Structural Spending Reform, Part 2

Spending cuts fall into two categories: reactive and proactive. The reactive kind is what legislators resort to when they have a budget deficit on their hands. The purpose behind these cuts is to maintain the structure of government spending but accommodate it to current revenue conditions.

The world is full of examples of reactive spending cuts. We see them on a regular basis, from minor downsizing of appropriations for isolated municipal agencies to large-scale austerity programs in European welfare states. By contrast, the proactive kind is not very well known. It has not been practiced on any broader scale; a rare example is the health-insurance reform in the Netherlands where a majority of health-care funding was transferred from government to private insurance.

Unlike reactive spending cuts, where the purpose is to maintain the structure of government funding, proactive cuts are designed to reduce spending by altering its very structure. In other words: where the reactive spending cut is aimed at preserving the welfare state, the proactive cut is aimed at eliminating it.

Reactive spending cuts: temporary reductions

To understand the reactive kind of cuts, one must first understand the purpose behind government spending – in other words, the reason why government spends money in the first place.

There is a simple technical answer to why we have government spending programs: because we created them. However, from an analytical viewpoint this is not a very useful answer, nor is the suggestion that we have government spending because bureaucrats and politicians want them. While there is a public-choice element in the perpetuation of government spending programs, this explanation only tells us something about why government programs continue to exist. It does not even give us the full answer why they do; in a democracy, political and bureaucratic greed are no match for the public vote, should the public vote decide against that greed.

An answer to the question why we have government spending in the first place must always center in on the purpose behind those programs. To do so we need to separate two types of spending: that which is consistent with the minimal state, and that which is not. The purpose of the former is to protect life, liberty and property; since this kind of spending is a small minority of the federal budget (national defense, e.g., is less than 15 percent), its purpose is of no real consequence in a discussion about structural spending reform.

We can identify the purpose behind the latter type of spending either by its ideological origin or by its operational outcome. The ideological origin is to be found in the structural reforms that established the current welfare state, i.e., the War on Poverty (which I covered in detail in my book The Rise of Big Government). As specified in the literature behind the War on Poverty, and by how the reforms were designed, the purpose behind the spending programs that emerged, is economic redistribution.

An examination of how the entitlement programs in the federal budget operate, leads to the same conclusion. The purpose is to redistribute income, consumption and wealth.

Once we have this purpose established, we can move on to the next step, namely the question how we can reform spending in these programs. We could debate the need for spending reform in the first place, but the need for such reforms is axiomatic, given our structural budget deficit. Therefore, our focus will now have to be on what type of spending reform is appropriate for government programs that are designed to be, and operate as, conduits for economic redistribution.

A reactive reduction in spending aims to reduce the cost of the program without altering its purpose. In other words, we still want the program to redistribute economic resources between citizens, but since we cannot pay for all of that redistribution (given that we have a budget deficit) we want to make a temporary adjustment to the cost of the program.

That temporary adjustment – the reaction to the deficit – can target either of two variables. To see which, let us specify spending on entitlement benefits, GE, as:

where e is the share of total population that is eligible for entitlements. Furthermore, we specify B as:

where b is the share of household income that gets paid out in the form of entitlement benefits, and Y is household income.

A spending cut can target either b or e. A reduction in the share of income that gets paid out as entitlement benefits takes one of two forms:

  1. Less cash paid out, for example in the form of a reduction in the Earned Income Tax Credit (EITC); or
  2. A smaller portfolio of in-kind benefits, for example by removing or capping access to services covered by Medicaid.

Either spending cut will reduce outlays as intended. It will constitute a breach of promise by government to constituencies eligible for entitlement benefits, which of course is a moral problem in itself. However, there is also an economic problem related to it. Those who are eligible for entitlement benefits gradually adjust their lives – their personal finances – to the government supplying them with those benefits. A person who receives $3,000 per year in EITC will suffer a noticeable loss if that amount is cut – even temporarily. A family on Medicaid that loses access to, say, maternity care will have no other option than to go without it.

If these cuts were temporary, aimed at reducing a temporary budget deficit, there is no long-term harm done to the economy. However, if they are repeated in response to recurring budget deficits, over time the cuts will inject uncertainty into the economic planning among those who depend on entitlements. Their financial planning will change, with reductions in spending or withholding (for saving purposes) of income increases.

