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CBO Forecast Accuracy
Economic variables are key drivers of the numbers in CBO’s budget projections. I noted last week that CBO’s new outlook assumes substantially lower interest rates, which appears to produce more than a trillion dollars of savings over the next decade.
Policymakers should be aware, however, that macroeconomic forecasts are not very accurate, despite the sophisticated models available today. Consider how CBO completely missed the recent recession until after it had already started (in December 2007).
Figure 1 shows CBO’s January 2008 projection of real GDP growth (blue bars). The recession had already started, yet CBO projected that U.S. growth would strengthen substantially in subsequent years. Their forecast for just one year ahead (2009) ended up being a giant 5.2 percentage points off. (These are fiscal years).
The recession caught most economists by surprise, of course. We know now that the deflating housing sector was a key cause of the recession, but it is interesting that CBO missed the seriousness of that factor, even though they have huge models hundreds of equations in length. Housing prices had peaked in 2005-2006, and had already been falling rapidly for two years when CBO made its faulty January 2008 forecast.
The point here is not to pick on CBO, but to raise skepticism about macro forecasts and the policy prescriptions that stem from macro model simulations. Ezra Klein, for example, is convinced that reducing the deficit at this time would be bad for growth because that’s what (Keynesian) macro models predict. But where’s the real-world evidence that cutting deficits is bad for growth? I’ve noted that Canada cut spending and deficits sharply in the 1990s and its economy boomed—the opposite of what Keynesian models would have predicted.
Klein warns America not to follow Britain’s “austerity” policies: “Note the struggles of Britain, which has embraced austerity more fully than perhaps any other major economy, only to see its growth falter and its total debts rise.”
Apparently, Klein hasn’t looked at the actual British data. OECD data (Table 25) show that U.K. government spending soared from 37 percent of GDP in 2000 to 51 percent of GDP in 2010. Spending in 2011 and expected spending for 2012 is cut to about 49 percent of GDP. That’s the brutal “austerity” policy that is undermining British growth?
Here’s one more angle on CBO’s forecast accuracy. Figure 2 shows CBO’s January projections from recent years for fiscal 2011 growth. In the first few years shown, CBO was actually strengthening its view of 2011 growth. It wasn’t until 2010 that CBO’s models finally caught up with the reality of the recession, and the forecast for 2011 was sharply downgraded. In January 2012, CBO reported that actual 2011 growth was 2.1 percent.
Upshot: With respect to budget policies, policymakers should forget what the macro models are saying. What we know for sure is that the government is spending $1 trillion a year more than it takes in. That’s just crazy. We need to cut spending, and we need to start now.
Has Congress Cut Any Spending Yet?
It’s been a year since Republicans assumed control in the House in the wake of the 2010 elections, which were powered by Tea Party concerns about massive federal spending and deficits. With the more conservative House, has Congress made any progress on spending cuts yet?
Let’s compare the new CBO budget projections to CBO’s January 2011 projections. The new 10-year projections do look a little better, at least by Washington standards. A year ago, CBO’s baseline showed the deficit falling modestly from more than $1 trillion this year to $763 billion by 2021. CBO’s new baseline shows the deficit falling to just $279 billion by 2021.
The chart shows federal spending of $3.6 trillion this year and CBO’s projections for 2021 from last year and this year. Last year, 2021 spending was expected to be $5.726 trillion, but this year 2021 spending is expected to be $5.205 trillion. Thus, Congress will apparently be “saving” $521 billion in 2021 compared to what it had planned to spend, although spending is still expected to rise 45 percent over the next nine years.
Downsizing the Interior Department
Cato has published a new section on www.downsizinggovernment.org that examines the Department of the Interior.
Interior is not one of the largest departments in terms of spending, but it has huge control over the lands and resources of the western United States. It oversees more than 500 million acres of land through the Bureau of Land Management, the National Park Service, the Fish and Wildlife Service, and other agencies. The department also houses the Bureau of Reclamation, which distributes subsidized water, and the Bureau of Indian Affairs, which administers aid programs for American Indians.
Here are some of ideas discussed at www.downsizinggovernment.org/interior:
- Federal Lands: During the nation’s first century, the federal government focused on selling and giving away its lands to individuals, businesses, and state governments. In the 20th century, the government reversed course and began grabbing more land, but federal ownership has not led to sound economic or environment stewardship. A revival of federalism in land policies is long overdue.
