Build Back Better: Build Debt Higher

The massive spending plan that Congress passed on Friday is not only an open ideological effort to advance socialism by means of expanded economic redistribution, but it is also a fiscal hand grenade thrown right into the federal government’s finances.

For this reason, I predict that the Build Back Better Act will be the beginning of the end of America’s era of big government.

For sure, a lot must go right for that to happen, but ironically the BBBA has actually laid out the landscape for the demise of the very welfare state that it seeks to expand.

The reason for this lies in the items of the bill that increase economic redistribution, primarily

  • the extension of the expanded child tax credit and its transformation into a fully refundable – in other words cash paying – tax-credit program;
  • the extension of the expanded Earned Income Tax Credit; and
  • more spending on low-income housing.

The annual costs of these items are not entirely clear, but according to at least one estimate we are looking at approximately $120 billion per year. However, it is almost a natural law that initial cost estimates for new and expanded entitlement programs under-estimate their cost. The classic examples are Social Security, the tax of which was raised 20 times by Congress in the 40 years from 1950 to 1990, and Lyndon Johnson’s War on Poverty, which caused the perennial budget deficit that is responsible for a large part of our $28.9 trillion pile of debt.

With that in mind, it is worth noting that an estimate by economists the University of Pennsylvania Wharton School points to the BBBA adding as much as $270 billion per year over a ten-year period. Their estimate is based on the realistic premise that all the temporary entitlement expansion are made permanent. What it does not seem to take into account, however, is the depressing effect on economic growth from a welfare state that exceeds 40 percent of GDP. With these new programs, the U.S. economy is slated to permanently cross that line.

As I show in Industrial Poverty with my own estimates, and with citing other studies, the 40-percent threshold is statistically well established. When the package of entitlement programs we know as the welfare state consume more than 40 cents of every dollar of GDP, the combined effect of

  • the taxes funding those programs, and
  • the disincentives toward workforce participation and career development that come with those programs,

depresses growth enough to bring an economy down into de facto perennial stagnation.

In practice, this means that makes itself unaffordable. It creates a permanent budget deficit that only widens with time. In the case of the U.S. economy, this budget deficit already exists – I discussed the reasons for this in my ebook Tax Cuts Don’t Work – and the welfare-state expansion that comes with the BBBA will drastically grow this structural government over-spending. Given how close we are to a fiscal crisis, this expansion will quickly push us to the brink.

In addition to the deficit expansion that Congress itself drives with its new spending programs, there is going to be mounting pressure in the opposite direction from the Federal Reserve. Their decision last week to start early with their tapering of U.S. debt purchases is both a tangible fiscal variable to take seriously, and a policy signal to Congress that they better start actively trying to reduce their budget deficit.

Congress, on the other hand, can’t have it both ways. They cannot balance the budget while maintaining and even expanding entitlement spending, and they cannot keep funding a large deficit without support from the Federal Reserve. Any attempt to force the Fed into compliance will be met with heavy resistance from the sovereign-debt market: the announcement that the central bank will start its debt-purchase tapering already in November has been received positively by Treasury investors. On Wednesday, when the Federal Reserve announced its new monetary policy,

  • The 30-year bond paid 2.00 percent per year;
  • The 20-year bond stood at 2.01 percent;
  • The 10-year note yielded 1.60 percent; and
  • The 7-year came with 1.46 percent.

After falling on Thursday and Friday, today on Monday Nov. 8 the yields are as follows:

  • 30-year: 1.89 percent;
  • 20-year: 1.91 percent;
  • 10-year: 1.51 percent; and
  • 7-year: 1.38 percent.

Any return to quantitative easing of any kind will be met negatively, i.e., with rising interest rates. This means, in turn, that the White House no longer has a choice: it must keep the Fed’s monetary policy leadership – its Federal Open Market Committee – largely intact. They may appoint an FOMC member who is more favorably positioned in terms of quantitative easing than the majority, but there will be no upsetting shift in the composition of the committee.

With the Federal Reserve gradually pulling out of the U.S. Treasury market, the deficit-spending majority in Congress (which, notably, is bipartisan) is now left to fend for itself. It will have to take its case for endless trillion-dollar budget deficits to investors that operate on a global scale; without the central bank as the default buyer, any attempt to sell virtually unlimited debt to the world will inevitably lead to an interest-rate shock and likely credit downgrades for the U.S. government. This, in turn, will send the cost of the debt skyrocketing, but we might not even get there before we hit the trigger point for a fiscal crisis.

