Fiscal Cliff

To Revive the Economy, Cut Federal Spending

Obama and Boehner are both big spenders. That's the problem.

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Note: This article originally appeared at Bloomberg View on December 18, 2012. Read it there by clicking here.

In negotiations over the so-called fiscal cliff, U.S. President Barack Obama is calling for $1.4 trillion in new tax revenue over the next decade.

The Republican opposition, led by House Speaker John Boehner of Ohio, has signaled that the Republicans could stomach generating as much as $800 billion in new revenue over the next decade.

Such a large difference obscures a more fundamental agreement: Neither side is interested in addressing the central role federal spending plays in creating persistent deficits and, more important, damping economic growth.

The deficit for fiscal 2012, which ended on Sept. 30, came in at about $1.1 trillion, marking the fourth consecutive year that the nation has posted a trillion-dollar-plus spending gap. Contrary to what Dick Cheney said when he was vice president, deficits do matter.

Under the most recent budget plans of House Republicans and Obama, the federal government will spend from $40 trillion to $47 trillion over the next decade. Yet in the current negotiations, Boehner has called for only $800 billion in spending cuts and Obama $400 billion, most of which would be pushed off until 2022 or later—tantamount to saying they won't happen at all. Neither side's long-term spending plans envision a balanced budget in the next 10 years.

Reduced Growth

In a paper released this year, economists Carmen M. Reinhart, Vincent R. Reinhart, and Kenneth Rogoff said that periods of "debt overhang" – when accumulated gross debt exceeds 90 percent of a country's total economic activity for five or more consecutive years—reduce annual economic growth by more than one percentage point for decades.

Over 20 years, the authors write, there can be a "massive cumulative output loss" that reduces gains by 25 percent or more. The U.S. went over the 90 percent threshold after the 2008 financial crisis. At $16.3 trillion, our current gross federal debt represents more than 100 percent of 2012's total economic activity or gross domestic product.

Obama hasn't explained precisely how higher tax rates on a small fraction of the population will do much to improve the country's balance sheet. According to the Congressional Budget Office, increasing taxes on the wealthiest Americans to Clinton-era levels will raise $220 billion over four years—$55 billion a year on average through 2016, the last year of Obama's presidency.

Over that same period, the White House Office of Management and Budget estimates federal spending at $15.8 trillion, or almost $4 trillion a year on average, and annual deficits of $700 billion.

A little history: 2000 was about the best year ever for federal revenue since 1950. The government raked in slightly more than $2 trillion in nominal dollars and $2.3 trillion in inflation-adjusted (fiscal year 2005) dollars. When measured as a percentage of GDP, revenue reached 20.6 percent, the highest fraction ever recorded in peacetime. Although it's true that receipts in 2006 and 2007 topped the $2.3 trillion mark in constant 2005 dollars, those totals represent smaller fractions of GDP, 18.2 percent and 18.5 percent, respectively. So it's fair to call the $2.3 trillion in constant dollars a high-water mark. (All these figures are drawn from the 2013 Historical Tables generated by the OMB; see table 1.3.)

The high level of revenue—both in constant dollars and as a percentage of GDP—was reached in a roaring economy. And all Americans were taxed at significantly higher levels than they are now.

Income Pyramid

Whatever you think about the decline of rates under President George W. Bush, it made the U.S. tax system more progressive by reducing the burden on middle- and lower-income people. That's one reason that singling out high-income earners for increases this time will yield such little revenue: All of us paid higher taxes then. It wasn't just the swells at the top of the income pyramid.

Even if government could attain the revenue levels of seven years ago, it wouldn't come close to covering spending, which crossed the $3 trillion mark, in inflation-adjusted dollars, in 2009. Neither Republicans nor Democrats are suggesting reducing total year-over-year spending.

The OMB estimates that annual government spending from 2013 to 2016 will average $3.25 trillion in 2005 dollars, or 22.7 percent of GDP. Whether measured in constant dollars or as a percentage of the economy, the government has never once reached that level of revenue, much less sustained it for a number of years.

Given low estimates for economic growth over the coming years, any attempt to reduce the debt-to-GDP ratio before Obama leaves office will thus require significant spending cuts in the near term.

Both the president and members of Congress worry that rapid spending cuts would cause a new recession or slow down the recovery. Such fears are overstated.

