Structural Spending Reform, Part 3

In Part 2 we discussed reactive spending cuts, which include the Penny Plan and traditional European austerity. We concluded that this type of spending reform defeats its own purpose: it does not solve the underlying problems causing a structural budget deficit. The reform type does not incentivize economic growth, but instead contradicts it by keeping government expensive over time, while eroding its benefits.

Today we will dive into the alternative reform type: proactive spending cuts. This type is almost unheard of in reality, and there is scant literature – if any – explaining either its theory or its practice. The closest real-world example is the Dutch health-insurance reform: in 2005, the year before the reform went into effect, government paid for two thirds of all health care in the Netherlands; in 2007, the year after the reform went into effect, the proportions were reversed.

As of 2017, the latest year with available data, the private share was three quarters. This is higher than in America.

A coming article will examine the Dutch reform in detail; for now, let us lay out the principles for proactive spending reform. Before we do, though, let us notice that this reform type is associated with some significant political and policy challenges. We can overcome those – in fact, we must. Proactive reform is the only way to secure the fiscal sustainability of our government. However, the challenges are not be under-estimated, and will be discussed in articles on specific reform proposals: health insurance, Social Security and income security.

In Part 2 we noted that entitlement spending, which accounts for two thirds of all federal government spending and more than half of state and local government spending, is defined in principle by a simple equation. Spending, GE, is determined by the share of the population, e, that is eligible for the entitlement program, and the amount they get in benefits, B:

Benefits, in turn, are determined by the value of those benefits, b, as share of household income, Y:

The problem with these two equations is that they define a trajectory of perpetual increase in government spending. The key element of proactive spending reform is to break this trajectory and point government spending in a new, fiscally sustainable direction.

There is a technical and a theoretical component to this reform. First, the technical component, which consists of severing the tie between b and Y in the equation above. We replace the bY variable with a fixed B:

Each eligible individual now gets a fixed amount of benefits. That amount is independent of household income; as a ratio of household income, it declines over time.

From a theoretical viewpoint, this reform requires a more substantial change than its technical representation may suggest. The key is to redefine the formula by which we estimate poverty: today our definition of what it means to be poor is relative, with the poverty limit largely tracking median household income. This has absurd consequences, primarily that a thriving economy cannot reduce poverty. On the contrary, the population defined as poor can actually increase, even though employment is high and household income is rising.

The reason is, again, that poverty is defined as a percentage of median household income:

  1. If median income is $50,000 and the poverty limit is 55 percent of that, then you are poor if you make $27,500;
  2. If median income rises to $55,000, then the poverty limit rises to $28,250.

You are now better off being poor than you were before. As a result, the amount of entitlement spending has to rise, as per the definition of B above.

To decouple B from Y, we need to replace the relative definition of poverty with an absolute definition. This is represented by the third equation above, where entitlement benefits are capped and kept constant.

Before the War on Poverty, the federal government used an absolute definition of poverty. It constituted the foundation for the welfare-program reforms under the Social Security Act of 1934. Figure 1a sketches the idea behind a return to this reform. The present trajectory in government spending (1) will continue unchanged (2) if no reform is made. If the definition of poverty is changed from relative to absolute (A) the trajectory of entitlement spending will change radically (3):

Figure 1a

But wait: doesn’t this look a lot like a Penny Plan in practice?

Superficially, yes, it does. However, Figure 1a only tells half the story of a proactive spending reform. There is another side to the equation, namely the funding of the welfare state. However, before we get to the taxes, let us also note that this is just the fiscal schematics of a proactive reform; its execution within each entitlement program will bring far more difference than is laid out here. Those details will come in subsequent articles.

One more point before we get to the tax side: let us not forget the purpose behind proactive spending reform. The reactive type aims to make the welfare state more affordable – it does not seek to eliminate the welfare state. Therefore, government promises remain on the shoulders of the taxpayers, whose duty it is to work harder and harder over time to foot the bill.

A proactive reform seeks to permanently alleviate the burden on taxpayers.