- American Indians: The federal government has an appalling record in its dealings with Indian tribes, and since 1824 the Bureau of Indian Affairs has been one of the most mismanaged and destructive of federal agencies. The path to prosperity for Indians is not through federal subsidies and top-down regulations, but through reforms to property rights and other institutions on reservations.
- Water Subsidies: The Bureau of Reclamation operates dams and other water infrastructure in the western states. Its large subsidies for irrigation combined with restrictions on water transfers are contributing to a growing water crisis in many areas. Policymakers should focus on reforms to reduce subsidies, transfer federal infrastructure to state and private ownership, and move towards water trading in open markets.
One interesting thing about reforming the Department of the Interior is that economists and environmentalists share some common ground. Federal policies that set prices for irrigation water, grazing lands, timber, and other resources too low are both economically inefficient and harmful to the environment.
Another interesting thing about Interior is that its long history reveals that special interest lobbying, corruption, and mismanagement are nothing new in Washington. Interior’s troubles have included the “Indian ring” corruption scandals of the 19th century, the Teapot Dome scandal of the 1920s, and Jack Abramoff’s influence peddling during the George W. Bush years.
In 1828, one expert noted that “the derangements in the fiscal affairs of the Indian department are in the extreme… there is a screw loose in the public machinery somewhere.” Fast forward to 2006, and Interior’s Inspector General found that “short of a crime, anything goes at the highest levels of the Department of the Interior.”
Isn’t two centuries of federal bungling and failed policies enough? Policymakers should begin exploring ways to downsize the Department of the Interior.
CBO Study on Federal Pay
CBO has released a study comparing the wages and benefits of private sector and federal non-military workers. The study uses statistical techniques to make comparisons with adjustments for education level, experience, and other factors.
Here are the overall results:
- The wages of federal workers are 2 percent higher than similar private-sector workers, on average.
- The benefits of federal workers are 48 percent higher than similar private-sector workers, on average.
- The total compensation (wages plus benefits) of federal workers is 16 percent higher than similar private-sector workers, on average.
CBO finds that the federal compensation advantage varies by education level. People with low and middle levels of education generally do better in the government, while people with doctorates generally do better in the private sector.
CBO’s results are generally in sync with my observations on federal pay. For example, I’ve pointed to the excessive pension and health benefits received by federal workers. The CBO says:
The federal government provides retirement benefits to its workers through both a defined-benefit plan and a defined-contribution plan, whereas many large private sector employers have replaced defined-benefit plans with defined-contribution plans. The federal government also provides subsidized health insurance to qualified retirees, an arrangement that has become uncommon in the private sector.
I’ve also noted that high job security is an important federal benefit that should be considered when deciding on federal pay levels. Federal workers get laid off and fired at much lower rates than private-sector workers. That benefit has value, and thus federal pay rates should be set somewhat lower than for otherwise comparable jobs in the private sector. The CBO notes:
…greater job security and less uncertainty about the size of pay raises tend to decrease the compensation that the federal government needs to offer, relative to compensation in the private sector, to attract and retain employees.
Given these results, I’ve proposed these action items for Congress:
- Continue the federal pay freeze for a number of years.
- Repeal the federal defined-benefit pension plan.
- Hire an outside accounting firm to audit the Federal Salary Council’s apparently erroneous “pay gap” method, which always seems to find that federal workers are grossly underpaid.
- Privatize as many federal activities as possible so that markets can figure out the appropriate levels of compensation.
Fact Checking the SOTU: Corporate Taxes
Let’s do some fact checking on President Obama’s corporate tax comments in last night’s State of the Union.
Claim: “Right now, companies get tax breaks for moving jobs and profits overseas.”
False: There are no such breaks. Instead, we punish U.S. and foreign businesses for investing and creating jobs here.
Claim: “If you’re a business that wants to outsource jobs, you shouldn’t get a tax deduction for doing it.”
False: There is no such tax deduction.
Claim: “No American company should be able to avoid paying its fair share of taxes by moving jobs and profits overseas.”
False: America is not a prison camp. Besides, imposing a 40-percent tax rate on corporations that invest here is not a “fair share.”
Claim: “From now on, every multinational company should have to pay a basic minimum tax.”
False: We’ve already got a corporate “alternative minimum tax,” and it’s an idiotic waste of accounting resources that ought to be repealed.
Claim: “It is time to stop rewarding businesses that ship jobs overseas.”
