From the comments: what does the fiscal endgame look like?

by on March 10, 2011 at 4:04 am in Economics, Political Science | Permalink

Slocum writes:

Nonetheless it is naive to think spending cuts can do the job alone, and insisting on no tax hikes drives us faster along the path of fiscal ruin.

This is a political, not economic judgement on Tyler's part — that a majority won't accept the necessary cuts. But I think it's much less politically feasible to imagine enacting VAT (which, in the past, has been Tyler's preferred approach). That's an idea that practically demagogues itself (A EUROPEAN-style Tax! A regressive, HIDDEN tax on EVERYTHING you buy! A tax that will hit the savings of RETIREES the hardest –people who 'worked hard and played by the rules' who were taxed when they earned and saved the money and are now going to be hit by a REGRESSIVE, EUROPEAN, HIDDEN TAX on EVERYTHING when they try to spend the money).

Republicans are so married to 'no new taxes' and Democrats to 'higher taxes only for the rich', that a VAT (or any other new broad-based tax) seems out of the question. So I can much more easily imagine spending cuts eventually getting bipartisan approval with only nominal tax increases included in the bargain.

A few points:

1. A VAT has never been my preferred outcome, rather I warn that it may be necessary if we do not act soon.

2. Balancing the budget within five to ten years with spending cuts alone would be difficult but by no means impossible.  I am all for doing that, but a) it won't happen as stated, and b) it still won't balance the budget over a ten to twenty year time frame.

3. The path toward long-run fiscal balance involves recalibrating Medicare, Medicaid, and Social Security to lower rates of indexation, reimbursement, benefit increase, and so on.  We need to start that process now.  It cannot be done overnight or even over a few years' time.  It takes a long time for those gains to come in, cumulatively.  No one is going to vote for a "thirty percent cut to Medicare, today," although they might vote for changes in rates, which over time would amount to large reductions.  

4. The time for a Grand Fiscal Bargain is now.  If we don't do it fairly soon, we won't get spending under control at all.  Furthermore the number and percentage of elderly voters will only increase, which will make spending cuts more difficult as time passes.

5. Let's say a proposal for long-run balance were presented, with $3 in spending cuts for every $1 in tax hikes.  That is still a good deal for the anti-tax, anti-spending conservative.  Rejecting such a deal means we will end up with something closer to $3 in tax hikes for every $1 in spending cuts.  (And no, I don't know what is the "break even" point for a good bargain in this regard.)

6. Bill Niskanen's research shows that by taking tax hikes off the table we simply encourage governments to spend more.  Spending then looks like a free lunch.  

7. Making it a priority to "avoid any tax hike today" is the same kind of short-run view which brings us to fiscal catastrophe in the longer run.  In the medium-run, much less the long run, this attitude will lead to higher taxes.  However much it may masquerade as a low-tax attitude, it is in reality a high-tax attitude.  Unintended consequences is a fundamental economic idea and it is very much operating here.

8. If I called on President Obama to push for a budget deal, and I cite CAP in support, it was not to criticize the Democrats, or Obama (as DeLong and Krugman mysteriously suggested), but rather because I see him as by far the most influential player in this process.

In short, I am asking for the true fiscal conservatives to step up to the plate, and bring about lower taxes in the long run, rather than simply "playing team on the tax issue" in the short run.  Time is not on our side, and if we think it is we are fooling only ourselves.

1 Steve Sailer March 10, 2011 at 12:23 am

Super rich people should pay more in taxes.

Alex Rodriguez should pay a higher marginal income tax rate than a utility infielder making the major league minimum. Why? Because he can afford it more.

2 a March 10, 2011 at 12:38 am

"A tax that will hit the savings of RETIREES the hardest –people who 'worked hard and played by the rules' who were taxed when they earned and saved the money."

I can see that you are doing best to start the demagoguing. They may have been taxed when they earned and saved, but obviously they weren't taxed enough – that's why the government has debt.

3 Cahal March 10, 2011 at 2:19 am

Oh god, not European! not that place where people are happier, have better public services and work less than in America!

