Thursday, September 22, 2011

"READ MY LIPS - NO NEW TAXES!"

So said president George H. W. Bush during his election campaign.  Elected, he did raise taxes and became a one-term president.

There are now even more dogmatic elected anti-tax representatives in Congress, playing Russian roulette with budgetary and debt ceiling issues at a time when the federal government of the United States is facing an in modern times unprecedented deficit, equal to 11% of Gross Domestic Product. This takes us somewhere north of annually missing 1,600 billion dollars to balance the books.  While federal government revenues from taxes and other sources represent about 14% of GDP, expenditures amount to 25%.  According to the dogmatists, mostly to be found within the Republican Tea Party movement, this gap is supposed to be closed without recourse to higher government revenues - in any shape or form.

This is total fantasy.

Even making some fairly heroic assumptions about the course of the economy over the next 10 years, government revenue as a percentage of GDP will, as far as I can surmise, have to be raised by some 10 percentage points on GDP over current levels to see the United States through to a balanced budget by 2020.

In trying to look objectively at this issue, a quick overview of the financial structure of U.S. governance will be helpful, since it is different from that of other countries one often compares it with.

While budget talks in Washington DC revolve around revenues and expenditures of the federal government, state and local governments generate their own expenditures and collect their own revenues (complemented by some 550 billion dollars of annual transfers from the federal government).  With the exception of Vermont, state and local government budgets need to be balanced under a variety of rules, while that of the federal government is under no such restraint.

However, for the federal government to run a deficit it has to obtain the authorization of Congress to borrow money to fund it.  Originally such authorization had to be sought on a case-by-case basis, but in 1917 Congress resolved to rationalize the process by stipulating debt ceilings within which the executive branch is at liberty to issue the required government debt instruments.  The debt ceiling was raised annually during World War II and has been raised 74 times since 1962.

Note that any such borrowing will always be the result of a budget deficit a priori approved by Congress, so for Congress to procrastinate on raising debt ceilings to accommodate the deficit it has already approved seems to makes no procedural sense.

Currently, total federal, state and local revenues represent 30% of GDP, while total expenditures represent 41%.  With state and local government budgets in balance, we end up with the same 11% federal deficit referred to above.  As far as total national government expenditures go, this still leaves the United States fairly far down on the international totem pole.  A representative cross section of other developed economies show an average of around 45% of GDP.

We can probably all agree that an 11% deficit is no way to manage the world's designated superpower.  But when it comes to solving the problem, political courage and common sense tend to be left at the door.  And the elephants in the china shop are called Health Care, Social Security and Unfunded Government Pension Entitlements, granted by law in bygone and happier times when the days of demographic reckoning were decades into the future.  Mind, this is not a uniquely American problem.  Most other developed nations are to varying degrees in a similar quandary about long term entitlement funding.

On the combined federal, state and local expenditures side, I cannot for the life of me see how they will drop below 40% of GNP in foreseeable future.  Between now and 2020 the number of Medicare and Medicaid recipients will increase by some 20 million.  Per capita health care costs have a history of increasing at twice the rate of GNP over the last 40 years, and there are powerful vested interests within the health care industry against any change to this trend.  The industry is the second largest spender on lobbying Congress, neck-to-neck with Finance, Insurance & Real Estate.

By stint of demographic realities, Social Security and government pension obligations, the second biggest budgetary items, will have increased by 50% in 2020 measured in constant 2010 dollars.

Number three on the list, defense spending, can and most probably will see reductions from its current 6.5% of GDP, but within the big picture this will not make all that much difference, particularly since there are other issues such as public infrastructure and education that could do with additional long term funding.

The expenditures referred to above currently consume close to 70% of joint federal, state and local revenues, leaving little room for substantial and politically digestible cuts from other holds.

On the revenue side of things there is the level of economic activity to consider, as well as the level of taxation.  Consumer spending is the main driver of the U.S. economy, and the immediate outlook on this front is not encouraging.

Average household income measured in constant 2010 dollars has fallen by 12% during the last 10 years. During the same time the debt-to-household income ratio has gone from 1.02 in 2000 to 1.92 in 2010, having peaked in 2008 at 2.14.  It may well take until 2020 for the average U.S. household to repair its balance sheet, during which period one can only hope that the trend of steadily falling real household income levels will be reversed.

If we take 2020 as a target for reestablishing economic normality, some 12 million new jobs must have been created between now and then to reach full employment.  This should not be all that hard, but would take some determined and creative action.  During Clinton's two presidential terms 22.7 million jobs were created, and the federal budget generated a substantial surplus. There is talk of a national development bank.  Brazil has operated such an institution for decades with considerable positive effect.  To this I would add incentives for bringing back industrial jobs from abroad.  For more on this, visit THE U.S. ECONOMY - A STRUCTURAL PROBLEM.

So, let us not be fooled.  Government revenues will have to be raised, and not only from the super-wealthy few, while the tax code needs to be restructured and simplified.  For example, while the nominal U.S. corporate income tax rate is a relatively high 35%, actual tax collected by the federal government amounts to only 10% of total corporate income, thanks to exemptions, loopholes and tax deferment opportunities allowed in the tax code.  The New York Times recently referred to a study pointing out that some very profitable major U.S. corporations actually pay less federal income tax than the remuneration they pay their chief executive officer.

On the expenditures side, the restructuring task is gargantuan, particularly in the out-of-control health care sector.  And the scary part is that political leadership and patriotic consensus-seeking among lawmakers to get the job done is nowhere to be seen.

The demographics and a resourceful populace of the United States leave me optimistic for the long term, but prospects for the next ten years or so look grim.  We can only hope that the nation will recover its footing and legendary recuperative abilities soon.