Cutting Government Expenditures

Federal government budget considerations
(c) Can Stock Photo/robwilson39

I have been promising for some time now, most recently in What to Do About Keynesian Secular Stagnation, to discuss how the federal government could cut its expenditures. This is a vital goal that will cost us the economic health of the nation if we can not achieve it. It is an absolutely necessary and otherwise desirable objective for the following reasons.    

Why We Must Cut Government Expenditures

1. At the current time the U.S. national debt is approximately 100.5% of GDP as of the third quarter of 2015. As I have noted before, research by Carmen Reinhart and Kenneth Rogoff has shown that once a country’s sovereign debt reaches about 90% of GDP, the national government begins to compete with companies for available capital to such an extent, it actually causes GDP growth to be less than what it would otherwise have been. The government begins to crowd companies out of capital markets. In a paper published in American Economic Review, they concluded “Median growth rates for countries with public debt over roughly 90 percent of GDP are about one percent lower than otherwise; average (mean) growth rates are several percent lower.” With our national debt at more than 100% of GDP, we can increase our GDP growth by reducing the debt. As I will discuss later, this can only be done with reduced expenditures, not by increasing taxes.
2. Over the past half-century or so, the federal government has almost never paid off principal on the national debt. Instead, as the maturity dates for U.S. Treasury bonds arrived, the Treasury paid them off by selling other Treasury bonds; they rolled the debt over. This means the growth rate of the national debt is almost always exponential as interest on the debt is added to the debt’s principal to make a new, larger principal. This would happen even if we never again had a budget deficit. If in addition, budget deficits are added, the situation is made even worse. Cutting spending potentially helps in two ways: First, by reducing deficits and second by giving resources to pay off the debt.
3. This third point is considerably similar to the first one. In The Rahn Curve and the Way Out of Economic Peril, I was able to show a Rahn curve actually exists for the American economy. It is a plot of the economic growth rate versus government spending as a share of GDP, as in the model figure below.

   

   By using a scatter plot of points, one from each quarter from the first quarter of 1947 to the second quarter of 2015, of real GDP growth in percent versus total government expenditures as a fraction of GDP, I was able to produce the plot below.

   

   The government expenditures are the total of federal, state, and local spending, with the data provided by the Federal Reserve. One would not expect such data points to form a tight curve due to stochastic scattering due to expansionary booms and recessions. However, one can imagine fitting a straight line with negative slope through the middle of the points to get a straight line with the approximate equation of ΔGDP =  6.0 – 0.6(S_g – 27.5), where ΔGDP is the annual GDP growth rate in percent and S_g is the total government spending as a percent of GDP. Because it has a descending slope, this line must be on the descending branch of the U.S.’ Rahn curve, where government spending as a percent of GDP is larger than the optimal government spending for maximum GDP growth. To increase our economic growth rate we must reduce government spending as a share of GDP. In the post The Rahn Curve, Hauser’s Law, the Laffer Curve and Flat Taxes, I used this knowledge, together with the theoretical connection with the Laffer curve and the fact that federal tax receipts are always around 19.5% of GDP no matter what the tax rates, to suggest an optimal flat tax rate would be around 19.5%. At that rate we expect both the GDP growth rate and government revenues to be maximized. Presumably, the reason such a tax reduction would work this way would be because of the capital resources that would be released from government use  to more productive uses by companies, individuals, and households. If we want this desirable situation to continue stably, we should also cut expenditures at the same time we cut taxes to insure a growing national debt would not spoil the picture with increased interest payments.

4. Finally, government choices for “investments” have been legendarily bad. Occasionally, some government might make a good investment, but this is not generally the case. One often sees politicians making economic decisions for non-economic reasons. This includes supporting tax and regulatory benefits to crony capitalists to obtain their support. See also The Government Did It,  When Government Investment is Bad Investment, and Barack Obama Solyndra Scandal: 8 Facts About Green Energy Company Controversy. Valuable economic resources are wasted when government allocates them to projects that do not produce output needed by the economy. By cutting government expenditures, we would also reduce such economic waste and encourage politicians to direct more limited resources to what is absolutely needed.

The Cutting of Mandatory Social Spending – Social Security

Now the necessity of cutting government spending has been established, let us try to think of the best ways to go about just that. The discussion naturally divides itself into two pieces: one on mandatory or entitlement spending required by law, and a second part on discretionary spending. The mandatory spending programs – Social Security, Medicare, and Medicaid – are growing the fastest as a share of both the budget and of GDP, and are the biggest threats to the nation’s economy as the American population grows older. Discretionary spending must be renewed each year with the federal budget, but the entitlements are written into federal statutes with their spending increasing on auto-pilot. To properly discuss the cutting of discretionary spending programs, one would have cover a huge number of programs, most of which are small compared to the total budget. Covering the cutting of discretionary programs will require a very large amount of writing that I will differ to later posts! For the rest of this post and the next, I will concentrate on entitlement spending.

The first thing to note is how fast entitlement spending is increasing. As a share of GDP the three major entitlement programs of Social Security, Medicare, and Medicaid grew from 4.3% in 1971 to 10.1% in 2012 to approximately 14.3% now, according to usgovernmentspending.com. If you include welfare program spending, the total entitlement spending accounts for about 17% of GDP.

The usgovernment.com website gives us the following two charts of entitlement spending both as a fraction of GDP and as a fraction of the U.S. government budget versus time. The Heritage Foundation projects entitlement spending at 34% of GDP by 2035. However, this leaves out Obamacare, which should be an expensive and growing entitlement by then if it is not repealed. The Heritage Foundation probably also assumes a GDP growth rate of our longterm average of over 3%. If we have entered an age of secular stagnation with a long term average GDP growth of 2%, the entitlement crisis will hit far, far sooner.

These are very large and alarming statistics! Let us speculate the U.S. electorate decides to not allow the national debt to increase further and to pay for these entitlement increases by increasing taxes. If entitlement spending changes from 14% of GDP now to 34% in 2035, an increase of 20%, and federal spending is roughly about 20% of GDP now according to the Federal Reserve, then somehow the federal government will have to capture at least 40% of the GDP by taxes by 2035! Since Hauser’s law tells us the U.S. has netted an average of roughly 19% of GDP every year in revenues, this says something very traumatic would have to happen to get the extra 21% or more. In that situation, how much will be left for households to consume and for companies to invest? According to the Federal Reserve, U.S. companies invested at the historically low rate of about 17% of GDP during 2015. Personal consumption expenditures on the other hand have been about 68% of GDP in recent years. Personal consumption plus corporate investments currently sum to 85% of GDP. If entitlements alone take up about 34% of GDP by 2035, investments and personal consumption will have to suffer big decreases. After all, all the rest of the government will have to be funded as well. Both as a matter of funding through taxes and as a matter about consumption levels, it would seem to be much less painful for the nation to decrease mandatory expenditures.

Having just touched the third rail of politics and unlike a politician surviving, I will continue this discussion in my very next post.

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