Time to Man Up
Despite a pause in the mudslinging, President Obama and Republican leaders Boehner and McConnell still have a lot to do.
Washington's epic budget battle ended last week not with a bang but a whimper. The Budget Control Act of 2011 that President Obama signed into law Tuesday does little to rein in a federal budget that is still out of control. The legislation raises the ceiling on debt by more than $2 trillion, thus enabling the federal borrowing binge to continue for another 18 months, until early 2013. As for the "control" part, the act requires about $2.4 trillion in deficit reduction over 10 years. • That $2.4 trillion might seem like a large number, but not against the sums the government is planning to spend.
Even if every last billion of that planned reduction does become reality -- as it turns out, a big if -- the most it can do is slow the torrent of red ink, not staunch it. Federal spending will still be much higher in 10 years than it is now; the budget will still be running huge annual deficits; and the federal debt will still have grown much faster than the domestic economy.
If you think the deal is better than nothing at all from the standpoint of taming the debt, you're surely right. If you argue that the atmosphere in Washington has changed for the better since President Obama submitted his new budget in February, you have a point.
But if Standard & Poor's can be taken at its word, the ratings agency will likely treat the results as a reason to downgrade U.S. Treasuries, even though the action will probably won't have an immediate impact on the terms at which the Treasury can borrow. A budget-control act that actually imposed some control might not have been politically feasible, but it is certainly is feasible from every other standpoint.
As mentioned, however, even the $2.4 trillion in deficit reduction is suspect on several grounds. The cuts come in two parts. First, what is known as "discretionary spending" -- which excludes the major entitlement programs, known as "mandatory" -- will be $917 billion lower over 10 years than otherwise planned. In budgetary jargon, otherwise-planned refers to the "baseline" budget for 10-year discretionary spending developed in March by the Congressional Budget Office, in which huge increases were projected.
Second, there will be another $1.5 billion in deficit reduction yet to be determined by a joint committee of 12 members of Congress, equally divided between Republicans and Democrats. If this Gang of 12 fails to produce a proposal that results in new legislation, there will be automatic across-the-board cuts of $1.2 trillion in discretionary spending, Medicare, and farm and housing subsidies. So far, then, it seems there could be just a little over $2.1 trillion in deficit reduction ($1.2 trillion plus $917 billion), not $2.4 trillion.
THAT $2.1 TRILLION is also a bit suspect because there could be many a slip 'twixt cup and lip when it comes to long-term follow-through.
Standard & Poor's anticipated that problem in a July 14 press release, which stated: "If Congress and the Administration reach an agreement of about $4 trillion, and if we…conclude that such an agreement would be enacted and maintained throughout the decade, we could…affirm the 'AAA' long-term rating and A-1+ short-term ratings on the U.S. "
Based on this statement, the affirmation will probably not be forthcoming, since $4 trillion is a lot more than $2.4 trillion. And what about confidence that the deficit cuts will be "maintained throughout the decade"?
Take the portion that has already been committed: the $917 billion in spending caps phased in over the 10-year period. For starters, the actual total of assumed cuts to discretionary spending will not be even $917 billion, but about $150 billion less. The budgetary planners can get $917 billion by throwing in an additional $150 billion in savings on debt-servicing costs, a great numerical luxury not available to those of us not already mired in debt. Given the math on debt-servicing, the more in spending cuts you assume in the early years, the more you save in debt-servicing costs.
So why not front-load the spending cuts in the early years to maximize the savings from debt-servicing? Our planners are having none of that.
Not surprisingly, the spending cuts are back-loaded. Almost two thirds (63.8%) of the projected cuts in discretionary spending are assumed to take place in the second five years of this 10-year period, beginning in 2017. By then, many of the politicians who passed this bill will no longer be in office, including Barack Obama himself (unless, of course, the president loses his bid for re-election in 2012, but then wins in 2016). In 2012, the assumed reduction comes to just $21 billion, a tiny fraction (2.3%) of the projected $917 billion.
