratio of 2 in 2008. The number of retirees is growing at a faster rate than the number of active employees. This trend may explain a policy reversal. Between 2008 and 2010 plans began to increase the retirement age for participants as well as the number of years used to calculate the average final salary. Vesting periods – the minimum number of years an employee must work to qualify for benefits – are also increasing.

 

Does unemployment insurance fuel economic growth?

Congress faces a year-end deadline on unemployment insurance. Currently, in states with the highest levels of unemployment, jobless benefits last for nearly two years. Extensions of benefits began in 2008 and have continued throughout the economic downturn. These extensions are set to expire, leaving all workers with the standard six months of benefits. President Obama has told Congress to make further extensions a priority:

“With millions of Americans still looking for work, it would be a terrible mistake for Congress to go home for the holidays without extending unemployment insurance. . . . Taking that money out of the economy now would do extraordinary harm to the economy.”

Here, the president is arguing that because the unemployed are likely to spend money that they receive rather than save it, the Keynesian multiplier will be high for unemployment benefits. Some evidence does support this hypothesis, suggesting that in the best case scenario, providing unemployment benefits can increase short-run economic output. However, this Keynesian view ignores the long run consequences of government provided unemployment insurance.

As jobless benefits continue to lengthen and unemployment insurance is funded with debt rather than payroll taxes, this program morphs from insurance to welfare. When policymakers make the case that unemployment insurance needs to be extended to protect the jobless and to spur the economy as a whole, they tend to ignore the perverse incentives that are inherent in the program. Unemployment insurance pays people not to work, and research has shown that longer unemployment benefits lead people to go without work for longer. Just before benefits end, the unemployed are most likely to find a job. By reducing the incentives for the unemployed to seek work, extended unemployment benefits prevent economic growth because they keep some people from working and adding to GDP.

While the federal government helps fund unemployment benefits, the unemployment trust funds are managed at the state level. Even before the economic downturn, many states lacked the reserves in these funds to handle an uptick in the number of unemployed workers. States are largely now funding unemployment insurance with loans from the federal government. A recent study from the Tax Foundation finds that states will be paying off these loans for years to come, facing higher interest rates as they continue to borrow increasing levels.

As Ben VanMetre wrote last week, rather than extending these flawed benefits, Congress should take up unemployment insurance reform. Eileen Norcross and I have argued that Unemployment Insurance Savings Accounts would provide the security of the current system without the unintended consequences. Under UISA, workers would contribute to individual savings accounts that they could access upon becoming unemployed. Because individuals would own their own accounts, they would not face incentives to remain unemployed in order to collect more benefits. Extending jobless benefits will not help either the economy as a whole or the unemployed in the long run, and turning unemployment insurance into a need-based program will only worsen its perverse incentives. Real reform would create improved incentives for all involved.

Olivia Mitchell on the future of defined benefit pensions

Steve Forbes’ interview with Dr. Olivia Mitchell of Wharton on the health and future of defined benefit pension plans raises a few points worth considering for policymakers and beneficiaries:

  • Public pension liabilities are undervalued and thus underfunded.
  • In general, future retirees including Baby Boomers, face a “much more fragile retirement” than the previous generation.
  • Be concerned as public plans try to make up for losses with riskier asset portfolios.
  • The fiscal burden of public plans will put immense pressure on several major cities and states including Philadelphia, Chicago, Illinois and Hawaii.
  • Public sector transitioning to a 401(k) doesn’t solve the problem of the expense of past negotiated benefits.

Dr. Mitchell also speaks on the topic of Social Security reform, longevity, 401(K) plans and annuities. You can watch the interview here:

Do a majority of Americans prefer tax hikes to state budget cuts?

According to an ABC/Washington Post poll, the real third rail of politics isn’t Social Security it is state budgets. According to the poll results, 55 percent of Americans favor freezing wages for state employees and 51 percent are for reducing pension benefits for new hires.

But when asked more specific questions about cuts, 89 percent oppose laying off firefighters, 86 percent don’t want teachers or police officers laid off. Seventy five percent of people reject cuts to state aid for schools, 76 percent reject cuts to Medicaid, and 76 percent also oppose closing parks. At the same time, significant majorities oppose tax increases (though not as robustly). Sixty-three percent of those polled oppose increases in state income taxes, 61 percent oppose sales tax hikes.

What to make of these results? People don’t like tax hikes, and they really don’t like service reductions. They are also not confronted with the full bill for public services upfront.

State aid, debt, income tax withholding, spending deferrals, intergovernmental transfers contribute to fiscal illusion, by obscuring the full cost of spending and making spending look less expensive than it is.

More direct forms of taxation such as the property tax tend to be less popular for a reason. The property tax is more directly observed – both in paying for it and seeing how it is spent. (though it is also argued that renters experience fiscal illusion since they do not pay property taxes upfront).

