Tagged: The Welfare State

Tax Cuts or Spending Cuts: Part 1

There are some very good organizations out there fighting to keep taxes down. Americans for Tax Reform is at the forefront, with others not far behind. They all fight the good fight: it is always preferable to have lower taxes than higher taxes.

Many economists propose tax cuts as a way to reduce the budget deficit. The idea, known as supply-side economics, is based on the premise that lower taxes generate stronger economic growth, which in turn generates more tax revenue.

Supply side economics is a valid theory and the Laffer Curve – almost the hallmark of supply-side theory – has strong empirical support. I recently published an article where I reported data for the European economy, showing a solid Laffer effect on tax revenue. However, I also cautioned:

There is another side to the Laffer Curve, of course. If government does not cut spending in tandem with the tax cuts, but if entitlement programs are allowed to continue to grow, then the rise in revenue collections will be inadequate and fail to fully fund the welfare state. Therefore, the Laffer Curve must not be used as a simple go-to solution when deficits get out of hand; it is an instrument that should only be applied as part of a structural transition from a big welfare state to a small government focused on its core functions.

Once the welfare state grows past a certain point, the Laffer effect, while still visible, will be far too weak to close deficit gaps. Plain and simple, the supply-side mechanism ceases to function insofar as the government budget goes. Tax cuts still generate more economic growth and thereby an increase in tax revenue, but without adequately affecting the government budget.

The reason is as simple as it is brutal: too much spending. Having grown increasingly frustrated with the lack of focused attention to the spending side among libertarians and conservatives, in the next few days I will be rolling out a series of articles on the dynamics between tax cuts and spending cuts.

While fiscal conservatives do pay attention to spending, it is almost always in an ad-hoc manner. A common idea for reform is a penny-plan style reform that slows the growth of government spending. This is not a bad idea in and of itself, but as we will see in a coming article it does not solve the underlying structural problems that drive government spending. A penny-plan style spending reform buys us time, slowing the growth of government enough to let Congress piece together a major entitlement reform agenda.

What we need is a master plan for the structural overhaul of our welfare state. We need to reform it away until government is out of the business of economic redistribution.

This is no easy task. It is in fact more daunting than it was back in the 1960s putting the first man on the moon. That, however, is no excuse not to do it. Leaving an unaffordable welfare state for our children to pay for, and asking them to do so while also funding our consumption of the welfare state in the form of a big government debt, is nothing short of collective egoism.

It is also a safe way to ruin the country and the future of generations of Americans.

To see why the master plan is the way to go, and supply-side economics no longer works, we will work our way through a stack of data. We start today with a review of state and local government finances. Specifically, the review will show that the absence of an income tax does not help in terms of containing government spending. Bluntly: states with no income tax have just as big governments as states where income taxes provide a large share of government revenue.

As a first step, Figure 1 reports the combined fiscal balance for general revenue and expenditure for 2018 in all the 50 states. The vertical axis represents the difference between general revenue and general spending as percent of general revenue. This metric varies from year to year, with the majority of states swinging between surplus and deficit. However, the picture is almost always mixed, as reported here:

Figure 1: State and local government fiscal balances

Source of raw data: Census Bureau

Over the long term, states and local governments have had about the same problem with balancing their books as the federal government has. The deficit problem is not as pervasive, but there are years when almost all of them run deficits.

It is important to remember that these numbers include both states and local governments; the local-government share of spending varies significantly across state lines. In other words, to ignore local governments would be to give an unfair, even skewed representation of the role of government in our states’ economies.

Most of our government spending is allocated to the welfare state, i.e., programs that provide government benefits to people for the purposes of economic redistribution.* Two thirds of federal spending is for the welfare state; in 2018 the average for states and local governments was 56 percent. This share has increased over time, slowly increasing the stress on government finances. A spending program for economic redistribution is driven not by what taxpayers can afford, but by the definition of the entitlement embedded in the program. Medicaid, e.g., provides health care to its enrollees, giving them access to a portfolio of medical services the quality of which is defined by medical technology, and the quantity by patient health conditions.