4 BTDTHTS March 10, 2011 at 2:58 am

Been there, done that, still have the tee shirt. Reagan thought he had the spending cut, tax raise deal. Funny thing, Tip O'Neil and the democrats didn't come through on the spending cuts. Republicans remember and for that reason will not support tax raises until after significant spending cuts. The question is how can the democrats credibly signal that they are serious about any possible deal when they have lied consistently before. (Think Lucy and the football)

5 foosion March 10, 2011 at 3:22 am

Also, what of the military budget? We spend as much as the rest of the world combined. It makes more sense to cut military spending than to cut a whole lot else.

6 Ricardo March 10, 2011 at 3:46 am

Social Security is essentially fine.

SS is not "in crisis" or "going bankrupt" as the demagogues would have it but Tyler has a point. Suppose you means-test/cut benefits, cut payroll taxes and raise taxes on the top brackets enough to be revenue neutral. You have just a bit more breathing room in the budget and a more progressive outcome to boot.

Krugman hates this because he thinks that once SS is means-tested, people will vote to abolish it altogether and leave senior citizens to live on the streets. I'm not so sure.

7 Mike Hammock March 10, 2011 at 4:25 am

The "it is time to do something now, because if we don't, more draconian action will be required later" argument has been true for years, but it hasn't resulted in reform. I predict Congress and the President will continue business as usual.

8 Max March 10, 2011 at 4:43 am

Tyler, several warnings about VATs, you will probably be aware of but that are not often stressed. VATs are a slippery-slope self-reenforcing way to fiscal irresponsibility. Just look at Europe for a prime example. Since the VATs were introduced in Germany or in France, they have only known one direction: upwards. They are a means to mask financial give-aways for pet issues. And they tend to make economic progress harder by increasing the amount of a monthly pay-check spend not on high tech goods but on basic nutrituion. It makes us and economy poorer on a more elemental level.

The last VAT hike in Germany was even lead and championed by a social conservative Angela Merkel. Once a VAT is introduced it will be the toy not only of democrats but also of Republicans and whenever the decision between cutting spending and rising the VAT comes up, guess what prevails.

9 Rich Berger March 10, 2011 at 5:05 am

The essential problem as Slocum has pointed out is that it is easy to renege on the spending cuts while the tax increases live on. As ably pointed out in "Never Enough" by William Voegeli, the welfare state is an open-ended pursuit and any reduction in expenditures is considered heartless. I don't think the welfare staters would accept a budget (I will allow you x% of GDP for the welfare state – spend it wisely!) when there are so many problems to solve!! I have a better idea – let's raise the income taxes on all those who are paying little or no income tax. That's where the big money is. I am sure that we can tell them that it's for their own good – look at all the benefits we will shower on you.

Although I would like a small lower-cost government, I could live with one where the welfare expenditures are kept within strict bounds and all programs were evaluated for effectiveness and ended if they fail to make the grade. This won't happen so it's going to be a battle until one side wins.

10 Rahul March 10, 2011 at 5:10 am

@Max:

Why is a VAT more fiscally irresponsible than a sales tax? Isn't the upward creep an argument applicable to all sorts of taxes?

11 eccdogg March 10, 2011 at 5:16 am

"5. Let's say a proposal for long-run balance were presented, with $3 in spending cuts for every $1 in tax hikes. That is still a good deal for the anti-tax, anti-spending conservative. Rejecting such a deal means we will end up with something closer to $3 in tax hikes for every $1 in spending cuts. (And no, I don't know what is the "break even" point for a good bargain in this regard.)"

This is the piece that I struggle with in this debate. When the poop hits the fan and the nation starts hitting a cash flow problem and starts getting shut out by bond markets what is the political outcome?

Sure the old folks could vote for higher taxes to fund their promised benefits, but that is pretty tricky because there are numerous ways for young people to avoid taxes and ultimately it will be the young who are running the country they will be the folks in congress, running businesses, filling the military, in the beuracracy, and the police. So even though I think the people on the dole will be numerically superior I realy doubt they will have the power to push throught much higher taxes.

Also empirically it seems to me that most fiscal crisis end up falling mainly on spending cuts not tax increases by at least 2-1 when the situation becomes too dire even in places much less averse to taxes than the US.

It seems to me that the folks who get nailed when the poop hits the fan are anyone who relies on a check from the feds (bondholders, SS, Medicare, Medicaid, fed employees, etc) Those folks will take a big haircut on promisses the fed govt has made.