In the 1990sCanada, for instance, reduced debt-to-GDP ratios through an aggressive combination of actual, year-over-year spending cuts and higher taxes. The result wasn't malaise but a burst in activity.

The same happened in the U.S. right after World War II. In 1944 and 1945, annual government spending (in 2005 dollars) averaged about $1 trillion and represented more than 40 percent of GDP. By 1947, it had plummeted to $345 billion in 2005 dollars and 14 percent of GDP. Even facing the demobilization of millions of soldiers, the economy soared and unemployment fell despite almost universal fears that the opposite would happen.

Such outcomes are not flukes. Research by economists Alberto F. Alesina and Silvia Ardagna underscored that fiscal adjustments achieved through spending cuts rather than tax increases are less likely to cause recessions, and, if they do, the slowdowns are mild and short-lived.

Spending Reductions

What's more, when spending reductions are accompanied by policies such as the liberalization of trade and labor markets, they are more likely to have a positive impact on growth.

While many economists—and certainly all politicians—worry that turning off the spigot of public spending will shrink an economy (and anger constituents receiving the cash), the opposite is likely to be true.

In an October 2012 study published in the National Bureau of Economic Research, Alesina and Ardagna point to Canada (1993-1997), Sweden (1993-1998) and the U.K. (1994-2000). In these cases, spending cuts had a positive effect on private investment while improving consumer and business confidence by reducing the expectation of higher taxes.

Obama said in September that he would cut $2.50 in spending for every new dollar of tax revenue—what he has called a "balanced approach." Yet his proposal for dealing with the fiscal cliff—$1.4 trillion in new tax revenue and $400 billion in spending cuts—represents a $3.50 increase in taxes for every $1 of cuts, assuming the reductions take place.

As the history of deficit-reduction frameworks (including those signed by Republican Presidents Ronald Reagan and George H.W. Bush) has shown, when immediate rate increases were "balanced" by spending cuts down the road, the spending cuts are never made.

In any case, recent experience shows that even if Obama's 2.5-to-1 ratio of spending cuts to revenue increases came to pass by some miracle, it is far too timid. Economist David Henderson estimates that during the 1990s retrenchment in Canada, the government cut spending by $6 to $7 for every new dollar of revenue it raised.

Obama and Boehner have been largely silent on the specifics of their cuts, though both seem bent on slicing off parts of old-age entitlements such as Medicare and Social Security long after they are out of office.

The best holiday gift the president and Congress could give the country is to spend the final weeks of 2012 working on an honest plan to cut spending here and now.

Note: This article originally appeared at Bloomberg View on December 18, 2012. Read it there by clicking here.

NEXT: Dem. Aide: Fiscal Cliff Deal Reached

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  1. To cut federal spending……stop giving our money to Israel and other countries!!!

    1. Sounds like a good idea, for principle’s sake. As far as being meaningful cuts in their own right, not so much.

      1. Yeah, we ought to cut them across the board by 50% this year.
        And the other 50% next year. (Bah-dum-BUM!)

    2. Dude…. they’ve already got your money at that point and will spend it in any number of ways.

    3. To cut federal spending……stop giving our money to Israel and other countries!!!

      As a linguist with a research interest in pragmatics, I find utterances such as the above fascinating. Why not just write “To cut feral spending stop giving out money to other countries”? It is clear that the writer intends to imply that giving foreign aid to Israel is somehow worse than to giving it to other countries.

      However, this inference is bizarre. Combining economic and military aid, the current amount of aid to Afghanistan (A kleptocracy led by that glorified drug lord Karzai) is sextuple the amount amount given to Israel. The second largest recipient of aid, of which Israel is a close third, is Pakistan, whose intelligence service openly assists the insurgency in Afghanistan, and whose people, in general, hold an extremely negative view of America and Americans. Other recipients of aid include: Iraq, the Gaza Strip, and Egypt three countries currently descending into Islamist madness; Russia, (yes, Russia, one of our few true geopolitical rivals), and various African failed states where the aid funds are sopped up by various government, NGO, and military cronies before even a drop is seen by the people.

      Indeed, by any rational metric, I cannot see how the writer’s inference can be supported.

      1. I think we should all be able to agree that Israel uniquely benefits from feral spending.

        1. mnarayan| 1.1.13 @ 7:28PM |#
          “I think we should all be able to agree that Israel uniquely benefits from feral spending.”