Speaking of which, if the proactive reform is going to work as intended – in other words to roll back the welfare state – it must include reforms that alleviate the burden on taxpayers. In other words, tax cuts, but not just any tax cuts.

Today, the welfare state is paid for with tax revenue that rise and fall with GDP and, more specifically, personal income. Let TE be total tax revenue paying for the welfare state. Let t be the aggregate tax rate – how large a share we all pay in taxes combined – and let Y, again, be household income:

If we leave taxes alone, the burden will rise not only with income, but also relative welfare-state spending after the reform in Figure 1a. In other words, we have to combine the reform that changes the spending trajectory with a reform that caps taxes on par with spending:

Let us now plot the tax-revenue trajectory together with spending from Figure 1a. We assume that we have a structural budget deficit, represented by the vertical difference between the red (spending) and blue (tax revenue) functions.

With points 1, 2, 3 and A being the same as before, we now have tax revenue originally growing parallel to, but numerically below spending (4). If no reform takes place, it continues upward (5). However, suppose we combine spending reform (A) with tax reform (B). Revenue now veers off (6) to eventually catch up with the news spending trajectory:

Figure 1b

What type of tax reform would produce this result? It would take a reform that shifts from a tax that is proportionate to economic activity – be it income or consumption – to a tax that is proportionate to expected spending. Denoting this spending variable with *, we set the tax rate to:

Expected spending, in turn, is determined by spending in the past – say one year – and a forecast for spending in the coming year:

Since economists are notoriously bad at forecasting, it is reasonable to balance the forecast against past experience.

An important consequence of defining the welfare-state funding tax in this way, is that the tax rate will change with spending. Increases in spending will immediately translate into higher taxes, and vice versa. This has one important effect: as incomes grow and entitlement spending remains constant, the tax burden will gradually decrease.

As the tax burden declines, the private sector gradually gets more room to spend, invest, create jobs and build wealth. Over time, this keeps the economy on a path where demand for government entitlements will not only be a lighter burden at a constant rate of eligibility, e, but where the population needing government assistance will gradually decline.

Now: how do we put this proactive type of spending reform to work? The answer begins with Part 4!

Click the Follow button to always get updates first!

Laffer and Moore Get It Wrong

Art Laffer and Steve Moore are widely considered to be the foremost economists of the libertarian movement. They are praised and raised to the skies, lauded and quoted widely. In Laffer’s case, it is in many ways merited. He did a fantastic job getting the Reagan administration to agree to a sweeping tax reform.

Since then, though, as I have shown in my four-part series on tax and spending reform, his theory has lost its steam.

Tax cuts don’t work anymore. I wish they did, but they don’t. The evidence is irrefutable.

But it gets worse than that. Not only do tax cuts don’t work, but these two fine gentlemen are selling this ineffective medicine as a means to pay for the welfare state. In short: cut taxes, and we can afford socialism.

Yes, that’s right. Art Laffer and Steve Moore make this case. In their book Trumponomics they explain that higher growth will pay for our socialist welfare state:[1]

One underappreciated dividend from this higher permanent pedestal of economic growth is that, if Trump succeeds, it will help largely solve the long-term funding crisis of Social Security and Medicare. With 3 percent economic growth, up from the 1.8 percent predicted by the Social Security and Medicare actuaries, the compounding effect over 50 years means more than $50 trillion of revenues into Medicare and Social Security trust funds, largely dissolving the funding shortfalls of these programs – and perhaps leaving them in long-term surplus, not deficit.

That’s it. Cut taxes, get more growth, and we can continue to use two thirds of the federal budget to take from Pete and give to Paul.

This paragraph is also the closest that Laffer and Moore get to even discussing government spending. They have a non-committal passage on pages 99-100 about how nice it would be if people didn’t get more in welfare than they get working a minimum-wage job, but they have absolutely no ideas on how to approach that problem with tangible reform ideas.

I have actually proposed a welfare reform that would do what Laffer and Moore are dreaming about. If Steve Moore had shot me an email, I could have shared my plan with him (again). If the original version is not palatable, I have an updated model from 2012, published on SSRN in 2013, that I originally developed for a presidential campaign.