When spending cuts get deferred in this way, there is a natural suspicion that they might be honored in the breach by future leaders who didn't approve them in the first place.
Chris Edwards, the Cato Institute's editor of DownsizingGovernment.org, points out that such reversals are not without precedent. The George H.W. Bush tax hikes of 1990 -- another form of debt reduction -- were passed with the promise of $2.50 of spending cuts for every dollar of tax increases, with projections going out to 1995. In reality, spending increased.
Deferred spending cuts aren't the only cause for mistrust. As Edwards also points out, reductions based on vaguely worded guidelines are much easier to reverse than cuts that are actually worthy of the name. Say the $917 billion package included a phased increase in the Social Security retirement age, which would lower the cost of funding benefits. Or say the cuts include the outright abolition, according to a predetermined schedule, of some federal agency, program or even department. Such specific and tangible reductions in spending wouldn't even have to be fully realized within a year or two to be considered credible.
But when all you get, to quote the White House "fact sheet," is "caps on discretionary spending that will produce more than $900 billion in savings over the next 10 years, compared to the CBO March baseline," you begin to wonder whether the government has gone Charles Dickens' immortal Mr. Micawber one better; that comic character manages his finances based on hope, rather than reality. Imagine a household that has to cut its spending. The household head announces no specific reduction -- say, no more dining out, or a staycation, rather than a jaunt over to France -- but instead promises "$9,000 in savings over 10 years by capping discretionary spending versus baseline increases." Micawber would applaud. And laugh.
THE PALTRY PROJECTED cut in 2012 renders any discussion of the potential fiscal drag from the Budget Control Act impossible to take seriously. The idea that the spending cuts could slow economic growth is widely held, but simply makes no sense under scrutiny of the actual figures involved.
Recent experience has even made it hard to believe in the flip side of fiscal drag, known as fiscal stimulus. Hundreds of billions of extra dollars have been spent to boost economic growth, to no apparent effect. Most recently, total federal outlays in the 2011 budget have jumped to a record $3.629 trillion, an increase of $173 billion, or 5%, over those in 2010. Yet real growth of gross domestic product through the first half of this year has slowed to an annual rate of just 0.9%.
If a 5% increase in federal spending can stimulate so little, what can you say about fiscal drag that is about the size of a statistical error? The second part of the $2.4 trillion projected deficit reduction -- the hoped-for $1.5 trillion -- will probably not begin until 2013. Barron's assumes, for argument's sake, that it will be phased in at approximately the same rate as the $917 billion, starting in 2013, with the same pronounced tendency toward back-loading in the later years (see chart).
Weak Controls
The Budget Control Act's $2.4 trillion in proposed cuts would phase in slowly over 10 years...
... allowing debt as a share of GDP to reach 91% by 2021.
That leaves $21 billion in deficit reduction in 2012. Since the baseline budget of the Congressional Budget Office predicts that federal spending will otherwise increase by $10 billion, the net reduction in spending comes to $11 billion, a cut in total spending of a mere 0.3%. If a 5% increase could be associated with growth of just 0.9%, we must leave it to the fiscal fundamentalists to calculate the drag on growth from a 0.3% cut.
As the chart also shows, even if we place full credence on the $2.4 trillion in promised debt reduction, the net effect on federal debt will be marginal. Based on the CBO's "alternative fiscal scenario," which assumes "changes to current law that are widely expected to occur" -- in other words, realistic assumptions -- federal debt held by the public will increase much faster than current-dollar gross domestic product. In fact, it will equal 101% of current-dollar GDP by 2021, versus 69% now. If the full debt reduction of $2.4 trillion does occur, the figure still would be a hefty 91%.
A 10-percentage-point cut from likely projections might nonetheless be regarded as better than nothing. But it amounts to the first few steps in a journey of 1,000 miles. Based on the same trajectory, the CBO projects that the debt will continue to grow faster than current-dollar GDP, rising to a 187% share by 2035. Lop off the assumed debt reduction of $2.4 trillion and you get 182%.