False: We penalize them for locating jobs here. Besides, the overseas operations of U.S. companies generally complement domestic jobs by boosting U.S. exports.
Claim: “Companies that choose to stay in America get hit with one of the highest tax rates in the world.”
True: Our rate is 40 percent, which compares to the global average rate of just 23 percent. See the chart below, which is based on KPMG data.
Claim: “If you’re an American manufacturer, you should get a bigger tax cut. If you’re a high-tech manufacturer, we should double the tax deduction you get for making your products here. And if you want to relocate in a community that was hit hard when a factory left town, you should get help financing a new plant, equipment, or training for new workers.”
False: It’s a horrible idea to create special breaks for certain types of government-favored businesses. It would simply encourage the exact type of tax game-playing and lobbying that the president decries. What’s a “high-tech” manufacturer? What’s an “American” manufacturer? What’s a “manufacturer”? How “hard hit” do towns need to be?
Upshot: From the president’s one “true” comment we can derive the simple and logical solution to our corporate tax problem. We should stop “hitting” companies with a 40-percent sledgehammer, and cut our corporate statutory rate to boost investment and reduce corporate tax avoidance.
Note to self: Mail copies of Global Tax Revolution to WH speechwriters.
U.S. Dividend Taxes Too High
The release of Mitt Romney’s tax returns is generating debate about the federal tax rates on capital gains and dividends of 15 percent. Great, let’s have a debate about why it’s both fair and good policy that these rates were cut in 2003.
Romney’s effective income tax rate in 2010 was 14 percent because most of his income was in the form of capital gains and dividends. Let’s focus on dividends, which were $4.9 million of his 2010 income of $21.7 million.
While Romney paid a 15 percent federal personal rate on his dividend income, the total tax rate on the stream of corporate profits that ended up in Mitt’s pocket was a huge 52 percent. That figure is from the OECD, and it includes the corporate-level burden on the underlying profits and the state-level corporate and personal taxes on dividends. So the total tax burden on Romney’s dividends is high not low, despite the dividend tax cut in 2003.
Just about every industrial country provides relief for the double taxation of corporate equity, either by having a lower personal rate on dividends, a personal tax credit for dividends, or a lower corporate-level tax. Despite the 2003 dividend tax cut, the overall U.S. rate on dividends at 52 percent is still the fourth-highest among the 34 high-income nations of the OECD.
Many people don’t seem to understand is that globalization has vastly changed the reality for capital income. Every major nation has cut tax rates on capital income in recent decades. The chart shows the average top dividend tax rate in the 34 OECD countries since 2000. The U.S. cut its rate, but so did other countries. Liberals say they want to bring back Clinton’s higher tax rates, but the world has changed since then. And we’ve got more cutting to do: Our dividend rate is still 11 points higher than the average of the 34 high-income nations.
David Brunori Comes Out as a Libertarian
My friend David Brunori announced this week that he is no longer a “liberal” but a libertarian, although he says of the “bleeding heart” variety.
This is interesting because David has long been one of the nation’s top state fiscal experts. He is currently an editor of the Tax Notes family of periodicals (which are subscription only).
What made David see the light about government?
I’ve been calling myself a liberal in the pages of State Tax Notes since I began this column in 1996. I’ve been introduced at conferences and bars as a liberal tax pundit, a liberal professor, and a card-carrying liberal. In my line of business, it was expected that one would either be liberal or, if you were a pawn of the 1 percent, a conservative. Decent tax policy folks weren’t libertarians. Libertarians had no tax policy. But I’m too old to hide my feelings.
I came to realize my true identity by taking a survey on the Libertarian Party website. I scored a perfect 100 percent on the personal freedom meter, but only an 80 percent on the economic freedom meter. Still, those scores make me a libertarian. Some of my liberal friends will hate me for coming out. But I’ll remind them that hate is not a tax policy value. Besides, by definition, I still care for the poor and dispossessed. I’m no anarchist. I’m no isolationist. I still believe that government has a positive role to play in society. I want good roads and teachers and appreciate that someone will answer the phone when I dial 911. But I think we should look at government more skeptically.
I’m weary of corporate welfare. I’m weary of tax incentives. I’m weary of government economic policy that’s largely intended to enrich politicians’ cronies. For example, California Gov. Jerry Brown (D) has been hellbent on spending $93 billion on a train that apparently no one wants and few will ride. But a small number of connected men would make a fortune building it.