I have discussed the discrepancy between health-care costs and tax revenue in a previous article. The same principle of independent cost hikes applies to education, income-security programs, housing and everything else provided under the welfare state.

This point is almost universally overlooked in the fiscal-conservative movement. Too much focus is no tax reform, specifically to keep taxes as low as possible. While, again, a respectable ambition in itself, it does not help with containing the growth of government. For example, if a state eliminates its income tax, it will most certainly not reduce the size of its government. Again based on 2018 Census Bureau data on state and local government finances,

-In the nine states where the personal income tax contributes 0-1 percent of total revenue, government spending amounted to 21.9 percent of total private-sector economic activity, a.k.a., private-sector GDP;

-In the 12 states where the personal income tax provided more than 15 percent of total revenue, government spending was equal to 21.2 percent of private-sector GDP.

The 29 states in between had roughly similar-sized governments. In other words, it does not help fiscal conservatism to abolish the personal income tax.

But does it harm fiscal conservatism to do so? That question is not primarily a matter of economic analysis, but there is one point that can contribute to the answer. Table 1 reports the revenue share of the personal income tax (Typ) and the revenue share from non-tax sources:

Table 1: Government revenue sources

Source of raw data: Census Bureau

In short: when governments cannot rely on the income tax they seek out other revenue sources instead. To take one of the favorite examples among opponents to the income tax, in 2018 government in Wyoming got 75 percent of its revenue from non-tax sources. This is the highest share in the country. Contrast this to Connecticut, where the personal income tax provided 22.3 percent of total government revenue and non-tax sources added one third of total revenue.

Government spending as share of private-sector GDP was 16.6 percent in Connecticut – and 29.9 percent in Wyoming. In other words, the supposedly low-taxed Cowboy State has the fourth largest government in the country. And this is a reasonably generous measure: if we use private personal income instead – the most proper tax base measure available – Wyoming has consistently ranked in the top two in the country.

However, more important than these factoids is the problem with political effort. It takes a lot of work to advance policy reform – spending of political influence capital – which means that every such effort must be designed to yield the best possible outcome. If we use proper metrics for that outcome (rolling back the welfare state) then it is unquestionably better to focus on spending reform instead of tax reform.

In Part 2 of this series we take a detailed look at why supply-side tax cuts are no longer effective, and why spending reform is the only way forward.


*) This category of spending includes social programs, income maintenance, health care, unemployment benefits, housing and community development and education. The last item is often overlooked, but regardless of whether or not one defines education as an essential government service, it does belong in the redistribution category. Government provides the service based on criteria defined by government, not decisions made by individuals; funding is also independent of the use of the service.

Reform Spending, Not Taxes!

In my latest op-ed for InsideSources I explain:

While the Democrat House leadership touts a very irresponsible plan for even more COVID-19 stimulus spending, the White House is signaling its equally irresponsible alternative. In an October 6 op-ed for the Wall Street Journal, Steve Moore, a member of President Trump’s economic recovery task force, proposes a 100 percent suspension of all federal personal and corporate income taxes for 2021.

Moore’s crazy idea is to simply suspend federal income-tax collections for 2021. In response, the U.S. Treasury would have to borrow $2 trillion from the Federal Reserve, on top of what the central bank is already supplying to fund the welfare state.

Moore, whom I know and who is a good and enthusiastic economist, seems to be unfettered by this increased practice of Mad Monetary Theory in Washington. To his credit, though, he has produced the same idea for abolishing the income tax in another context. Here is what Moore said back in July:

Stephen Moore, a member of President Trump’s economic recovery task force and an economist at FreedomWorks, has a bold idea for how to reinvigorate the economy: abolish the federal income tax, and replace it with a national sales tax. On the face of it, it may seem like a radical notion especially since essentially all Americans nowadays have grown up having a chunk of their income pulled out by the IRS every year. But Moore notes that the income tax is a relatively new invention in the U.S. — having only been introduced in the early 20th century.

This idea has been on the table for a long time. It has been called many things and is sometimes referred to as a “fair tax” reform.

Moore is right in that a sales tax is preferable to an income tax, and all other things equal this is a good reform to pursue. The problem is that all other things are not equal – especially not government spending. Right now, we need spending reform more than we need tax reform.

