Sunday, January 30, 2005

Why do we have a budget deficit?

The Club for Growth's Social Security phase-out website posted an item, You Can't Fix Social Security by "Taxing The Rich" , which postulates that federal revenues "began a scary decline during the last days of the Clinton administration, and that the 2003 tax cut "for the rich" has brought in more, not less, revenue.

The chart below shows a plot of federal spending and revenues for the "on budget" portion of the budget, which for practical purposes means the part of the budget paid for by income taxes. The graph plots these figures as a fraction of GDP. The plot in green shows revenues, while the red shows spending.

The most notable feature of this graph is that income tax revenues really fell off a cliff the past three years, compared with historical norms. If you review the spreadsheet data above, you'll find that on-budget revenues have not been this low since World War II, by a wide margin. Yet, as you can see from the chart, spending, which was constrained from 1993 through 2001, has grown considerably since then. Thus we have a combination of higher than average spending, along with abnormally low revenues.

This abnormally low revenue continued through the third year of an economic recovery, when revenues ought to be back to normal. Revenues finally seem to have hit bottom, but are growing now from an extraordiarily low level. Simply put, we're bringing in a much smaller fraction of GDP in revenues, while our on-budget spending as a fraction of GDP is now above the post-WWII average

The Club for Growth believes that if we restore the top marginal tax rate to the level Clinton set, federal revenues would go down, not up, because the top 1% of earners will stop working, stop investing, and go sulk in a hole if you raise their tax rate. "In the long run", we're supposed to make up for the gaping deficits with explosive economic growth.

But look what happened between 1993 and 2000. Clinton raised income taxes just for the top 2% of earners in 1993. Every year between 1993 and 2000, tax revenues grew. At the same time, federal spending grew more slowly than the economy. We went from record budget deficits and projections that deficits would stay near that record level as far out as projections went, to a balanced budget.

Meanwhile, economic growth during Clinton's two terms in office was the highest since the 1960s. The labor force participation rate hit a peak, and if some conservatives were sulking through it all, it was certainly made up for by exuberance from somewhere else that defied conservatives' predictions.

Unemployment fell consistently below five percent, again for the first time since the 1960s.

There isn't any empirical data that suggests marginal income tax rates around the level set by Bill Clinton in 1993 significantly constrain economic growth. On the contrary, there are "facts on the ground" that the sort of fiscal discipline the Clinton administration engaged in helps the economy more in the long run than borrowing money to finance tax cuts and spending beyond our means.

There's no good reason for the federal government to habitually bring in a lot less revenue than congress chooses to spend. Right now, the federal government is bringing in a whole lot less revenue than it is spending, and as the chart shows, the biggest gap is on the revenue side - we just aren't bringing in as much income tax revenue as we've brought in for the past sixty years.

Sunday, January 09, 2005

Conservatives debate Free Lunch

Today, the National Review Online debates the political merits of a free lunch , where we get to divert up to 40% or more of Social Security old age revenue to private accounts without cutting benefits. Excerpt below: .

The going is getting tough in Washington, so a lot of conservatives are going the other way. The White House is considering a Social Security reform that includes a substantial reduction in the growth of benefits. A number of influential conservatives say this would be "political suicide," to use the phrase favored by Newt Gingrich. Among the balkers are people who are usually White House allies, such as Gingrich and Grover Norquist. They are joined by Jack Kemp, longtime Social Security reformer Peter Ferrara, and some congressmen, all of whom want to push a personal-accounts bill with no benefit cuts. John Shadegg of Arizona, an influential House conservative, leans toward this camp.

I'm not prepared to endorse their argument, at least yet. In a future article, I'll explain some of my reasons for holding back. But it must be admitted that the so-called free lunchers make a strong case.

That case is almost entirely political. The argument is not chiefly that reducing the growth of Social Security benefits would be a bad policy, but that proposing such a reduction is too risky politically.

