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September 1, 2014

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Making sense of the fiscal cliff

Federal spending

To understand federal spending, break it down to what the government spends against the nation's gross domestic product. For every dollar of GDP, the federal government spends:

• 5 cents on national defense

• 5 cents on Social Security

• 5 cents on Medicare, Medicaid and health insurance for children

• 4 cents on income security measures

• 2 cents on interest on the national debt

• 2 cents on other programs

• 1 cent on veterans

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The news is full of the so-called “fiscal cliff,” where through an accident of timing and procrastination, big cuts to the federal deficit will be implemented on Jan. 1.

It is not as dramatic as it seems. The cliff is more of a downslope, which we can climb back up if we choose. If we get past the new year without a deal, the economy does not go into free fall.

For those who aren’t news junkies, it can be hard to make sense of what all these numbers mean. Congress plans the budget for the next decade, and this makes all the billions and trillions seem incredibly large. I suggest thinking about these amounts relative to gross domestic product (GDP).

For every dollar of GDP, the federal government spends about a nickel each for national defense and Social Security, and another nickel for Medicare, Medicaid, and health insurance for children. Then we add four cents for income security (a range of programs including the Earned Income Tax Credit), two cents for interest on the national debt, a penny for veterans, and two cents for everything else the federal government does.

All this adds up to 24 cents. About three cents of this total amount goes as grants to state and local governments, mostly for Medicaid, income support, and highways. About nine cents of the total is considered discretionary.

In 2009, at the bottom of the recession, the federal government was spending about 25 cents, so it is down a little, partly because the stimulus has mostly expired. But back in 2000, when the economy was running at full speed, we weren’t in a war, and the baby boomers weren’t retiring yet, the feds only spent 19 cents of each dollar in GDP.

Back in 2000, of course, we were running a budget surplus. Then President Bush pushed for a large and popular tax cut: tax rates fell, especially for capital gains, while spending rose and deficits returned. Federal revenue is now down to 15 cents for each dollar of GDP, nowhere near what we need. On average, Americans — especially wealthy Americans — now pay a lower share of their income in federal income taxes than any time in the last 60 years.

So our national debt is now growing by nine cents a year for each dollar of GDP. Since in normal times our GDP (including inflation) can be expected to grow by 4 to 5 percent, we need to cut the deficit in half just to keep the national debt at a constant share of GDP.

In the short run, borrowing sometimes makes sense. In a recession, when people aren’t spending and government revenues are temporarily low, deficits are a natural result. A balanced budget in a recession sends the economy into a tailspin. Borrowing for investment can also make sense, if the eventual return on investment is higher than the cost of borrowing. Otherwise, it is hard to imagine this growth in the national debt being sustainable in the long run.

But the baby boom generation has reached retirement age, and this means that spending on Social Security and Medicare is going to rise, and fewer people will be paying in to the system. With fewer people working, some economists expect real GDP growth to slow down in the future, even once we are finally past the nasty after-effects of the Great Recession.

A year and a half back, Congress passed a set of automatic spending cuts which they refer to as the sequestration. These were intended to be arbitrary and painful cuts to the military budget (except pay and benefits) and discretionary spending, as a threat to recalcitrant Congressmen who failed to come to some bipartisan agreement. These cuts are supposed to kick in on Jan. 1, and they will reduce federal spending by another cent for each dollar of GDP.

Letting the tax cuts expire would add in about two to three cents. President Barack Obama proposes to let the cuts expire for the top 2 percent of income earners, but keep the cuts for everybody else. Unless the Republicans agree, it is likely that the cuts will be allowed to expire for everybody, which changes the question somewhat after Jan. 1.

Back in October, Republican presidential candidate Gov. Mitt Romney advocated capping some deductions for the wealthy. The big deductions are for mortgage interest, medical insurance premiums, 401(k) plans, and state and local taxes. Obama includes this idea in his proposal too, and both higher rates and lower deductions together would raise one cent in taxes for every dollar of GDP.

President Obama’s cuts to the payroll tax are about to expire too, and that will bring back another cent in revenue. There appears to be no political interest in extending these, even though they affect many more people than income taxes, probably because these cuts affected the long-term solvency of Social Security and Medicare since the lost revenue was not replaced.

Taxing capital gains at the same rate as regular income is not seriously under consideration, even though there is no real evidence that the preferential treatment for capital income over labor income has increased savings and investment. This could raise up to one cent per dollar of GDP, but never mind.

Starting with a nine cent deficit, and subtracting one cent each for spending cuts, income taxes on the wealthy, and payroll taxes for working stiffs, we are down to six cents. What’s next?

To reach our sustainable target, the final ingredient is more economic growth, which will increase tax revenues, reduce the need for some types of spending, and increase the sustainable target deficit. Housing prices have finally stopped falling, and that was a huge drag on the economy. Firms and consumers have been paying down debt as much as the recession allowed, but spending in the U.S. appears to be picking up again and the unemployment rate is starting to come down.

However, these three ingredients — reduced spending, increased taxes and more growth — are likely to mix badly. Discretionary spending cuts, especially arbitrary ones, are projected to have a negative impact on state budgets, where times have been hard for years. Sudden increases in taxes are also not likely to be popular either.

Europe’s recent efforts at government austerity have helped pushed that region back into recession, making their debt problems worse, not better. Economists expect that austerity would have a similar effect on the U.S. economy. Reducing the deficit too quickly could backfire.

In the long run, the argument that lower tax rates (especially the very low rate on capital gains) are needed for economic growth just does not hold water. The federal government needs to collect enough taxes to cover what it spends, and in normal times spending should come down before taxes are allowed to. We should never again create a debt crisis for political purposes.

But in the short run, at least during a recession, higher taxes reduce overall private spending, especially for those at lower incomes. Reduced government spending reduces private spending too, and together this means less income and fewer jobs.

Skiing down such a precarious fiscal slope, it is hard to keep your balance. Hopefully we won’t go too far downhill before Congress reconsiders.

Elliott Parker is chairman of the economics department at UNR.

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  1. Sometimes a hard fall is just what it takes to get the skier back on the right slope and not take unneeded and unwarranted risks. Perhaps the same is true with the fiscal cliff dive. With one exception, the GOP should give the president his tax hikes on the 2 percent for the good of the 98 percent. Then, if the president refuses to put spending cuts on the table, the GOP should sit on its hands.

    CarmineD

  2. If we had kept spending at 2007 levels and adjusted for inflation we'd have a budget surplus now with no need to raise taxes. The problem is the government ramped up spending considerably (over $1 trillion) in the last year of the Bush administration and now Obama continues this policy as if we MUST. Its nonsense.

    We've had 5 years of listening to people like Dr. Parker - your ideas flopped hard like we predicted. Terrible economic growth, terrible employment rates and a crap ton of spending you said would make everything better. It is time to stop listening to these Keynesian ideologues and try something that works...

    More on this: http://reason.com/blog/2012/09/13/terrif...

  3. Also this: http://reason.com/blog/2012/12/06/want-b...

    Article makes the point that if you want Clinton era tax rates then we should also have Clinton era spending. ;)

  4. Under the current economic model followed by both party's elected officials it doesn't make much difference what kind of agreement they make. We will still be stuck in a big mess. Neither party's elected officials will do what is necessary to get us out of the hole.

    Time to go over the fiscal cliff.