Take a look at Figure 1. It reports the shares of total government spending in the United States, federal, state and local added together. The numbers are the “rawest” you can get, with no adjustment for inflation or seasons. The message is unmistakable:

Figure 1: Shares of total government spending

Source: Bureau of Economic Analysis

Ever since the 1960s, government consumption has declined in importance. This is the kind of spending that goes to national defense, law enforcement, education, infrastructure and other outlays where a person is paid to do work for government (including on a contracting basis). In the past decade, social benefits – cash paid out under entitlement programs – has surpassed consumption as the most important function of government.

A point of order, before we move on: some consumption spending also qualifies as entitlements. For example, when government pays for health-care services through Medicare and Medicaid, it provides medical-service entitlements. We also refer to them as “in-kind entitlements”. This is a small but important note, because it helps us understand what is happening behind the numbers in Figure 1.

Before we get down into those details, let us first take a closer look at the same numbers for the federal government:

Figure 2: Shares of federal government spending

Source: Bureau of Economic Analysis

The trend from Figure 1 is even stronger here: social benefits overtake consumption already in the 1970s. Before the stimulus spending in 2020, this type of spending was already claiming more than half of the federal budget.

Which brings us back to the point about entitlements. Again, social benefits are one entitlement type – cash entitlements – but some consumption also falls in the entitlement category. Health care and education stand in the forefront, but any consumption (also known as “government services”) that is not for national defense, law enforcement and infrastructure qualifies as in-kind entitlement.

If we add up cash and in-kind entitlements, we get the welfare state. Its share of the federal budget was around two thirds before the Covid-19 stimulus craze. It remains to be seen what it will be going forward, but it is a rather safe bet that it will be higher.

Herein lies the real problem with spending: entitlements grow not because Congress keeps adding money, but because of their design. Each entitlement specifies an eligible population and how much they are entitled to. This is the entitlement value of the program, and it grows for two reasons:

  1. The eligible population grows;
  2. The product offered to them changes in character.

The second point sounds abstract, but its actual meaning is simple. In terms of services, the entitlement program promises the eligible population a portfolio of benefits with the explicit or implied promise that those benefits will be of a certain quality over time. In health care, this means that entitlement spending must grow with the rising cost of high-quality health care.

For cash entitlements, the cost driver is partly in the protection of the benefits against inflation. However, there is also the eligibility threshold: one example is the Earned Income Tax Credit, which tapers off with rising income but also expands its reach as its thresholds increase.

In short: once Congress has designed an entitlement program, it gives up control over its cost drivers. It can claim that control again, but it takes legislative action. One such action would be to bring entitlement spending out of the “permanent” section of the federal budget and into the “discretionary” fold. It is only an administrative maneuver and won’t make any difference in itself to the costs of the program, but it is the one step Congress needs to take in order to be able to reform entitlements.

Once that practical problem has been solved, Congress can move on to the next step, namely reforming the programs themselves.

How do they do that? Here is some food for thought to start with.

Stagnant Economy Kills Retirement

Over the past 20 years our economy has been growing more slowly than it did during the 20th century. We went through two presidential terms under Obama without a single calendar year with three percent growth. In his first term, Trump has presided over a modestly better economy, thanks in no small part to his tax cuts and his deregulation policy, but we still have barely touched three percent.

The source of our slow growth is to be found in the welfare state. This big conglomerate of economic redistribution puts mechanisms to work in the economy that slowly grind it to a halt. I explained those mechanisms in my book Industrial Poverty and I discussed them further in my book The Rise of Big Government.

Slow economic growth claims many casualties. One of them is, of course, the welfare state itself, the entitlement systems of which are slowly starved to the brink of implosion as tax revenue dries up. Europe is painfully aware of what this means; here in America we have seen the first glimpses of this phenomenon in the massive money printing that the Federal Reserve has engaged in from time to time over the past two decades.

Another casualty is our children’s prosperity. As I explain in Industrial Poverty, a country that is brought into economic stagnation by its welfare state will suffer from high, permanent youth unemployment. It will be so high that the young generation is effectively barred from ever obtaining a higher standard of living than the generation of its parents. More than likely, every generation will grow up to be slightly poorer than its parents were.