That figure would exceed the debt-as-share-of-GDP numbers of beleaguered Italy and Greece, estimated at 100% and 150%, respectively, assuming no major meltdown. For the U.S., the peak was 112.7%, reached in 1945, the last year of World War II. That figure rapidly fell after the war ended.
The total of federal debt held by the public is currently $10.4 trillion, a lot lower than the $14.29 trillion widely cited in the fight over raising the debt limit. (That figure is also comparable to the quoted debt of countries like Greece and Italy.) The difference of nearly $4 trillion between the two figures reflects the artificially-created IOUs of the federal government, technically known as "trust funds" to cover entitlement programs, mainly Social Security.
The trust funds seriously understate the unfunded liabilities of Medicare, Medicaid and Social Security, more accurately estimated in the tens of trillions. And the use of the misnomer "trust funds" again harkens back to the Micawberish concepts of government finance. Perhaps the truest note in the debt-limit fracas was struck by the president himself, when he warned that if the debt limit wasn't raised, Social Security checks might not be sent out. None of Obama's supporters wondered why this could be a worry. For if there were a trust fund running in the trillions that covers Social Security, why not just sell some of the assets and pay for the checks in that way?
Answer: This trust fund never had any assets. It is essentially a memo-to-the-file to pay on future liabilities.
PROBABLY THE FALSEST NOTE was also struck by President Obama, when he constantly inveighed against the "millionaires and billionaires" who needed to pony up to cover government's runaway costs. Maybe they do. But then, so does just about everyone else, especially the middle-class, a fact the president neglected to mention.
A recent Barron's cover story ("Grow Up, Guys!" May 2), outlined a possible menu of choices that came to $11.7 trillion in debt reduction over the next 10 years. The cuts included trimming defense spending to 2000 levels; abolishing the Departments of Education and Housing and Urban Development; and modifying Medicare, Medicaid and Social Security. The $11.7 trillion also included Obama's own proposal for raising rates on the two top income brackets and increasing the estate tax.
These tax hikes have been scored by the president's own Office of Management and Budget as contributing a bit less than $1 trillion in reducing the debt over the 10 years. Even without discounting that figure as probably erring on the high side, it barely makes a dent in the long-term fiscal problem. Unless the president is willing to consider far more ambitious cuts, especially on the entitlement programs, he will have to hike taxes on virtually everyone with an income.
CBO FIGURES SHOW that the full burden of the federal tax is about progressive as it was in the late 1970s; the richer the income group, the greater the share that it pays. All income groups pay a somewhat lower effective rate than they used to, but by far the steepest proportionate drop has been among the lowest 20%, which paid just 4.2% of their income in taxes in 2006 and 2007, the most recent years for which figures are available. The top 1% of income recipients paid 30.4% of their income in federal taxes in 2006-07, the highest effective rate. That figure includes all ways the Internal Revenue Service can make claims on income, including corporate income taxes, of which the top 1% pay a disproportionate share, because they own a disproportionate share of stock. (The 30.4% excludes estate taxes.)
In order to be in the top 1% in those two years, you had to earn at least $350,000, a figure that might not even qualify you for the president's targeted group of "millionaires and billionaires." (Millionaires here being defined as households that earn at least $1 million a year.) But because there are plenty of real M&Bs in the top 1%, this income group did account for 28.2% of all federal taxes paid in 2006-07.
That's an impressive number, but regardless of how much it is raised, it won't cover the soaring cost of government, especially when you consider that the aggregate tax take already falls far short of paying those costs. You have to hike taxes on the top 20%, who earned a minimum of $75,000 in 2007, and even on the next quintile, who earned a minimum of $50,000.
Or you can face the prospect of making drastic cuts in the cost of government. That journey of 1,000 miles has barely begun.
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