          I think you’re full of it.

    4. Hmmm. I commented on this but my comment disappeared. What the hell is wrong with this site?

  2. lol, that will never happen. Wishful thinking.

    http://www.GoinAnon.tk

    1. Has reason.com blacklisted AnonBot’s trademark ‘jsut’?

      1. Apparently no.

        1. I would jsut go with it, man.

          /anonybot

          1. Jsut gotta love those bot snd psid for policians. LOL!

            http://www.anonderp.lolwut.de

          2. I jsut realized I hadn’t seen it for something like three days. Made me wonder, [ lol | wow | dude ].

          3. On a separate note, misspelling certain words seems to be a method spammers employ for a purpose, although I don’t know what it is.

            The best I’ve seen was ‘faecbook’.

            1. Most likely a poor attempt at seeming more human.

  3. At this point in the frog-boiling, the only spending cuts that would have a significant net positive effect include:

    1. reduction of defense spending to pre-Cold War levels

    2. dismantling of entire federal departments not authorized in the USC

    3. progressive reduction of income taxes with a mandated goal of ending them in our lifetime

    4. return to the ‘gold standard’, possibly involving repudiation of current debt

    5. structured, phased dismantling of all federal welfare programs

    Anyone in Congress assembled care to make a “New Year’s Resolution” on so much as one of those?

    1. What year do you peg as the start of the cold war?

      If asked, I’d say 1946. I am sure that you don’t want WWII levels of military spending, so is your suggestion to return to 1939 levels?

      1. 1946 federal outlays totaled $55.6 billion dollars.
        That’s something like $610 billion, adjusted for inflation.
        Yeah, I’d go for that.

        1. That’s only 70 billion less than today’s budget

          1. Back then, it was half the federal budget.

            I want to cut military spending as much as the any cosmoyokeltarian, but anyone who’s looked at the federal budget lately and compared the spending and revenue/GDP ratios can tell you that alone will not get us where we need to be.

          2. To add on, total defense spending–if you count DoD, DoE, Homeland Security, etc.–is actually about $900 billion. Cutting that down to $610 billion really would be a good start, but here’s the catch–that’s nearly 2% of GDP, and slashing that immediately would likely plunge us into recession.

            It’s not that it isn’t necessary, it’s that no politician has the balls to actually cut that much fat off due to the economic implications. And Obama’s so mathematically illiterate that he can’t explain this to Americans in a way that would get them behind the cuts anyway.

            1. Whoa, whoa, whoa. No offense, but I’ve seen a tendency in the press to equate any government spending with “stimulus” but I did not expect to see it here!

              The defense budget is OBESE. The meme (which I’ve used myself many times) is that the US spends as much on “defense” as the rest of the world combined (I saw a figure of 47%). But even this is misleading because part of the rest of the world is comprised of our allies. I’d like to see a figure that compared our “defense” spending to “enemy” or “potential enemy” countries.

              Sorry — I got off track. My original point is that if we concede the argument that cutting gov’t spending is going to lead to a recession, let’s just go ahead and flush Austrian economics down the toilet and be done with it.

              1. Whoa, whoa, whoa. No offense, but I’ve seen a tendency in the press to equate any government spending with “stimulus” but I did not expect to see it here!

                Pointing out that cutting $300 billion from current spending will result in a recession isn’t arguing that it is “stimulus.”

                Government spending is, by equation, counted as GDP. The question of whether it should be isn’t the one at hand–the point is that it is, and cutting it by 2% will result in a recession. Are the cuts necessary? Yes. Will they be voluntary enacted? No–for the reasons I explained.

                The defense budget is OBESE. The meme (which I’ve used myself many times) is that the US spends as much on “defense” as the rest of the world combined (I saw a figure of 47%).

                Of course it is. And it needs to be cut. But as the math shows, you can cut defense spending 100% and we’ll still be in the hole. The cuts are going to have to come from somewhere in addition to that–either Social Security or Medicare/Medicaid, because those are two of the three biggest items on the budget. And they’re going to get bigger as the Baby boomers retire.

              2. My original point is that if we concede the argument that cutting gov’t spending is going to lead to a recession, let’s just go ahead and flush Austrian economics down the toilet and be done with it.