Anchoring the other side of the war among conservative factions, here's an economist's case against the free lunch bunch.

This progressive wonders why accelerating the date when revenues go negative from 2018 to 2006, while still leaving benefit payments in excess of revenues all the way out till 2050, is fiscally responsible in an era when "transition costs" are only accounted for during the first 10 year budget plan.

If you think it's bad that we'll have acknowledged "transition cost" of $1-2 Trillion during the next "10 year plan", it's worse that these "transition costs" will recur during the 10 year plans for the 2010s, 2020s, 2030s, and 2040s.

But worse still, all it would take would be an act of congress to switch back from "price indexing" to "wage indexing" anytime between now and 2050 to make those "transition costs" go out to infinity.

I suspect Newt Gingrich will win this debate, especially if the Bush administration leaves the heavy lifting up to congress.

Who can turn down a free lunch?

Friday, January 07, 2005

Who would benefit from private Social Security Accounts?

Social Security provides a low risk, lifelong, inflation adjusted old age insurance benefit as well as disability and survivor benefits. The structure of Social Security old age benefits is an inflation-adjusted annuity.

Private fixed annuities are available now - these annuities provide a fixed lifelong payment, but not a payment that keeps up with inflation. And, these fixed annuities typically have a fairly high cost for a given level of benefit. This issue was studied by CBO when evaluating personal investment accounts as a component of Social Security. Table 1 of that report shows the discount from expected value available with current annuities. The report poses the problem:

If markets for private annuities are imperfect, however, those annuities may be costly or unavailable, and long-run gains from prefunding a privatized social security system may be smaller than suggested in some recent papers.

The conclusion is that private, self selected annuities have a lot of overhead. If annuities are an important component of retirement security, then the cost of converting personal Social Security accounts into annuities, as well as the market timing risks and the inflation risk, have to be compensated for to achieve equal value to traditional Social Security benefits. The overhead for converting to an annuity might be 10 to 20%, and the risks of inflation and of market timing significantly increase the assets required to assure lifelong livings standards.

Who might find the benefit of personal accounts exceeds these risks and costs

As it is currently structured, Social Security provides a secure complement to private retirement savings for those who have sufficient assets. The security of a lifelong, inflation adjusted annuity with survivor benefits allows those with adequate assets to take measured risks with retirement savings, as well as allowing them to plan to leave assets to heirs. Asset allocation models used for defined contribution savings plans like 401Ks build in the presumption of complementary Social Security benefits. Presumably, rational individuals using professional guidance would have to adjust their voluntary personal investment portfolios to achieve the same risk-adjusted profile they've had with a Social Security annuity. If they shift privatized Social Security assets into equities, they'd have to make an equal shift OUT of equity in their voluntary savings, to keep the same balance of risk.

If they trade off SS annuity benefits at a rate equal to the treasury bond yield plus 7/10ths of a percent, and they intend to replace the complementary security of a lifelong annuity, exactly how much more savings would they need to assure their minimum goals would be met?

You certainly wouldn't want to hold treasury bonds in your private Social Security account, since you'd be losing 7/10ths of annual yield at the start, in addition to the loss of the annuity benefit. You'd also lose the 10 to 20% cost for converting the account to annuity upon retirement.

But if you hold more equity in your privatized account, you'd want to adjust your risk in the voluntary savings. You'd need to shift out of equity into bonds there. Whoops! You just lost 7/10ths of a percent of annual yield. And you still have to compensate for the cost of converting to an annuity, plus add additional assets to compensate for the possibility you will outlive the fixed benefit annuity.

So, for those who already have adequate voluntary savings, the value of converting your traditional Social Security benefit into a private account seems questionable. As long as the government can keep its promise to pay, it's quite likely you'd want to stick with traditional benefits.

What about for those who don't have adequate personal savings, or for those who outlive their personal savings?

For those who lack or who have outlived their retirement savings, Social Security provides a safety net, assuring sufficient lifelong income so that most elders are able to maintain living standards above the poverty level.