As the door slams shut on deficit monetization, Congress is left with only one option: to reform away as much of its entitlement obligations as it can. This will take a structural redesign of the entire welfare state; as I explained in Tax Cuts Don’t Work, a penny-plan approach only delays the fiscal crisis, but will not stop it. The reason is to be found in the very fiscal design of our entitlement programs:

  • The cost of a program that pays out cash to people or provides them with a service based on their income, is determined by the nature of the benefit and the threshold for eligibility;
  • The tax revenue that pays for the entitlement program is determined by the tax rate and the size of the income from which the tax is paid.

Plainly, in order to balance the budget Congress must hope that the cost of the entitlements they have promised the American people – or selected segments thereof – grows no faster than aggregate personal income (which currently funds 80 percent of all federal tax revenue). The conundrum can be expressed as follows:

where:

  • E is the set of variables that define the entitlement program, namely who is eligible and what they are entitled to;
  • B is the amount of benefits paid out in cash or provided in kind;
  • T is the total amount of tax revenue collected for the purposes of funding B; and
  • Y is the tax base.

To make the equation work, E must never rise faster than Y. Is that possible? No. Let’s look at some graphs to see why. First, Figure 1, which illustrates the cost of benefits rising along a red function; the slope is determined by E, in other words the terms on which Congress will have to put more money into the program to keep its entitlement promises. The dark green “wave” function is the regular business cycle with which Y rises and falls. The dashed dark green function is the long-term average trend of tax revenue.

Figure 1

Figure 1 illustrates the normal relationship between tax revenue and the entitlements it is supposed to pay for. This is why we have a structural deficit in the federal budget, in other words a deficit that does not go away over one business cycle.

What, then, can Congress do about this situation? The option often heard in the debate – as often as proposals for spending reform are heard – is to follow the so-called penny plan. Its principle is simple, though its nuance tends to vary depending on who propose it. Basically, the plan says that Congress should cut one percent of the budget for all entitlement programs every year for ten years, and then let them revert back to normal again.

The problem with this plan is that the entitlements that constitute the program do not change. For example, Medicaid still promises the same package of health benefits to its enrollees under the penny plan as it does before the plan is implemented. The cost of those benefits is not determined by what Congress can afford, but by the overall cost of providing health care; the “E” in Medicaid changes with the cost of medical staff, the production and distribution costs of medical technology, etc. Over time, those costs increase because the science of medicine becomes better and better at curing more and more advanced health conditions. To keep up with those costs, Congress will have to increase the “B” of Medicaid on a regular basis.

Proponents of the penny plan sometimes point out that entitlements are run inefficiently, that the bureaucracy around Social Security, Medicare, Medicaid, TANF, WIC, SNAP, the EITC, etc., can be reduced without impacting benefits. This is true to some extent, but bureaucracy costs usually represent only a few percent of the cost of the programs. The big option for reduction is in the entitlements themselves.

The costs of other programs, such as the Earned Income Tax Credit or even Social Security, are determined by income-eligibility variables. The EITC pays out a refundable tax credit to people making up to a specified threshold; the “B” in Social Security is defined by the beneficiary’s income history. In neither case is the growth of the benefit related to the growth of the tax base. Therefore, the scenario in Figure 2 is possible if, and only if, Congress consistently – and increasingly – defaults on its promises to the eligible population:

Figure 2

Do tax hikes work? In a situation with a structural budget deficit caused by excessive entitlement spending, tax hikes are, to wit, even worse than tax cuts. For two reasons, Congress would have to repeat them over and over again:

  1. The structural imbalance between B and T in Figure 1 means that one tax hike will only temporarily close the gap; the long-term growth trajectories of benefits and tax revenue remain unchanged;
  2. Higher taxes make business activity, workforce participation and household spending more costly; the long-term trajectory for tax revenue actually flattens over time.

Taken together, these points tell us that if we try to close the structural deficit with higher taxes, we will have to not only raise taxes repeatedly, but raise them more each time we try. As we do, we create a need for even larger tax hikes in the future:

Figure 3

There is only one way to solve the deficit problem in a modern, socialist welfare state: to structurally reform away the socialist welfare state. Back in 2012 I collected a set of papers explaining how this can be done; since then the need for structural spending reform has only grown bigger.

It sounds daunting to suggest that Congress might actually resort to reforms that permanently reduced the size of government and even got it out of the business of economic redistribution. However, with the Fed standing firm against more deficit monetization, and with increasingly alarming warning signs of higher inflation, I am cautiously optimistic that Congress will get its act together. It won’t happen now, but it might actually happen after next year’s election.

The only question is: will that be soon enough?