This economic regress takes many forms. One of the less explored is the slow demise of retirement security. It is well known that Social Security is one of the big casualties of our emerging economic stagnation. As I explained in Ending the Welfare State, we can still save retirement security from the Social Security collapse, and the solution – an algorithm-driven transition into private accounts – could serve as a platform for saving another stagnation casualty.

Private retirement saving.

Americans continue to rely to a large degree on private savings accounts. This is good, because it gives people a certain level of independence from government fiscal excesses, but those savings are not immune to economic stagnation. All other things equal, private retirement savings depend on the long-term growth in personal income. That growth, in turn, is closely tied to the growth rate of Gross Domestic Product.

Pension systems – government or private – are never better than the balance between contributions and benefits. The original pension-system form where retirees relied on defined benefits are the most vulnerable to the long-term slowdown in economic growth, but the alternative, also known as defined-contribution plans, is also vulnerable. The reason is in the difference between the plans:

  • Under a defined-benefit plan the implicit assumption is that discrepancies between benefits and contributions are solved by means of changes to contributions (higher fees, simply);
  • A defined-contribution plan is supposed lower benefits to weather cash-flow crunches.

In reality, the maneuverability of either plan is limited. The defined-benefit plan can only raise its fees within the realm of what people can spare out of their current paychecks. The defined-contribution plan cannot lower its benefits more than what people will tolerate without pulling their money out. Nevertheless, the prospect of fixed fees and some variation in benefits has slowly increased the attractiveness of defined-contribution plans. As Figure 1 reports, over the past decades this plan type has slowly gained ground on the defined-benefit alternative:

Figure 1: Source of retirement benefits by plan type

Source of raw data: Bureau of Economic Analysis

Despite the shift toward defined-contribution plans, our retirement systems are slowly sinking into a cash-flow squeeze. The rise of the defined-contribution alternative has slowed this trend, but it has not stopped it. As Figure 2 reports, those plans are also fighting a losing battle against economic stagnation. The cash flow reported in this figure is simply the margin between, on the one hand, actual employer and household contributions plus the plan’s earnings on assets, and on the other hand benefit payments, withdrawals and administrative expenses. The net, which is the cash flow surplus, is reported as a percentage of total plan revenue:

Figure 2: Pension-plan cash flow

Source of raw data: Bureau of Economic Analysis

In addition to the slow cash-flow decline, the urgent message in Figure 2 is the plunge of defined-benefit plans into negative territory. They pay out more than they take in, simply. This means, plainly and brutally, that we are already in a situation where our retirement system is degrading.

We hear a lot about how our pension-plan problems are allocated to government. This is correct, and as Figure 3 demonstrates, state and local governments are seeing their defined-contribution plans bleed cash. However, what is often overlooked is the precarious situation for the defined-benefit plans in the private sector:

Figure 3: Cash flow balance in defined-benefit plans

Source of raw data: Bureau of Economic Analysis

To some degree the deterioration of defined-benefit plans in the private sector could be the result of withdrawals to invest in defined-contribution plans. As we saw earlier, those have grown in prominence and are now responsible for almost half of all benefits paid out. However, as Figure 2 told us, even that type of plan is in financial decline.

To get another perspective on the problems with the private plans, consider Figure 4 which reports the cash-flow deficit in defined-benefit plans as share of total employee compensation for the private sector. The red columns represent the rise in fees needed each year to avoid the negative cash flow:

Figure 4: Cash Flow and Employee Compensation

Source of raw data: Bureau of Economic Analysis

Over the past ten years, owners of private defined-benefit plans would have had to surrender almost one extra percent of their employee compensation – or about 1.2 percent out of their wages and salaries – to avoid the negative cash flow. This does not sound like much, but it is only to keep the defined-pension plans afloat. We have not even taken into account what we would have to do to stop the deterioration of defined-contribution plans.

Then, of course, we have the state and local government plans, plus Social Security. Adding up all these plans, we as a nation face a retirement-funding crisis that is being exacerbated by our inability to get the economy back to higher rates of growth.