Since I think those programs need to be cut anyway I don't see what I gain by voting for higher taxes now. To the extent I can I will still vote for lower spending and constant/lower taxes. If congress still continues to make promisses it can't keep then so be it, when the chickens come home to roost it is going to be the folks relying on a govt check that take the biggest haircut. Those are the folks who have an incentive to get this thing fixed.

As a 30 something net tax payer the BATNA http://en.wikipedia.org/wiki/Best_alternative_to_… of no change is tolerable.

12 quadrupole March 10, 2011 at 5:30 am

Tyler… what about Hauser's Law?
(The observation that empirically, since 1946, across a broad range of tax rates, federal revenue has hovered in the neighborhood of 18% of GDP)

I simply don't believe anyone who claims that tax hikes are going to contribute more revenue unless how *their* tax hike gets around Hauser's Law. Any deficit reduction plan that involves sustained federal revenue greater than 18% of GDP is, historically speaking, a fantasy 🙁

13 Rahul March 10, 2011 at 5:31 am

Bill Niskanen's research shows that by taking tax hikes off the table we simply encourage governments to spend more.

Why do governments do that? Seems counter intuitive. Why would they spend more if they knew less money was coming in? Assuming no tax hikes means less money coming in. Again, sorry for the naive question.

14 AC March 10, 2011 at 5:51 am

As a net taxpayer, I don't see why I should particularly prefer higher taxes now over default. A default would be a better lesson in the importance of fiscal sustainability, and while it would be a big deal for the government, wouldn't affect me any more (probably less) than a serious budget-balancing program. Any reason why we, as citizens, have an incentive to bite the bullet?

15 quadrupole March 10, 2011 at 6:18 am

anon,

I grew up in physics. Hauser's Law is a good example of an empirical law. It's in the same class as Boyle's Gas Law, which was observed long before it could be adequately explained (as is true of many physical laws). It's what we actually observe in the data. We don't know *why* it is (I sure as hell don't) but it is. There's nothing saying that some change in conditions wouldn't allow us to violate it. But the onus is *clearly* on anyone advocating revenue increase by tinkering with the current tax system (mucking with rates, deductions, etc) to demonstrate why they are not bound by it, else they can't be taken seriously.

As to the European example… as mentioned before, we don't understand why Hauser's Law is, and it's not clear that even if we did that there's a way to get from 18-19% of GDP to 30-40% of GDP as it is in Europe. Until someone can demonstrate violation of Hauser's Law (say by having 10+ years of 20%+ GDP federal revenue), discounting it would simply be arguing with the data.

16 Andrew March 10, 2011 at 6:20 am

SS is not 'fine' because the surplus was not invested properly. A ponzi system is flawed because it is a ponzi system, not only at the moment the money runs out.

17 Cyrus March 10, 2011 at 6:30 am

To summarize, quadrupole does not know the underlying mechanisms of Hauser's law, but assumes they are analogous to the underlying mechanisms that determine a commissioned salesperson's take-home pay.

18 Andrew March 10, 2011 at 6:44 am

8. Oh yeah, I thought of that one on the way home one night and forgot to catalog it. One more thing they were wrong about. Tyler never insinuated Obama to be a villain, just that he's the guy holding the ball. But they apparently can't get their heads out of the white-hat black-hat paradigm. They produce misinformation so fast that it's hard to keep up.

19 quadrupole March 10, 2011 at 6:53 am

stubydoo,

As Hauser's Law speaks *only* to federal revenue, your examples are in fact *not* a violation of it. Since the only revenue relavent to the federal deficit is federal revenue, clearly Hauser's Law is of relevance to the discussion.

Hauser's Law posits *no* mechanism, it is *only* an observation about the data itself.

60+ years isn't a modest period for a time series… it's a significant fraction of the lifetime of the entire nation.

20 stubydoo March 10, 2011 at 7:02 am

quadropole,

since by your rules "a significant fraction of the lifetime of the entire nation" is sufficient for establishing a "law", then if we lived in a 3 year old nation, you'd declare 2 years to be sufficient? When you have massive autocorrelation, 60 observations is a tiny sample.

"it is *only* an observation about the data itself."

– then stop calling it a law. It tells us nothing about the possibility or otherwise of increasing revenue.