The problem, of course, is that spending reform is hard work. It is quite a bit harder than to propose and lobby for tax cuts. Spending reform quickly runs into a fire storm of criticism from the left: do you really want to take away Medicare from this grandma and Medicaid from that poor family? Are you cruel and cold-hearted?

My reform circumvents that problem. In other words, the big obstacle to spending reform is not the design of workable solutions – it is the lack of courage among the layers of libertarians. Courage to propose workable reforms. Courage to convince Congressional Republicans to think anew.

Courage to go against the mainstream.

Laffer and Moore lack that courage. The closest they get to discussing actual, actionable spending reform is a quick, positive mention of the Penny Plan. As I recently demonstrated, this plan is entirely unworkable. Why? Because it keeps all the welfare-state promises intact. It rests on the premise that government can provide everything it has said it will provide, only do so more efficiently.

As my numbers show, that is wholeheartedly impossible. The only option is to reform away the promises – to return them to the private sector and get government out of economic redistribution altogether.

Laffer and Moore steer clear of that one. Their solution is a dreamy comment about how higher growth would eliminate the budget deficit and perhaps even let the welfare state run a surplus.

This is the neoconservative approach to the welfare state. It is close to what Irving Kristol, William F Buckley Jr. and others talked about when they discussed the American welfare state. Like Laffer and Moore, the neocons of the 20th century firmly believed that the welfare state should be preserved, but that it should be run a bit more efficiently than it would be under socialist management.

In the 21st century model, this neoconservative dream relies on yet more tax cuts to generate yet more economic growth. I hate to be the Grinch that stole Christmas, but the facts on the ground speak a different language. First, consider Figure 1, which reports 715 pairs of observations of government revenue as share of GDP, and GDP growth. The numbers are from 29 European countries from the period 1996-2019 (with limited availability from some countries). These observations are then organized in deciles based on the tax-to-GDP ratio, with average tax ratios and growth rates for each decile:

Figure 1: Growth and government in Europe

Source of raw data: Eurostat

The bigger government gets, the more sluggish the economy grows. The same economic mechanisms that work in Europe, work here as well.

But wait – didn’t I just say that this is tax revenue as share of GDP? Exactly. But what if we cut taxes? Doesn’t that move us up the blue function?

No, it doesn’t. Laffer and Moore want to keep spending as usual (assuming that they realize what will happen in Congress when the Penny Plan starts pinching away big chunks of our entitlement programs) which means that the welfare state will not get smaller. It will continue to grow. Therefore, government spending will continue in the bracket of 37-40 percent of GDP. If we are going to balance the budget, we need to collect the same share of GDP in taxes, fees and charges.

Since the size of the welfare state remains unchanged, all that the Laffer-Moore growth strategy will accomplish is a redistribution of the tax burden.

But wait: if GDP grows, then the denominator grows. That means the welfare state may not shrink in terms of dollars, but it certainly declines are share of GDP, right?

No, it doesn’t. As I explained in my book The Rise of Big Government, our welfare state has a built-in mechanism that automatically grows its size as GDP grows. It is called the “relative definition of poverty” and states that people are entitled to government benefits, cash and in-kind, when their income is at a certain percentage of median household income. Since GDP growth means that median household income grows, so does the eligibility threshold for welfare-state benefits.

In short: the more the economy grows, the bigger the welfare state gets. Therefore, if Laffer and Moore got what they wanted, their sought-after surge in tax revenue would be chasing welfare-state spending like the rabbit that tried to race the turtle and never caught up with him.

To solve this problem, you need to redefine the ideological nature of the welfare state.

Then, of course, there is the problem with economic planning. Government does not operate under the free-market price mechanism. It uses a different value unit, one that is directly derived from Marxist labor-value theory. Therefore, the allocation of resources under government is neutral, even hostile, to economic growth.

I elaborate on this problem in my forthcoming book Socialism or Democracy: The Fateful Question for 2024. Until it is out this winter, we will simply note that the bigger government gets, the larger a share of the economy is put under growth-hostile administration. There is simply less economic activity out there that can produce the growth that Laffer and Moore depend on.