The larger the eligible segment of the population – the larger e is – the more significant this uncertainty will be for macroeconomic activity. However, it pales in comparison to another macroeconomic effect, one we can best illustrate under another form of reactive spending cuts.

Reactive spending cuts: austerity

When the occasional spending cut described above is put to work as a regular response to declining tax revenue, we call the policy “austerity”. We have seen it being practiced in several European countries in the past few decades, though the highest concentration was during and after the Great Recession ten years ago.

Austerity means that government tries to reduce not just the occasional budget deficit, but recurring deficits, by cutting spending and raising taxes. The principle was captured very well by Cato Institute senior fellow Michael Tanner in the foreword to my book Industrial Poverty, where he called it a strategy to “make the welfare state more affordable”. It is a doomed strategy, for reasons that we saw spelled out above, but instead of returning to the two simple equations, let us put it in the form of a graph.

Suppose government spending is growing at a steady rate, along function 1 in Figure 1 below. A recession happens, tax revenue fall and a budget deficit opens up. In response, Congress decides to reactively cut spending (A). The cuts reduced the two variables from above, e and b: fewer people are eligible for benefits and the value of the benefits is lower.

However, we haven’t changed the purpose of the benefits. They are still supposed to provide the eligible population with entitlements in order to elevate their standard of living. To do so, the entitlement programs still pay out benefits relative to total household income. For example, if a family makes $36,000 (to take a random number) and get $2,500 in EITC. As their income grows and the EITC thresholds move up with indexation, their benefit is supposed to stay unchanged. In other words, if their income increases by three percent and the indexation increases the EITC by three percent, they still receive the same boost in their income as before.

Does it make a difference if we cut the EITC from $2,500 to $2,000? No. The next year the benefit will still be three percent higher.

A similar increase will happen in all entitlement programs. Medicaid costs more because health care gradually becomes more expensive (it is in good part the nature of quality advances in the practice of medicine), food price inflation drives up the cost for food stamps (a.k.a., SNAP), and so on.

In other words, after we have cut benefits (A) we return to the same growth path as before, though at a lower trajectory (2). Then a new recession happens and a new deficit opens up. Congress repeats the process with another round of spending cuts (B) and the bump-down of spending to a new, still up-sloping trajectory (3):

Figure 1

As Congress continues the process of reactive spending cuts, they gradually erode the quality of the entitlements they provide. The underlying problem remains unsolved: promises made in the entitlement programs are manifested in certain cash and in-kind benefits; so long as we don’t rewrite those promises, we will continue to see spending go up over time. Repeated, reactive cuts only serve to frustrate entitlement recipients, who have no alternative but to rely on increasingly stingy government benefits.

But why do they not have an alternative?

Before we answer that question, let us briefly note that the Penny Plan, as proposed by many member of Congress including Senator Rand Paul, also belongs under the reactive spending-cut headline. It is a more elaborate form of austerity, but its fiscal effects are the same as those seen in Europe under the austerity policies explained in Figure 1. All the Penny Plan does is chain together the “troughs” of points A, B and subsequent spending cuts into a preset trajectory of “troughs”.

Once the chain ends, as proposed in Senator Paul’s version of the plan, spending returns to the underlying upward sloping trajectory. The problem that brought about the Penny Plan in the first place, remains unsolved.

But why, then, do people not have an alternative to relying on increasingly stingy entitlement programs?

Because the government promise is still intact. To take Medicaid as an example, it still occupies the same space in the health-care market. Its cost to enrollees vs. other options is still the same. The taxes that pay for it – and the entire welfare state – are still unchanged. Regulations that protect government programs are still unchanged.

In other words, when government cuts the benefits of a program, the rest of the economy remains the same. The taxes, fees, regulations and other incentives and disincentives that in the first place drew people into their entitlement dependency, are all still there. For those who make low wages and depend on an increasingly austere Medicaid plan for health care, the job market has not changed. Just because government cuts away benefits from the plan, does not mean it has become easier for them to go out and find a job with better benefits.

So what do we do instead?

We change the entire situation for the Medicaid dependent. We alter the conditions that keeps him trapped in the program.

How? Click here and read all about it in Part 3.

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