The evaluation is different here, because there are few assets outside of Social Security to consider. There may be a benefit allowing these individuals to capture the equity premium, but for each dollar shifted out of a guaranteed anuity, there is a much bigger risk. Would we, collectively, require this group to purchase an annuity? Would the annuity have to be inflation adjusted and insured? Would compensating for these risks and costs require a larger program than a basic, simple defined benefit Social Security program?

Might we do better to try to capture the equity premium within the Social Security trust itself, and keep the benefit side of Social Security simple and minimal?

Sunday, January 02, 2005

Objectivists in the Reality Based World?

An opinion expressed over at the Any Rand institute extolls about the evil of foreign aid:

As the death toll mounts in the areas hit by Sunday's tsunami in southern Asia, private organizations and individuals are scrambling to send out money and goods to help the victims. Such help may be entirely proper, especially considering that most of those affected by this tragedy are suffering through no fault of their own.

The United States government, however, should not give any money to help the tsunami victims. Why? Because the money is not the government's to give.

The USA is spending $5 Billion a month nation-building in Iraq. The $35 Million of aide proposed by the Bush administration at the time of the above op-ed amounted to seven hours of Iraq funding. With the increase to $350 Million, now we've committed funding sufficient to maintain our presence in Iraq for three days, though hopefully, we haven't also offered two or three American lives that go along with the $350 Million of funding. At $350 Million, we've committed to 0.3% of the funding we've committed to war in Iraq.

I can't quite figure out the Ayn Rand Institute's position in our war against terror or in particular to our war against Iraq . Some of the objectivists seem to think we've botched things up, but the botching seems to be that we haven't asserted our force sufficiently to demonstrate our will to enforce our rationalist (god-given ?) right to the pursuit of life, liberty, and happiness. There generally seems to be some confusion about who the enemy is - a recognition that our first war in Afganistan failed because we didn't target the terrorists, but a breakdown of reason by jumping to the conclusion that states are the primary sponsors of terrorism. States, in the plural, no less.

Another interesting bit of surreality is the conclusion that the US, in pursing state sponsors of terrorism, must lose its inhibitions about collateral damage to innocent civilians in other nations, as well, apparently, as our concerns about casualties among our own soldiers, since we must fight a war to the finish and winning that war (eradicating ALL of the individuals in those nations that support the hypothetical governments that support terrorism) will require a serious ground war, not just a remote-controlled war.

But I digress. I'm not trying to fully understand how objectivists think about the US government's war on states that sponsor terrorism, or about the US government's actions in providing foreign aid relief for a disaster about 50 times the scale of 9/11 and 100 times the scale of the Florida hurricanes of 2004. I'm looking for a connecting thread of logic or reason between the two, instead.

If war is diplomacy by other means, and foreign aide is a form of diplomacy, and wars against states that sponsor terrorism put the USA into a position in which we're killing many more innocent civilians than the terrorists that sponsor terrorism - putting the US into a position of building nations in our image - shouldn't we also concerned enough about our image in the world, and particularly among Islamic nations, about the positive aspects of US policy? A carrot and a stick, perhaps?

At $350 Million for tsunami disaster relief, we've got a one-inch carrot compared with a 35 foot stick ($200 Billion and no apparent exit strategy for Iraq).

Perhaps the US government shouldn't be offering carrots, or helping hands, for tsunami relief at all. Perhaps in our enlightened self-interest, our government shouldn't be engaging with the world with that sort of diplomacy. But if not, then perhaps we should reconsider the much larger committments of force against the ozymoron of "states that sponsor terrorism", since no state sponsor of terrorism has ever attacked the USA.

If we can't see the comparatively low cost rational benefit of the US government taking a leading role in providing disaster relief in Indonesia, perhaps the USA would be best served by withdrawing from the world stage, rather than trying to remake the Middle East in our own image.

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