21 Marvin March 10, 2011 at 7:09 am

Actually, we don't have to do anything other than retain existing law to arrive at a long term budget balance. That means allowing the Bush tax cuts to expire on schedule, stop voting temporary fixes to the AMT problem, stop voting for an annual "doc fix" for Medicare. It's all there in the CBO's projections of the long term budget outlook UNDER CURRENT LAW. It's the alternative scenario, the one where the political system keeps voting for tax cuts without paying for them that is the problem. See http://www.cbo.gov/ftpdocs/115xx/doc11579/06-30-L… page 5.

22 Andrew March 10, 2011 at 7:13 am

(errata – meant tax increases, not cuts)

23 CuriousCat March 10, 2011 at 8:00 am

Are there any nations that don't have sales taxes nor VAT at all? Why not run the country entirely via corporate and income taxes?

24 Dan Weber March 10, 2011 at 8:34 am

Assuming no tax hikes means less money coming in. Again, sorry for the naive question.

It's a fair question. I used to believe it, too.

The theory is that the price of government has gone down, so politicians buy more of it.

Or: government is popular when taxes are low, and unpopular when taxes are high.

How does Europe work around Hauser's Law?

Europe gets around Hauser's Law with a VAT.

* France only has about 10% of their revenue from corporate and income taxes: http://en.wikipedia.org/wiki/File:Structure_of_th

* Germany is around 36% of GDP in taxes http://en.wikipedia.org/wiki/File:Germany-Tax-Rev
but a VAT is about a third of it http://en.wikipedia.org/wiki/File:German_Tax_Reve
so they aren't much above 20%. The income tax only gets 40% of that revenue.

Other people can look up other Eurozone countries. But it should be clear that there are just limits to an income tax's ability to suck up money. I'd be surprised if a democracy could get more than a very few percentage points over 20%.

All in all, the petty arguments on this thread just leave me depressed about any ability for the adults to steer us off our course.

25 quadrupole March 10, 2011 at 9:26 am

Dan,

Thank you for a well thought out response. I'd buy a VAT (or a national sales tax) as a potential workaround Hauser's Law as you suggest because:

1) There's indications from Europe it might work
2) It's not something that's been tried over the period during which Hauser's Law has been observed.
3) It's one of the ways state and local governments derive their revenue, and as has been observed there does not seem to be a Hauser's Law like effect on state and local revenue.

I do in fact, rather *like* the FairTax Proposal, which is a national retail sales tax.

What I don't find credible are claims that if we just let the Bush Tax cuts expire, or raise corporate income tax rates, or tax rates on the rich we would magically get more revenue than Hauser's Law predicts. It's been tried. It's failed. I see no reason why it should be different this time.

26 Rahul March 10, 2011 at 9:35 am

Dan,

If VAT is the way to beat Hauser's law it shows that people successfuly change their work patterns to compensate taxation but cannot change consumption. Is there other evidence for this? Is propensity to work more elastic than consumption?

Another explanation could be that by going the VAT route we are shifting the burden to a different sub-set of the population. One that is inherently constrained on its elasticity to consumption by poverty etc.

27 Steven Donegal March 10, 2011 at 9:46 am

Hauser's Law is the simple observation that over a long period of time (60+years, since 1946) over a very broad variation in tax policy (28-92% top marginal rates plus a lot more variation) federal revenue as a percentage of GDP has hovered within a narrow range of about 18% of GDP, generally returning towards that mean.

During this period, federal revenue as a % of GDP has varied from 20.9% to 14.4%. That is a very significant variation. That on average it is 18% is relatively meaningless. Federal revenue as a percentage of GDP for each of 2009 and 2010 was 14.9%. It is estimated at 14.4% for 2011. Increasing taxes to revert to the "Hauser mean" would solve a lot of our current problems.

28 anon March 10, 2011 at 10:05 am

quadrupole:

I grew up in physics. Hauser's Law is a good example of an empirical law. It's in the same class as Boyle's Gas Law

Look at Boyle's original data. And now look at Hauser's data.

Need we say more?

29 Dan Weber March 10, 2011 at 10:53 am

Is propensity to work more elastic than consumption?

Well, during the latest downturn, we saw in states that income tax revenue fell (especially revenue from the rich), consumption tax sort of fell, and property taxes hardly fell at all. It seems like income is more elastic, but I realize this isn't the strictest examination.