That, in turn, is a problem caused by our ideological commitment to a fiscally unsustainable welfare state.

We as a nation have a lot of work to do.

Covid-19 and Medicaid for All, Part 1

The Covid-19 epidemic has given the world a good opportunity to study the quality of health care systems. We often hear from proponents of single-payer systems that we would get so much better health care if we just handed it all over to government.

Experience from this epidemic says otherwise. On the contrary, Europe, which is saturated with government-run health care systems, has struggled quite a bit with the epidemic. At the forefront of their problems has been a shortage of hospital beds.

Before we get there, though, we first need to take a quick look at the U.S. system. Thankfully, we don’t have a Medicaid-for-All system, but politically we are closer to it than most people realize. We are in fact hanging on the precipice of it, which makes the recent European experiences so much more important. There are few people remaining on the right side of the political aisle who are willing to fight back against the Medicaid-for-All movement. Outside of the Republican Study Committee, whose report last year presented a great plan for strengthening free-market health care, there is not too much happening among conservatives and libertarians.

This is strange and tragic. A Medicaid-for-All system is the crown jewel of the socialist welfare state, and since the libertarian movement has essentially surrendered on the welfare state in general, it lacks the ideological prowess to fight back on the Medicaid-for-All issue.

The lack of interest in fighting socialism in practice – the welfare state – is clearly noticeable across the libertarian movement. Their own party and presidential candidate barely even pay token interest to the welfare state. Worse still, America’s leading libertarian think tanks only use about ten percent of their resources to the fight against socialism in practice:

  • The Cato Institute reports 67 experts on their website; six of those can be said to be working with issues even tangentially related to the welfare state and its systemic impact on the U.S. economy;
  • American Institute for Economic Research, with its 63 experts, has four or five that touch the welfare state in their work (depending on how thin you want to stretch the definition);
  • The Reason Foundation, proudly libertarian since 1968, boasts no more than three welfare-state interested individuals among its 32-strong expert crew;
  • The Mercatus Center, the think tank at George Mason University, has practically enrolled the entire economics-department faculty among its 60 scholars, yet they still cannot find more than five whose research interests even affiliate with the welfare state.

The Heritage Foundation is the strongest institution in this respect. They have the Grover Hermann Center, which is dedicated to the study of the federal budget. In total, spread across all their departments, the Heritage Foundation has 12 welfare-state oriented experts, out of 96. Still spending only a small minority of their resources on the most critical problem of our time, Heritage nevertheless leads the libertarian movement in that regard.

With this scant attention to the practice of socialism in general, there is very little in the libertarian movement that can stop a Medicaid-for-All program. This leaves the field essentially open to the neoconservatives within the Republican party (who want a single-payer system because Irving Kristol said so) and the socialist left. Our hope lies with the aforementioned RSC report and its appeal to more conservatively minded Republicans.

Hopefully, they can find some strength in the numbers presented below. It looks increasingly as if private health-care funding is instrumental in protecting public health. This is not surprising, given that government-run health care systems suffer from two deficiencies, the first of which is its reliance on taxes for funding. By virtue of advancements in medical skills and health-care technology, the cost of providing health care goes up over time. In other words, just to keep health care quality intact, medical professionals need to raise prices over time.

This tendency, in turn, is countered by market forces. He who does more with less will always win over less productive competitors. Only a market-based health care system can strike a proper balance between the rise in costs due to quality advancements and the competition-driven decline in prices.

As an example of what this means, the health-care share of our economy (our GDP) has increased over time: looking at medical technology alone – disregarding for now all other components of health care expenditures – it was 1.3 percent of our GDP in 1980. In 2017, the latest year for which the Department of Health and Human Services publishes comprehensive data, that share is more than twice as high at 2.9 percent.

How would a single-payer system handle this? Since it lacks a countervailing force to the cost drive from quality advancements, and since health-care costs evolve independently of what taxpayers can afford, the only choices for a single-payer government are to raise taxes constantly, or ration health care access.

If we had operated a Medicaid-for-All single payer system, and if Congress had been wise enough not to raise taxes, we would have been forced to keep the med-tech share of our health care costs constant. We would therefore have had to forfeit advances in medical technology – or raise taxes.

