Structural Spending Reform, Part 3

In Part 2 we discussed reactive spending cuts, which include the Penny Plan and traditional European austerity. We concluded that this type of spending reform defeats its own purpose: it does not solve the underlying problems causing a structural budget deficit. The reform type does not incentivize economic growth, but instead contradicts it by keeping government expensive over time, while eroding its benefits.

Today we will dive into the alternative reform type: proactive spending cuts. This type is almost unheard of in reality, and there is scant literature – if any – explaining either its theory or its practice. The closest real-world example is the Dutch health-insurance reform: in 2005, the year before the reform went into effect, government paid for two thirds of all health care in the Netherlands; in 2007, the year after the reform went into effect, the proportions were reversed.

As of 2017, the latest year with available data, the private share was three quarters. This is higher than in America.

A coming article will examine the Dutch reform in detail; for now, let us lay out the principles for proactive spending reform. Before we do, though, let us notice that this reform type is associated with some significant political and policy challenges. We can overcome those – in fact, we must. Proactive reform is the only way to secure the fiscal sustainability of our government. However, the challenges are not be under-estimated, and will be discussed in articles on specific reform proposals: health insurance, Social Security and income security.

In Part 2 we noted that entitlement spending, which accounts for two thirds of all federal government spending and more than half of state and local government spending, is defined in principle by a simple equation. Spending, GE, is determined by the share of the population, e, that is eligible for the entitlement program, and the amount they get in benefits, B:

Benefits, in turn, are determined by the value of those benefits, b, as share of household income, Y:

The problem with these two equations is that they define a trajectory of perpetual increase in government spending. The key element of proactive spending reform is to break this trajectory and point government spending in a new, fiscally sustainable direction.

There is a technical and a theoretical component to this reform. First, the technical component, which consists of severing the tie between b and Y in the equation above. We replace the bY variable with a fixed B:

Each eligible individual now gets a fixed amount of benefits. That amount is independent of household income; as a ratio of household income, it declines over time.

From a theoretical viewpoint, this reform requires a more substantial change than its technical representation may suggest. The key is to redefine the formula by which we estimate poverty: today our definition of what it means to be poor is relative, with the poverty limit largely tracking median household income. This has absurd consequences, primarily that a thriving economy cannot reduce poverty. On the contrary, the population defined as poor can actually increase, even though employment is high and household income is rising.

The reason is, again, that poverty is defined as a percentage of median household income:

  1. If median income is $50,000 and the poverty limit is 55 percent of that, then you are poor if you make $27,500;
  2. If median income rises to $55,000, then the poverty limit rises to $28,250.

You are now better off being poor than you were before. As a result, the amount of entitlement spending has to rise, as per the definition of B above.

To decouple B from Y, we need to replace the relative definition of poverty with an absolute definition. This is represented by the third equation above, where entitlement benefits are capped and kept constant.

Before the War on Poverty, the federal government used an absolute definition of poverty. It constituted the foundation for the welfare-program reforms under the Social Security Act of 1934. Figure 1a sketches the idea behind a return to this reform. The present trajectory in government spending (1) will continue unchanged (2) if no reform is made. If the definition of poverty is changed from relative to absolute (A) the trajectory of entitlement spending will change radically (3):

Figure 1a

But wait: doesn’t this look a lot like a Penny Plan in practice?

Superficially, yes, it does. However, Figure 1a only tells half the story of a proactive spending reform. There is another side to the equation, namely the funding of the welfare state. However, before we get to the taxes, let us also note that this is just the fiscal schematics of a proactive reform; its execution within each entitlement program will bring far more difference than is laid out here. Those details will come in subsequent articles.

One more point before we get to the tax side: let us not forget the purpose behind proactive spending reform. The reactive type aims to make the welfare state more affordable – it does not seek to eliminate the welfare state. Therefore, government promises remain on the shoulders of the taxpayers, whose duty it is to work harder and harder over time to foot the bill.

A proactive reform seeks to permanently alleviate the burden on taxpayers.

Speaking of which, if the proactive reform is going to work as intended – in other words to roll back the welfare state – it must include reforms that alleviate the burden on taxpayers. In other words, tax cuts, but not just any tax cuts.

Today, the welfare state is paid for with tax revenue that rise and fall with GDP and, more specifically, personal income. Let TE be total tax revenue paying for the welfare state. Let t be the aggregate tax rate – how large a share we all pay in taxes combined – and let Y, again, be household income:

If we leave taxes alone, the burden will rise not only with income, but also relative welfare-state spending after the reform in Figure 1a. In other words, we have to combine the reform that changes the spending trajectory with a reform that caps taxes on par with spending:

Let us now plot the tax-revenue trajectory together with spending from Figure 1a. We assume that we have a structural budget deficit, represented by the vertical difference between the red (spending) and blue (tax revenue) functions.

With points 1, 2, 3 and A being the same as before, we now have tax revenue originally growing parallel to, but numerically below spending (4). If no reform takes place, it continues upward (5). However, suppose we combine spending reform (A) with tax reform (B). Revenue now veers off (6) to eventually catch up with the news spending trajectory:

Figure 1b

What type of tax reform would produce this result? It would take a reform that shifts from a tax that is proportionate to economic activity – be it income or consumption – to a tax that is proportionate to expected spending. Denoting this spending variable with *, we set the tax rate to:

Expected spending, in turn, is determined by spending in the past – say one year – and a forecast for spending in the coming year:

Since economists are notoriously bad at forecasting, it is reasonable to balance the forecast against past experience.

An important consequence of defining the welfare-state funding tax in this way, is that the tax rate will change with spending. Increases in spending will immediately translate into higher taxes, and vice versa. This has one important effect: as incomes grow and entitlement spending remains constant, the tax burden will gradually decrease.

As the tax burden declines, the private sector gradually gets more room to spend, invest, create jobs and build wealth. Over time, this keeps the economy on a path where demand for government entitlements will not only be a lighter burden at a constant rate of eligibility, e, but where the population needing government assistance will gradually decline.

Now: how do we put this proactive type of spending reform to work? The answer begins with Part 4!

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