During this period, federal revenue as a % of GDP has varied from 20.9% to 14.4%

There are spikes up and down — the one time we got over 20% was at the height of the dot-com bubble and all those short term capital gains were being taxed. (You missed 1950, when it was 13.5%.) But the vast majority of years the ratio is beteen 0.16 and 0.195.

If you look at this <a href="http://www.wolframalpha.com/input/?i=(US+federal+government+receipts)/(US+GDP)">wolfram and compare it to the maximum federal tax rate, you'll see no relation.

The relation you will see is that receipts/GDP go up during boom times and go down during bust times. This is because federal revenue is very heavy on income taxes.

30 The Anti-Gnostic March 10, 2011 at 12:19 pm

Some people have raised this point and I'm having a hard time not agreeing.

For net tax payors, what's a 'solution' have in it for them?

Serious question. Why should they keep the system limping along so they can continue being tax fodder for the District of Columbia and its crazed, messianic schemes?

Why should they work harder and pay more taxes so the Fed's primary dealers can keep marketing bonds and sending their kids to the Ivies, the better to learn how to plunder the rest of us?

I don't want a solution. I want the debt discounted, the government scorned, and the hard lessons learned.

31 mulp March 10, 2011 at 1:02 pm

If I called on President Obama to push for a budget deal,…

Obama took office by calling for nonpartisan government, and in the spirit of "the deal" he proposed mostly Republican budget solutions:

– Republican stimulus made up mostly of tax cuts and block grants to States, with a very small FDR style spending program.

– Republican health reform to control the long term cost to government, and the economy, from the out of control health care cost increases.

– Republican "market solutions to harmful pollution"

Republicans went on strike and effectively "fled the state" and refused to participate in governing – the few who did work with Democrats were attacked by conservatives and Republicans.

In a discussion on Scott Walker politics, this quote was used:

Richard Benedetto
American University professor; former USA TODAY political columnist :

When New York's iconic Democratic Sen. Daniel P. Moynihan retired in 2001, he issued a parting warning: Never pass major legislation with the votes of only one party. The other party and a large segment of the public will never support it, Moynihan said.

While he went on to talk of Obama's experience, I'm sure Moynihan was talking about the Clinton "ramming" through his deficit reducing budget in 1993 without a single Republican vote. And while Clinton blocked Republican tax cuts and Republican spending efforts to eventually balance the budget, Clinton's budget policies did not win public support even though the economy that resulted was the best in decades.

So, Obama is faced with no option to reduce the deficit in any meaningful way because Republicans are unified in total opposition to every viable means of meaningfully reducing the deficit in the short and long term.

Republicans are totally opposed to hiking taxes.

Republicans are totally opposed to cutting the massively wasteful defense budget.

Republicans are totally opposed to taking the only actions that have been shown to control health care costs – universal coverage and taking economic profit out of health care (distinct from market return on investment).

The only thing Republicans are willing to agree to are further consumption of capital of all sorts to bring short term benefits with long term disastrous results. We can continue to allow transportation infrastructure to deteriorate as has been done for the past three decades. We can sell off right to rents on transportation capital to gain some cash – the sale of the Indiana Toll Road, Chicago Parking, and the Chicago Skyway revenue streams for the next 75 years for a shot of cash in a single year. Breaking pension contracts for the short term gains while increasing the almost certain burden in the future from the lost retirement income which will increase the social costs while cutting economic growth (if investment doesn't result in higher growth, then capitalism is a flawed theory.)

For Obama, the only option I see is to wait for Republicans to put tax hikes, cuts to defense, serious and viable health reform on the table to deal with the budget deficit over the long term.

Republicans did a lot of things, many things that hurt the budget, with bipartisan support. So, the budget busting things Republicans proposed and that passed with bipartisan support are overwhelmingly supported by the public and voters.

The Republican policy of increasing the debt and budget deficit by tax cuts and increased spending have overwhelming public support, and Obama knows he doesn't need to sacrifice himself to reverse those Republican policies.

And the Republicans were right in their health reform policies – everything that has gone into effect is very popular after a few bumps in the road. Even if Obama loses in 2012, so much health reform will be in effect by Jan 20, 2013 Republicans will not be able to repeal it all – at least 30 States will have passed laws in support of the health reform law with bipartisan support, so a simple repeal will be impossible.

And if a Republican is president in 2013, he will need bipartisan support or his budget policies will be extremely unpopular with heavy public opposition.

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