But what is a tiny share of our economy like this one to quarrel about? As a general point, this is a valid question, of course. As share of GDP, spending on medical technology looks like chump change. However, looking at it as a market within the economy, medical technology actually translates into significant numbers. In 2017 we spent a total of $569 billion on medical technology. This includes durable technical instruments, non-durable instruments, prescription drugs, health-care facilities and the medical equipment needed for them to be operational.

If we had kept the med-tech share of GDP constant, from 1980 to 2017 we as a nation would have been limited to spending only $267.4 billion on medical technology. This would have meant a loss of more than $301 billion worth of instruments, equipment, clinics, hospitals and pharmaceutical products.

Such rationing would have had serious consequences for health care access. For every $1 million we reduce spending on medical technology, we have to make proportionate reductions in staffing. Over time, this kind of rationing has serious cumulative effects: as a thought experiment, consider what the effects would be if we removed 53 percent of all health-care spending in our country.

Another key question is, of course, what incentives entrepreneurs would have had to develop new technology for our health care system. To stick with the time horizon from 1980 and on, where would our health care have been today in terms of quality and ability to cure and heal?

Proponents of health care socialism often bring up administration as the holy grail of cost reductions. What they forget is that the decisions being made by administrators in today’s systems also must be made under a single-payer system. Hospitals and clinics still need to file claims for every procedure; someone needs to evaluate every claim; someone needs to process every claim; someone needs to cut the checks and send them out to the health care provider.

Someone still needs to keep track of supplies, order supplies, pay for them, make sure deliveries were according to specifications, distribute the supplies within the hospital… Human resources staff still need to make sure there are enough doctors, nurses, midwives, cleaning staff, procurement staff, computer experts and other employees throughout the health care system.

And someone still needs to evaluate the health care procedures to make sure that resources are not being wasted. For a glimpse of what this means under a government-run system, see the chapter on fiscal eugenics in my book The Rise of Big Government.

Table 1 explains the components of health-care costs (billions of dollars) in 2017, for the nation’s entire health care system.

Health Care Cost BreakdownUS$ billion
National Health Care Expenditures       3,492.1
Of which:
Hospital operations       1,142.6
Physician and clinical expenditures          694.3
Dental services          129.1
Other health-care professionals            96.6
Home health care            97.0
Non-durable medical products            64.1
Prescription drugs          333.4
Durable medical products            54.4
Nursing, continuing care          166.3
Other health care          183.1
Administration, net insurance costs          274.5
Public health activity            88.9
Research            50.7
Structures and equipment          116.9
Source: U.S. Department of Health and Human Services

Administration costs amount to less than eight percent of total health-care expenditures. Of this, 83.6 percent is the net cost for insurance. In other words, even if the entire insurance administration cost was eliminated it would only save the health care system 6.6 percent of its total costs.

This would, again, be possible if and only if there would be no need for any administration in a single-payer system. As mentioned earlier, that kind of administration is always going to be needed. Government doesn’t just funnel money out to hospitals, clinics and other health-care providers without any kind of information on what is being done, when, how, why and for how much money.

On the contrary, a single-payer system would come under intense cost scrutiny, given the very high taxes it would require. If anything, administration would increase to minimize waste, fraud and abuse. It is simply a pipe dream to think that elimination of administrative overhead would have paid for the $301 billion in med-tech advancements that we would have had to give up in order to not raise health care taxes from 1980 for our hypothetical Medicaid-for-All system.

But that’s not all. A single-payer system requires another layer of administration: central planning of all resources. It would require National Medicaid-for-All Agency that would micro manage the appropriations for every hospital bed, every medical procedure, every drug prescription and every other transaction within the entire American health care system.

That takes a lot of people, and a lot of people cost a lot of money.

Once the single-payer system is in place, government will freeze its costs in parity with the tax base. This means making health-care rationing a standard operating procedure for the allocation of health care resources, meaning in practice that access and quality are made scarce.

In Part 2 I explain what this means in practice and what it meant during the Covid-19 epidemic. In the meantime, listen to our podcast that talks about this very same issue.