Click HERE for a PDF version of this position paper.

Our Government has a Spending, not a Revenue Problem

The United States Government, at all levels, has been living beyond its means for some time.  The recent economic difficulties and greatly increased federal spending, have accelerated that situation to the point we are borrowing about 41 cents out of every dollar our government spends.  Clearly, this is a totally unsustainable level of spending and if we continue on this path we will do permanent damage to the financial health of our nation, and burden our children and grandchildren with a huge and unpayable debt that will guarantee them a decreased standard of living than they should expect as Americans.  We have arrived at a point of choosing.  Are we to continue to be an engine of dynamic economic growth and rising standard of living with the associated inequalities inherent in capitalism, or will we choose to become a social-welfare state where equality is prized above achievement?

This situation is one that few Americans probably thought we would have to consider; yet we are at that point.  The current Administration and Congress have made it clear that we are embarked on a path of government dictated equalization of outcomes vs. guarantor of equal opportunity.  That distinction is stark and profound and has significant implications on how we, and our children will live.  In the system we are currently racing towards, the government has an outsized role in picking winners and losers, how much money you are allowed to make and keep and how your health care, energy and other personal choices will be made.   How have we arrived at this juncture?

The Financial Crisis and our Government’s Response

In a separate paper we detailed the roots of the housing meltdown, here we will focus on the recent response of our Government to trying to rectify the problems we have.  In 2008 before the last Presidential election, the Bush Administration asked Congress to pass an “Economic Stimulus” bill to help a clearly sagging economy get back on track.  That effort was about $170B in tax rebates to boost “demand”.  It had a minimal and temporary impact.  Then we had massive intervention into the financial system and automobile companies known as TARP at over $700B, President Obama’s roughly $800B in government directed “Stimulus” spending mainly to prop up state and local governments and some infrastructure projects.  Then there was few billion for “Cash for Clunkers”, then the $8000 homebuyers tax credit and now another $29B to pay for teachers salaries.  That is a lot of money.  All borrowed money and spent to little good effect.  After a few trillion in spending borrowed money we still have nearly a 10% unemployment rate, about a 17% underemployed rate, and a very low growth economy that is slowing.  How is it possible to spend that much money and get such poor results?  Simple:  it was spent poorly.

The problem is the assumption that government spending can drive demand and create private sector growth.  This is commonly known as Keynesian spending; an interesting theory to be sure, but unfortunately it has little evidence of actual success.  This program was followed for about 10 years in the 1930’s during our Great Depression and didn’t get us out of the Depression, we had structural unemployment at greater than 15% for many years.  If it worked, why couldn’t it end the Depression for 10 years?  In the 1990’s the Japanese tried this and racked up huge debts and built lots of infrastructure, but it all resulted in no growth and they still suffer from low growth. 

If spending government money could end a recession then there would never be any recessions.  It doesn’t work, never has and never will.  Here’s why.  Every dollar the government spends is a dollar that the private sector can’t spend or invest.  Every dollar that our government gets its hands on instantly turns into about 79 cents just to fund the cost of the government itself.  Then they are generally directed to politically driven projects like a bridge in this politician’s district, a park in that one’s, a homebuyer’s credit, credit for solar panels, etc.  None of which creates any sustainable economic activity.  If that dollar was left in the private sector, a business with incentive to make a profit and grow will make economically driven decisions and will inherently more effectively deploy that capital.  A dollar left in the private sector will turn into a $1.05 or $1.10 instead of instantly turning into $0.79 when spent by the government.  We’ll leave it to the reader to decide which makes more sense.

The Budget, Spending and Liabilities

This last year our government has spent $12,500 per household in deficit spending.  Somebody has to repay that.  Forty-one cents ($0.41) of every dollar we are spending is borrowed money.  A look at your latest family portrait will tell you who gets the tab. In inflation-adjusted constant dollars, our federal government spending has roughly tripled since 1965 as shown in the figure to the left.  Do you feel that the government three times better than it was then?  Are we receiving three times better service, or are we three times better off? Clarence Darrow couldn’t argue that case.  Government spending has been increasing over multiple administrations at a rate that is unsustainable by any measure but has accelerated sharply since 2007 as shown in the figure above. 

Federal government spending has accelerated at a much greater rate than personal income.  The following figure shows how the federal government spending has exploded relative to growth in median income.  The growth in spending is largely driven by entitlement spending on programs such as Social Security and Medicare but discretionary spending has also increased greatly.  This is not a sustainable trend by any measure.  Spending cannot grow faster than revenues in this manner for long or you will run huge deficits, and indeed that has been the case.  The following charts show the deficits and accumulated debt that we have been running over the years.  Note that the deficit rose after the market crash in 2000 and the 9/11 attacks and the War on Terror but were coming down sharply until 2007 when spending accelerated rapidly.   Debt exceeding 90% of Gross Domestic Product has proven historically to be a point where the debt service begins to significantly degrade growth and has been a point of decline for many countries.  After WWII the US had accumulated a significant debt but set out to decrease it quickly and we were the only fully functioning major economy remaining after the devastation of the war.  Greece was only at about 113% of debt to GDP when they collapsed earlier this year.  We have recently crossed the 90% Debt to GDP threshold.