                It will lead to a recession by definition–because government spending is considered part of GDP. The whole problem is that we’ve covered our entire GDP growth over the last 12 years with deficit spending. Not capital growth–just the national credit card. When that artificial support is removed, recession is inevitable.

                I don’t have a problem with that–I think a recession is exactly the financial enema this country needs. Unfortunately, the people in charge aren’t honest enough to deal with how fucked we really are, which is why we’ve had over a decade of can-kicking on this.

                1. Actually GDP growth has been less than the yearly deficit since 2008.

                  1. I know–that’s what I said. And it’s been greater than accumulated debt, collectively, since 2000.

                    1. Sorry, less than accumulated debt.

          3. A billion here, a billion there, petty soon your talking about real money!

            1. er…. make that “pretty soon”

    2. possibly involving repudiation of current debt

      Heh. You hear that? That’s the sound of Dongfeng 5 ICBMs being launched at various American metropolises.

      1. I’d be curious to see what China actually does at that point.

        Would the trillion they lost over the years be worth the risk of losing their economic backbone?

        One of the reasons China will always sit on the sidelines in terms of debt is because their growth is so reliant on US economic activity.

  4. Today’s feature:

    http://www.youtube.com/watch?f…..w3UWY_Atps

  5. Of course substantial spending cuts would help foster real growth. Which makes it all the more appalling that spending cuts aren’t actually on the table. Regardless of your politics, this should disturb you. Just what is the goal of the parties, anyway?

    1. Just what is the goal of the parties, anyway?

      To obtain and maintain power at all costs.

      Duh!

      1. Sure, but I’m asking that of the true believers.

        1. You’ve seen how the true believers think when they post in the comments here. Are you certain that you really want to hear them talk about why they think the Kool-Aid they drink tastes so good?

  6. OT

    President Obama signed an executive order Thursday lifting the ban on federal employee pay increases. The ban was put into place in 2010 as part of a spending cut agreement.

    Executive order

    Anyone know the background on the original ban and/or how it can be repealed with an executive order?

    1. The text of the order reads at though he has authority from US Code to make adjustments to the applicable pay rates. It cites several laws, which I am not going to research, but it should be fairly easy to verify.

  7. No hangover links today?

  8. Remember that one time? That was awesome.

    This? Not so much.

    Merry New Year! Bah! Humbug!

  9. Oh! Almost forgot:

    No, fuck you, cut spending.

    1. Also, fried chicken.

    2. and my axe!

  10. Does anyone remember if the “$800 bn one-time stimulus” is still in the baseline of all those CRs they keep passing in lieu of a real budget? If it is, that strikes me as a real spending cut they could pull off for this year.

    1. IIRC, Gillespie recently made the point that that they are not cutting spending — they are cutting ephemeral budget numbers!!!! I wish to god this country had a viable press so that that point could be made clear to the common man, and hammered home every freaking day.

  11. …has signaled that the Republicans could stomach generating as much as $800 billion in new revenue over the next decade.

    “As much as.” We know that tax hikes do not automatically equal increaded revenue.

  12. Happy New Year!
    Formula 1 supremo Bernie Ecclestone says he may be forced into retirement if he is charged in a bribary case surrounding the sale of the sport to private equity firm CVC back in 2006.

    1. I’d be tickled pink if Jackie Stewart took over for Bernie.

      1. I want one of these tshirts

        1. Holy crap, I MUST have one of those!

  13. Bold predictions for 2013:

    -No spending will be cut, very little new revenue will come in, and the deficit will be a trillion dollars again.

    -Barbasol Ben Bernanke will continue endlessly destroying our currency in order to fund virtually this entire deficit.

    -TurboTax Tim Geithner will continue playing games and fudging the numbers to try and hide this deficit as much as he can.

    -Block Yomomma, having unmasked himself and ditched the phony Mr. Nice Guy Act, will make many people seriously regret not kicking him out of office as he boldly carries out his agenda of destroying the country.

    -The Cosmos who run Reason will continue to ignore many of the worst things he says and does, and their drinking buddies in the leftist media will continue blaming republicans for everything while their guy brings the country down.

    -Islamic terrorists continue to take over the Middle East with help from their good friend Block Yomomma, wreaking death, havoc, and misery all over the planet.

    -Packers beat Patriots in the Super Bowl, and Alabama easily beats Notre Dame.