I’m weary of the incessant arrogance of the nanny state. The Boston Public Health Commission recently voted to ban electronic cigarettes from the workplace. Memo to those in Boston: Electronic cigarettes are fake. They blow a harmless vapor of mist. Real cigarettes are banned from public places purportedly because of the dangers of secondhand smoke. Personally, I think the marketplace can handle smoking issues just fine, but let’s assume people are too stupid to make decisions about working at or patronizing places that allow smoking. What gives political elites in Boston the right to ban a product that has no secondary harm? Nothing. They do it because they don’t like people who smoke (even ersatz smokers). But more importantly, they do it because they have the power. I’d go blow real smoke rings in their faces if it weren’t so obviously immature.
David also provides a useful essay in Tax Notes this week: “A Practical Approach to Libertarian Tax Policy.” He proposes seven principles to guide tax policy from a limited-government perspective:
- Pay for Government—With Taxes [not debt]
- Reject Tax Expenditures
- Make Taxes Visible
- Reject Excise Taxes
- Reject Inefficient Taxes
- Oppose the VAT
- Embrace Federalism and the Property Tax
It’s a pretty good list. David and I particularly have a mind meld on the importance of fiscal federalism. David is an excellent analyst and concise writer, so I’m glad he’s now on the team.
For more on libertarian tax policy, readers can look at my “Options for Tax Reform.” I propose three broad principles to guide tax reform: simplification, efficiency, and limited government.
Keep the Federal Pay Freeze
The Washington Post is reporting that the Obama administration will propose a 0.5 percent cost-of-living pay increase for federal workers in its upcoming budget. The paper says that “the modest cost of living increase in federal compensation would be the first pay jump for federal workers since before President Obama ordered a two-year freeze in late 2010.”
That’s not quite accurate. USA Today recently reported that average federal worker wages rose 1.3 percent in 2011, or slightly more than the 1.2 percent increase in average private wages. The federal increase, while modest, occurred despite the pay “freeze” because increases from “longevity, merit, and promotions” were not covered, the paper noted.
I fear that as the economy gains strength and starts expanding, policymakers will forget that we’ve still got a $1 trillion budget deficit. Even with growth, we’re still heading for a Greek-style debt crisis unless we pursue major spending cuts. So Congress should decline Obama’s request and retain the federal pay freeze for a few more years. At the same time, policymakers should pursue cuts to excessively generous federal worker benefits.
Controlling federal worker costs is only part of the budget solution, but it does make economic sense because pay and benefits have risen so rapidly over the last decade.
Federal Pay from USA Today
Even with a “freeze” in effect, federal pay rose faster than private-sector pay in fiscal 2011, according to the USA Today’s Dennis Cauchon. Crunching Bureau of Labor Statistic’s data, Cauchon found that average federal worker wages rose 1.3 percent in 2011, or slightly more than the 1.2 percent increase in average private wages. The federal increase—while modest—occurred despite the freeze Congress and the president put into effect because increases from “longevity, merit, and promotions” were not covered, according to Cauchon.
I’ve argued that federal pay and benefits are excessive and should be cut as one of many needed reforms to rein in federal deficits. Lawmakers should extend the wage freeze, but they should also reduce overly generous federal worker benefits. For example, lawmakers should repeal the defined-benefit pension plan received by federal workers because it comes on top of the 401(k)-style retirement plan that workers already receive.
The good news is that increases in federal pay have slowed from the torrid pace of the early George W. Bush years, as shown in this chart. But we will need more reforms to start reversing-out the large federal pay advantage that has been built up over the last two decades.
Income Inequality Data Has Flaws
In the Wall Street Journal yesterday, Alan Reynolds pointed out some of the flaws in the data being used in the income inequality debate. Far too many policymakers, analysts, and reporters assume that the data showing rising inequality is carved in stone, but it isn’t. Some portion of the supposed change in income inequality in recent decades is a statistical artifact due to changes in marginal tax rates and other factors.
One of Alan’s points is that fluctuations in capital gains (CG) realizations by the top 1 percent of earners plays an important role in that group’s measured income share out of total American income. I constructed two charts with Alan’s data to illustrate the point. The two charts are scatter plots using data from 1979 to 2009.