Clearly, this is not a healthy and sustainable situation.  Our debt service now, that is interest we are paying on our current $13 Trillion debt will be about $400B this year and interest rates are extraordinarily low. When the economy begins to recover and interest rates begin to rise again the annual payments on the debt will grow rapidly.  By comparison, the 2010 Defense Department budget was about $530B not including the war funding.  

 When interest rates rise the debt service will overtake defense spending and are projected to quadruple over the coming decade according to the Office of Management and Budget. 

Another massive and rapidly growing budget problem is unfunded liabilities that we face in the future.  Entitlement programs such as Social Security, Medicare and Medicaid have an absolutely enormous and unpayable liability.  Over $100 Trillion over the next 75 years and that is almost certainly to go up.  On our current trajectory, interest payments on the debt and entitlement spending will consume all tax revenue in less than 20 years.  Is this the America we want to leave for our children?

Taxes

For most politicians the answer to revenue shortfalls is to reflexively raise taxes.  Indeed, this Congress and Administration are set to allow taxes to increase dramatically in January of 2011.  Raising taxes will not help our economy grow and could well trigger another recession.  Raising tax rates does not necessarily result in more revenue.  The following chart shows that the amount of total tax revenues captured in taxation is remarkably independent of tax rates.  

 Regardless of tax rates the total tax revenue as a percent of GDP never exceeds 20%.  Spending is the problem, not revenue. For reference, our spending this year is about 25% of GDP and President Obama’s plan has a persistent spending of about 23% of GDP.

What does change with tax rates is economic growth and tax revenue.  Every dollar taken in tax revenue by the Federal government is a dollar not at work in the private sector creating economic activity and growth.  Every time there has been a significant cut in marginal tax rates, revenues to the federal government have increased not decreased.  When President Kennedy lowered marginal rates, the economy grew quickly and revenues increased, when President Reagan cut marginal rates in 1981 the economy grew out of recession and revenues to the Treasury grew by $1 Trillion in less than a decade, when President Bush cut rates in 2001 and 2003 the economy grew and revenues grew quickly.  Reducing tax rates increases incentives to earn, reduces tax avoidance behavior and stimulates economic growth.   When Capital Gains taxes are cut, the revenue from Capital Gains taxes increases, even President Obama had to acknowledge that fact when he was a candidate.  He still wants to raise them anyway for reasons of “fairness”.

The Tax Cuts from 2001/2003 are scheduled to expire on December 31^st of 2010 and rates will increase across the board unless Congress acts to keep them.  The chart on the left shows some of tax rates changes scheduled to take effect on January 1^st, 2011.   The Administration wants to increase rates on the “rich” or those who earn over $200K per year.  

 That is hardly rich. In Santa Barbara that is basically sustenance wages if you own a home.  This administration and this Congress seem obsessed with raising taxes on
upper income earners to get them to pay their “fair share”.  What precisely they believe is their fair share is unclear, but it is instructive to see how much upper income earners pay in taxes under the current rates.  As you can see from the nearby chart, the top income brackets pay about 60% of the total income taxes in this country.   

How much more should they pay?  The top 1% is about $400K per year in income and the top 5% is about $160K per year.  The upper rate will actually be about 42% due to phase out of deductions. 

When Federal and California State income taxes are combined it is over 50% on the top braket and that is before paying sales taxes, property taxes and other fees to the government. 

The new Health Care law (ObamaCare) has an array of new taxes that will kick in soon as well as other taxes on an array of programs that have been passed in the last 18 Months.  Raising taxes on anyone in this struggling economy is extrordinarily ill advised.  Many of these “rich” they intend to tax are primarily small business owners who are the engine of job growth in our economy.  Indeed, all net new jobs in our economy are created by start-ups and small businesses.   By definition, when we tax an activity there will be less of that activity because taxes reduce the capital available to grow and expand.   Raising taxes on capital formation means we will end up with less capital formation.  Capital formation is a precondition to growth, growth is a precondition to wealth creation and wealth creation is a precondition to prosperity.  Raising Capital Gains taxes will starve the economy of the capital it needs to grow when we can least afford it.

What should we do?