    -Shrieking Idiot and Chony “The Sockpuppet” Krugnuts spend another year as Reason’s most vile and dishonest griefer trolls.

    1. My prediction –

      The deficit in 2013 will hit 1.6Tn and even they no one will propose any serious spending cuts for 2014.

    2. “-Block Yomomma, having unmasked himself and ditched the phony Mr. Nice Guy Act, will make many people seriously regret not kicking him out of office as he boldly carries out his agenda of destroying the country.”

      Nope. Not a single Obozo voter will admit a mistake, nor will they admit Obozo is horrid.
      It’s Bush’s fault or the fault of the GOP; Oboz said it, Obozo voters believe it and that’s the end of the discussion.

    3. What? No way!

      The Packers are not making it to the Super Bowl.

    4. Is that you Munger?

  14. The first thing we need to do is to get rid of the scam known as baseline budgeting.

  15. The solution is cut spending he says. He is right and so it’s hard not to be pessimistic since Democrats will never, ever cut spending and the Republican house will cave and compromise when they could refuse to fund Obama’s entire executive branch. That would save some money.

  16. Bush Tax Cuts = Banana Republic Tax Cuts
    Forget no spending cuts; spending, regulations, welfare, cronyism, etc. all ballooned under hidden costs. The economy and populace was essentially socialized long before Obamacare, in a perverse way similar to banana republics right before they go belly up and start calling the IMF.
    While they’re at it, they should toss “Starve the beast” onto the Failed Beltway Wonk Ideas pile. The only way the beast will let itself starve is if it chokes to death first.

  17. lol, gotta love those bought and paid for politicians!

    http://www.DareAnon.tk

    1. Further 2013 predictions:

      Anonbot finishes becoming self-aware and enslaves us long before we have to worry about our fiscal issues.

  18. As I often reveal in fireside conversations, buying physical gold is a big step towards unplugging from the collectivism matrix, of which Bernanke is the Architect.

    And nothing sends Bernanke the middle finger like using his fiat dollarz for the only thing they’re (still) good for: buying gold and gold equities. It’s still a good time to buy equipment and machinery, but I wouldn’t be buying farmland now. Farmland has been pushed ridiculously high by low interest rates and high corn prices, but farm acreage is selling at prices that will take decades for those acres to pay for themselves.

  19. I was always a little curious about the smatterings of Chinese in the dialogue of Firefly, but now it’s all making sense.

  20. It seems that neither Nick or Veronique have a true grasp of the operational realities of our monetary system — with its fiat currency.

    The recent efforts to balance the books that’s at the heart of the fiscal cliff are misguided. Instead of fighting over whose taxes to raise and which programs to cut, lawmakers should be negociating about how to use the tool of the federal deficit to boost incomes, employment and growth. That’s the balancing act we need.

  21. Forgive me, I’m a libertarian way of thinking novice, I promise this is not a trolling question. If someone asks you, “what proof do you have that government is innefficient?” Besides rolling your eyes and wondering WFP they live on, how do you phrase your argument? Do you roll out data, talk about why government can’t be as efficient as a free capital market, site examples of lower taxes resulting in GDP growth, say Greace, what?

    1. @grey. Ask where the government gets the money it spends. The answer is either a) it gets it from you in taxes, b) borrows it and uses your taxes next year to pay interest and repay the capital later or c) steals a little of your money by printing money (quantitative easing). It also drives down interest rates thus paying less interest and hurting savers and their savings. See http://www.lifestrategies.net/inflation

      It all comes from you. But the vast overhead as well as lack of competition mean much of it is wasted before they do anything with it.

      The proof? Why does government generally ban competition with it (think postal “service”?) Why are government employees paid so much more than private ones doing the equivalent job? What is the reason for such lower employee turnover, as well as turnover per employee when this can be measured? Who pays for the sky-high government employee benefits? Why are Detroit and Stockton etc. etc bankrupt? …

      Think straight, don’t just buy other people’s mistaken beliefs and stories: When the government spends more than its income, then it has to get the extra from somewhere – that’s you! This decreases your prosperity and means less capital investment. The laws of economics are not magically suspended just because the government gets involved….

      There’s enormous correlation between the size of government and prosperity of citizens. eg. Switzerland, Hong Kong, and China who have learned lessons from Hong Kong.

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