“No Man’s life liberty or property is safe while the legislature is in session”.

- attributed to NY State Judge Gideon Tucker

Thursday, December 30, 2010

Biggs, Hassett & Jensen On Budget Balancing

Three people from the American Enterprise Institute wrote an impressive piece in yesterday's Wall Street Journal entitled The Right Way to Balance the Budget.

As I noted in yesterday's post concerning Howard Dean's recent delusional rant on CNBC, it's not simply a matter of tax hikes or spending cuts being apparently arithmetically equal. The authors begin,

"In new research that builds on the pioneering work of Harvard economists Alberto Alesina and Silvia Ardagna, we analyzed the history of fiscal consolidations in 21 countries of the Organization for Economic Cooperation and Development over 37 years. Some of those nations repaired their fiscal problems; many did not. Our goal was to establish a detailed recipe for success. If the United States were to copy past consolidations that succeeded, what would it do?

The data also clearly indicate that successful attempts to balance budgets rely almost entirely on reduced government expenditures, while unsuccessful ones rely heavily on tax increases. On average, the typical unsuccessful consolidation consisted of 53% tax increases and 47% spending cuts.

By contrast, the typical successful fiscal consolidation consisted, on average, of 85% spending cuts. While tax increases play little role in successful efforts to balance budgets, there are some cases where governments reduced spending by more than was needed to lower the budget deficit, and then went on to cut taxes. Finland's consolidation in the late 1990s consisted of 108% spending cuts, accompanied by modest tax cuts."

That's pretty riveting. No qualitative arguments about income redistribution philosophy. Instead, it's black and white. Raise taxes and you'll fail to regain fiscal integrity. Cut spending, and you may. They continue,

"Consistent with other studies, we found that successful consolidations focused on reducing social transfers, which in the American context means entitlements, and also on cuts to the size and pay of the government work force. A 1996 International Monetary Fund study concluded that "fiscal consolidation that concentrates on the expenditure side, and especially on transfers and government wages, is more likely to succeed in reducing the public debt ratio than tax-based consolidation." For example, in the U.K's 1997 consolidation, cuts to transfers made up 32% of expenditure cuts, and cuts to government wages made up 21%.

Likewise, a 1996 research paper by Columbia University economist Roberto Perotti concluded that "the more persistent adjustments are the ones that reduce the deficit mainly by cutting two specific types of outlays: social expenditure and the wage component of government consumption. Adjustments that do not last, by contrast, rely primarily on labor-tax increases and on capital-spending cuts."

The numbers are striking. Our research shows that the typical successful consolidation allocates 38% of the spending cuts to entitlements and 25% to reductions in government salaries. The residual comes from areas such as subsidies, infrastructure and defense."

Again, very deterministic evidence. And sensible. Cutting recurring government spending, e.g., salaries/jobs, is a recurring benefit to fiscal rectitude. Cutting entitlements gets at the heart of why, as I argued in yesterday's post, we arrived here in the first place. Spending on promises that never should have been made in the flawed manner that they were, with no contingent limits.

The editorial's authors conclude,

"Why is reducing entitlements and government pay so important? One explanation is that lower social transfers spur people to work and save. Reducing the government work force shifts resources to the more productive private sector.

Another reason is credibility. Governments that take on entrenched, politically sensitive spending show citizens and financial markets they are serious about fiscal responsibility.

While tax hikes slow revenue growth, policies that credibly reduce government spending in the long run boost economic growth by more than their simple effects on deficits might imply. Any attempt to address the federal government's budget shortfall that relies on less than 85% spending cuts runs too large a risk of failure. The experience of so many other countries shows that it's crucial for the U.S. to get this right."

That's another hard datapoint. The federal government needs to be cutting spending to the tune of 85% of the gap needed to be closed. That leaves precious little for tax increases.

Perhaps the new GOP House is up to the task. Let's hope so. We may not have a second chance at this.

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