The rational approach to digging out of the financial hole in which we find ourselves is to first stop digging it deeper.  The means getting control of our spending and putting our budget on a path to fiscal sanity immediately.  Secondly, we need to remove obstacles to growing our economy which includes burdensome regulations and counterproductive taxes.  Corporate taxes in the US are the second highest in the developed world and are an incentive for companies to move production offshore, expand overseas and keep profits earned outside the country in order to avoid excessive taxation.  The chart below compares corporate taxes with our competitors.   Corporate taxes account for only about 12% of our government’s overall tax revenues.  A cut in corporate taxes would not cost the government much in the short term and would make our country more competitive internationally and help encourage economic growth.   Our corporate taxes should be not higher than the average for industrialized countries which is about 25%.  The trend internationally has been to reduce corporate tax rates to encourage businesses to locate in their countries.  Novel concept.

Reducing spending in the Federal government must be the first priority.  If overall Federal spending were at 2006 rates we would actually have a balanced budget, this gives one some perspective on how much government spending has exploded.  Discretionary spending has increased dramatically over the last couple of years.  The Stimulus Bill accounts for much of the increase, but what was done was the added Stimulus funds were then baselined into the budget making the total the the starting point for next years budget locking in those “temporary” funds into the long term budget.  The Federal government begins its budget every year with the baseline of what the budget was the previous year then they decide how much more they want to spend.  Little or no regard is given to how much we actually have to spend.  This process must end.

During this recession we have lost about 8 Million private sector jobs while adding thousands and thousands of government jobs.  Growing the public sector at the expense of the private secton is a recipe for disaster.  Federal government compensation for an average employee is totally out of balance.  The average Federal worker receives total compensation in salary and benefits twice the total compensation of a private sector worker.  Total average compensation for a Federal worker was $123K per year whereas the average private sector worker was only $61K per year.  This situation is completely and totally backwards from how things should be.   Why should government workers enjoy such superior compensation at our expense?  This disparity must be addressed.  Government jobs are overhead.  They don’t produce self-sustaining, revenue and profit producing jobs, only the private sector can do that and those are the jobs that should be prioritized not an ever expanding government workforce.

Specific Recommendations

Federal spending must be reduced.  Taxes must not be raised.  When I am in Washington I will push for the following changes in the way our Federal government spends our tax dollars:

Continue 2001/03 Tax Cuts – Increasing taxes on anyone, regardless of their income level, is going to hurt our economy. We need to continue the 2001/03 tax rates across the board; there is no question about it. We need economic growth and we need job creation, raising taxes on the productive sector of our economy will hurt economic growth and job creation.

Reduce Corporate Tax Rates – Our corporate tax rates are a disincentive to do business in this country and they need to be brought in line with our competitors for international business.  Corporate tax rate should be reduced to at most 25%.

Freeze Federal Hiring – The Federal Budget/Deficit/Debt are not the only things that have been growing. The size of the Federal Government itself has also grown wildly out of control. The Government does not need any more employees – particularly when they cost twice as much as a private sector employee.

Cut 5-10% of Underperforming Federal Employees – A mandated Reduction in Force should be implemented and the lowest performing employees should be cut just like they would be in private industry.  Between normal attrition and merit based cuts the federal workforce should be reduced to 2006 levels as soon as possible.

Cut Federal Workers’ Pay by 5-10% - Federal workers make more than twice as much in total compensation as their private sector counterparts and Federal pay has grown rapidly over the last few years.  When the taxpayers have suffered 8 million lost jobs in this recession there is no excuse for increasing public sector compensation.   They work for us after all.

End Baseline Budgeting – The process of the Federal government spending what they want and not what they have to spend must end.  No more starting with last years budget and adding to it as a normal course of business.  We simply cannot afford this any longer.

Begin Restructuring our Entitlement Programs – Social Security, Medicare and Medicaid must be restructured for long-term solvency.  Almost nobody under the age of 50 believes that they will receive the benefits promised by these programs, and they are correct.  Without reforming these programs our country will be bankrupt.

Privatize Programs within the Government’s Control – Wherever possible programs that the Federal Government oversees should be privatized. It is true that Government plays a unique role that cannot be duplicated by private industry. Those programs should remain under government control, but offloading programs that will run more efficiently under private control will do one of two things: stimulate the economy by creating private sector jobs as well as profit, and it will save the taxpayers’ money every year for a program they no longer have to pay for.

Study eliminating and/or de-scoping Departments – It is time to revisit the legitimate functions of our Federal government and what they are Constitutionally authorized to do.  Departments such as Education, which educates no one; Energy, which creates no energy; Agriculture, which grows nothing, and other departments need to considered for significant cuts or elimination altogether.  We simply cannot afford the Department of Redundancy Department any longer.

Bottom line is everything needs to be on the table for cuts, focusing the mission, de-scoping responsibilities or elimination.  The Federal government needs to focus on reducing burdens on the private sector, helping our economy grow and getting out of the way instead of constraining our entrepreneurial drive and economic growth with burdensome regulations, high taxes and destructive spending.  

Click HERE for a PDF version of this position paper.