Chart 1: Lower CG Tax Rates Lead to Higher CG Realizations for the Top 1%. In years when we had a higher 28 percent CG tax rate, the share of high earners’ income from CG is lower. In years when we’ve had lower 15 and 20 percent CG rates, the share is higher.
Chart 2: Higher CG Realizations Increase the Measured Share of the Top Earners’ Income. In years with lower CG tax rates, high earners realize more CG, and that inflates their measured share of total American income.
(Note for data wonks: Regressions on these two relationships were highly statistically significant, i.e. high F-statistics).
Supercommittee Fails; Now Let’s Talk Specific Cuts
It looks like the congressional supercommittee has failed to agree on a deficit-reduction plan. That’s probably a good thing because it sets up an automatic sequester to trim spending by $1.2 trillion over 10 years.
If the supercommittee had agreed to a deal, it might have paired phony spending cuts with real tax increases. For example, while Republicans had offered to raise taxes by $400 billion, there had been talk of adopting smoke-and-mirrors savings of $700 billion for the withdrawal of troops from Iraq and Afghanistan.
Also, one of the tax increases that Republicans were apparently offering was to change the indexing of income tax brackets. That would have been the worst kind of tax hike, as it would have been a hidden way of steadily increasing marginal tax rates over time.
A sequester is far from the best way to cut spending, and spendthrift members of Congress will have until January 2013 to try and weasel out of cuts. However, it does help to put the big spenders on the defensive. If defense hawks such as Senator John McCain want to reverse the roughly $55 billion a year in defense savings, then they have the burden of coming up with alternative cuts that can gain broad agreement.
CBO has analyzed the sequester mechanism. In typical congressional style, the simple sequester idea of “across-the-board cuts” has morphed into complex procedures that only Washington lawyers would love. The sequester’s main effect will be to reduce the discretionary caps on defense and nondefense spending that are in place from the Budget Control Act passed earlier this year. The sequester will make only tiny cuts to so-called entitlement programs. Still, any cuts are good cuts.
What’s the next step for budget control? Conservative Republicans have focused nearly all of their energy this year on trying to impose overall limits on the budget. The Budget Control Act and likely sequester have established discretionary caps for the next decade. Meanwhile, an effort to pass a Balanced Budget Amendment has failed.
Now Republicans should do what most of them have been evading all year—start pushing cuts to particular programs in order to launch a discussion about the federal government’s proper role. How about ending federal subsidies for public housing, high-speed rail, urban transit, farm businesses, and energy? How about raising the Social Security retirement age, increasing Medicare deductibles, and block-granting Medicaid?
To his credit, Rep. Pompeo is showing the way with his push to eliminate the Economic Development Administration. The EDA is a relatively small program, but Pompeo did a nice job on Fox last week making the case for termination. We need every fiscal conservative in Congress to do some research and then target a handful of specific programs for repeal.
Enough of the “noncommittal gibberish” about cuts, as Robert Samuelson says today. The nation’s “adult discussion” on the budget will begin when policymakers start talking specifics.
Engineers for Big Government
The American Society of Civil Engineers does a flashy study every year called “America’s Infrastructure Report Card.” The wrench-turners give a grade of “D” to the mainly-government infrastructure they examine. Based on the low grade, they ask for taxpayers to cough up another $2.2 trillion so the engineers can fix the supposed mess.
There are two big problems with the ASCE report. The first is that it is devoid of economic thinking. Every infrastructure asset that is old and less than perfect is apparently a disgrace to the engineers. But economists would point out that to maximize our standard of living we generally want to wear out fixed assets pretty thoroughly before we buy new stuff.
Consider America’s automobile stock, which includes everything from brand-new cars to old clunkers. The engineers would probably give the nation’s automobile infrastructure a “D” because it includes many old cars like my wife’s 11-year-old Honda. But it would be hugely wasteful—both economically and environmentally—to throw out all the old cars and give everyone brand new Acuras.
Instead, it’s efficient if car owners compare the likely stream of benefits and costs of their current used cars with the likely stream of benefits and higher costs of possible new cars, and then make an optimal choice. That’s what my wife is doing, but the ASCE would probably give her a “D” grade, castigate her frugality, and insist she immediately blow her savings on a new Rolls Royce.
The other problem with the ASCE report is its naiveté regarding the efficacy of central planning. I’ve discussed federal infrastructure failures in this op-ed and this testimony, but the ASCE seems to believe that all-knowing visionary leaders in Washington can direct us to infrastructure salvation.
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