New Jersey’s property tax crisis is an example of this. While the state instituted an income tax in 1976 to help defray the cost of public school spending on the local level, property taxes continued to rise over the period – in recent years to crippling levels for many residents. In 2010, when confronted with reductions in state aid and revenues and the request by teachers unions to grant salary hikes, New Jersey voters rejected the majority of school budgets for the first time since 1976.

It is not surprising that people will want to maintain or increase spending as long as the bill remains hidden. More than half of state Medicaid programs are sustained by federal transfers paid for with deficit spending, continuing to participate in this fiscal illusion has serious consequences for our economic future.

Tyler Cowen writes in The New York Times about how this disconnect between spending and revenue (identified by James Buchanan), results in institutionalized fiscal irresponsibility. Ultimately, we don’t recognize what it will take to pay off the debt we have accumulated at the federal level. It will take eroded savings, “…there is a rude awakening coming. One way or another, some of our savings will be taxed away to make good on government commitments, like future Medicare benefits, which we currently are framing as personal free lunches.”

 

Little Hoover Commission on how to reform California’s pensions

The Little Hoover Commission’s report on how to stabilize California’s pension system, and therefore the finances of its  many governments, was published yesterday. It is worth reviewing. They state bluntly that “pension costs will crush government.” The report places the blame on bad math, lack of accountability and a lack of discipline. Reforms include: freezing benefits for current workers and moving to a hybrid defined contribution-defined benefit-Social Security based plan, modeled after the Federal Employees Retirement System (FERS) established in 1987.

The CAP Act: A Glass Half-Full?

Aaron Merrill is “very pessimistic” about the new “CAP Act” proposal. I’m mildly pessimistic.

First, a few things that I think are good signs:

  1. Unlike PAYGO, the law isn’t just about making sure spending is paid for. It is an attempt to actually limit spending. Also unlike PAYGO, the law targets existing, not just new programs.
  2. In the event that Congress can’t agree on where to cut, the act would trigger automatic, evenly distributed cuts across all categories of spending. This is good. Across-the-board cuts are sufficiently unpleasant to make legislators want to prioritize. But since the cuts will be evenly-distributed, Congress won’t have a strong incentive to scuttle the bill altogether. The last time something like this was tried (the Gramm-Rudman-Hollings (GRH) Act of 1985), a number of programs were exempted from the automatic cuts. These included: Social Security (which was actually in surplus at the time), veterans’ pensions, the earned income tax credit, the president’s compensation, the postal service, welfare payments, and (for the most part) Medicare. This meant that the cuts had to be concentrated on a relatively few programs. David Primo writes (p. 111) that: “At one point, GRH authorized the [office of management and budget (OMB)] to make cuts of over 30 percent to both defense and unprotected discretionary spending.” Faced with this option, Congress found it much more palatable to simply repeal GRH.
  3. It is smart to give OMB—an executive branch agency—the authority to execute the automatic cuts. The goal here is to tie legislators’ hands so that they don’t have to police themselves. GRH initially gave Congress’s Government Accountability Office the authority to execute the automatic cuts. But when a court struck that provision down, the fallback provision was for a joint committee of Congress to execute the cuts. As Primo explained (p. 111), this meant that Congress had “to pass legislation each time it wanted to trigger a sequester.” You can imagine how eager they were to do that. Ultimately, GRH was amended so that the OMB would make the cuts. And to me, that makes sense.   
  4. The CAP Act would permit legislators to avoid the cuts if they can muster a supermajority in both houses. This, too, is a step in the right direction, though I share Aaron’s concern that it is not enough. Normal legislation, of course, can always be repealed with 60 votes in the Senate and a simple majority in the House, plus the President’s signature. By requiring a supermajority in both chambers, this raises the hurdle a bit. But I would be much happier if it were a higher bar (90% of lawmakers?). Of course, even a 90% hurdle could be overcome by repealing the law. In the end, a Constitutional Amendment may be the only way to really bind.    
  5. The cuts are gradual which means that they are more likely to happen. As the GRH experience shows, spending reduction plans that call for cuts that are too dramatic often end up being repealed or ignored.

But it isn’t all sunlight and rainbows. I still have some concerns:

  1. As Aaron points out, the bill is enforced via a “budgetary point of order.” As my friend Jim Musser explained to me, the House Rules Committee can and often does waive all points of order when they consider certain pieces of legislation. In this case, this evidently means that a simple majority of a committee can basically suspend this rule whenever it so chooses.
  2. The reductions are not enough to solve the problem. They want to get spending down to its historical average, but I’d point out that the historical spending average is greater than the historical revenue average and this is a formula of unsustainable debt accumulation.
  3. The reduction in the growth of spending doesn’t start until 2013 and even then, the glide path is so shallow that after 10 years, the national debt will still be well above 100 percent of GDP (assuming revenue remains at its 10 year average).
  4. It is possible that the CAP Act could—perversely—act as an excuse to spend up to the limit. 20.6% may have been the norm for the last 40 years, but I don’t think it is the ideal by any stretch.