Saturday, February 13, 2010

Long-run Deficits

As you might have gathered from the post below, those who are serious about deficit reduction must be willing to talk about slimming down the large parts of the budget [note: this doesn't literally need to be a cut in spending, it can just mean slowing the rate of growth of spending], including defense, medicare, medicaid, or social security. Or they must be willing to raise taxes drastically in the future. Anyone who says that these parts of the budget are forever sacrosanct and also that taxes must remain low is not a serious thinker on this matter and should be ignored. When people talk about fiscal responsibility, they often talk about cutting down on pork-barrel spending. This is a laudable goal, perhaps (too much pork-barrel spending may allow bad politicians to stay in office by "buying" their constituents' votes), but it is basically irrelevant to the problem of the deficit. We routinely have deficits in the hundreds of billions of $, and these days they even top a trillion. When someone talks about cutting out $1 million somewhere, he might be right, but he's not really making a serious suggestion regarding the deficit. If you're $100,000 in debt due to college loans and someone suggests that it might help if you try to pick up pennies off the pavement, you would be right to ignore that person or maybe kick him in the shin.

So, what to do: raise taxes or cut spending as a % of GDP or some combination of the two? I think a good case can be made for keeping taxes relatively low. Taxes affect the incentives people face, thus altering their behavior. Higher income taxes can cause people to choose to work less. Example: You're interested in being promoted to regional manager, but you find out that this higher salary will move you into a higher tax bracket, so that you only get to keep, say, 40 cents on each additional dollar you earn. It's not so unlikely that the new job will look less appealing. You might not think it's worth all the time and effort to get this promotion. So, you're content to remain assistant to the regional manager and spend more leisure time learning about new beet recipes. So, higher taxes can mean that people work less than they would have otherwise, in other words they produce fewer goods and services than they would have otherwise. So, as a society we end up less wealthy than we would have been. This harmful effect of taxation is what economists call a "deadweight loss" (i.e. there's some income that goes neither to you or to the government, but is just never produced, because you choose to spend more time watching TV rather than working.) This doesn't mean that higher taxes are never justified, but it means they can impede economic growth, and so I tend to have a bias against them.

So, I think most of the deficit reduction will have to come from the spending side. Defense spending isn't my biggest concern, because it doesn't appear to have a consistent upward trend. It ebbs and flows as threats rise and fall. So, you see the spike of spending during the Vietnam War. You see the increased spending under Reagan and under Bush after 9/11. But you also see that it fell in the aftermath of the Cold War, for example. So, the main problem for future deficit hawks is to deal with entitlement spending (e.g. Medicare, Medicaid, and Social Security; especially Medicare.) Social Security and Medicare (and in some cases Medicaid) are entitlements given to the elderly. But we have way more old people than we did when these programs were created in the 1930s and 1960s, respectively. Also, these old people are living longer than they used. Thus, the number of people benefiting from these programs has sky-rocketed, but the number of taxpayers has grown more slowly. So, to a large extent our budget problems are demographic problems. One of the most economically efficient, humane solutions would be to raise the retirement age (i.e. when people are eligible to participate in these programs.) This has already been raised from 65 to 67 for people born after 1959. Perhaps it should be raised again to 70 or so, for people who are, say, 45 or younger and have time to make the appropriate changes in their work and saving habits. Even this wouldn't completely fix the system, but it would be a good start.

Unfortunately, when politicians talk about changing Social Security or Medicare, senior citizens go bonkers and opposing politicians play into this fear. This happened to Reagan (though there was a compromise made in 1983 to gradually raise the retirement age to 67), G.W.Bush, and in 2009 it happened to the Democrats.

Thus, these entitlement programs are basically seen as politically impossible to fix. Not many politicians are willing to touch these programs, preferring instead to punt the problem to future politicians. But eventually they will have to deal with it. It will take courage, but it would be best to solve these problems before they truly become disasters.

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