Simple arithmetic, in other words. I am surprised that two guys as smart as Steve Moore and Art Laffer did not figure this out.

Structural spending reform, folks. Nothing else works.

[1] Moore and Laffer: Trumponomics. All Points Books (2018).

Tax Cuts or Spending Cuts: Part 3

One of the more popular ideas for spending reform in America today is a so-called Penny Plan: you allow for a slightly slower growth in spending over an extended period of time, and eventually you actually balance the budget.

In 2019 Senator Rand Paul introduced a more explicit version:

Dr. Paul’s budget simply states that for every on-budget dollar the federal government spent in Fiscal Year 2019, it spend two pennies fewer a year (a cut of two percent per year) for the next five years (at which point balance is reached), with spending then growing at two percent for five years afterward.

On the face of it, this looks like a good idea. If this plan had been introduced in 2010, the trajectory of federal spending would have looked quite different over the next decade. Figure 1 reports actual federal government spending (red) and the same spending simulated according to Rand Paul’s two-penny plan (green). Under his plan, by 2019 Congress would have spent almost exactly the same amount of money as they did in 2011:

Figure 1: Penny Plan spending simulation

Source of raw data: Office of Management and Budget

The Penny Plan looks like a good idea, does it not?

Before we answer that question, we might want to take a closer look at what it would do to individual programs under the federal budget. Table 1 reports what these cuts would mean to individual programs. The effects are illustrated under two premises: a proportionate cut in all programs (PPP) and a cut where defense, justice and veterans’ benefits are protected from the 35.6-percent total budget reduction (Mod. PPP). The programs listed are those that would take a hit under the modified scenario, with a reduction of 46 percent from 2010 to 2019:

Table 1: Simulation of Paul’s Penny Plan; $ billions appropriations in 2019

ActualPPPMod. PPP
International affairs            52.7            34.0            28.5
Science and techn.            32.4            20.9            17.5
Energy              5.0              3.2              2.7
Nat’l res., environm.            37.8            24.4            20.4
Agriculture            38.3            24.6            20.6
Transportation            97.1            62.5            52.4
Community dev.            26.9            17.3            14.5
Educ., sco.svcs          136.8            88.1            73.8
Health incl. Medicaid          584.8          376.6          315.6
Medicare          651.0          419.2          351.3
Income security          514.8          331.5          277.8
Social security       1,044.4          672.6          563.6
General gov.            23.4            15.1            12.6
Source of raw data: Office of Management and Budget

The total reduction of the federal budget in 2019 under the Penny Plan would have been $1.4 trillion. Regardless of whether the cuts are made straightforwardly or under the modified scenario, the reductions to individual programs are quite remarkable and raise two pertinent points for Penny Plan proponents to consider.

Before we get to those points, however, let us dispel one of the many myths that float around about the federal government, namely that we can just trim the bureaucracy and keep it affordable. I am the first to agree that government is over-bureaucratized and too large, but the reason is not the staffing itself. In 2019 the total employee-compensation cost for the federal government was $527 billion. This paid for 5.1 million employees, placing the average compensation at almost $103,000. This is, of course, an excessive amount, far above what private-sector employees make.

However, the big problem here is that under Senator Paul’s Penny Plan we would have cut away $1.4 trillion; Congress would have had to fire every single federal employee three times over to cover that cost cut. Furthermore, about 40 percent of all federal employees are in the military; if we wish to protect that function of government – which of course we should – it becomes totally impossible to execute the Penny Plan relying solely, or even predominantly, on staff reductions.

Which brings us to the two points from Table 1 about the Penny Plan. First and foremost: is it morally right to tell every American receiving checks from Social Security that they will have to do with less money so that Social Security in total can keep its spending constant over ten years? Remember that as Figure 1 reported, total federal spending in 2019 was the same in dollars as it was in 2011.

A similar point applies to Medicare and Medicaid. Is it morally right to tell people who enrolled in either of these programs, trusting that government would provide for their health-care needs, to make do with less than two thirds of the health care they were promised?

The answer to these moral questions leads us over to the next point about the Penny Plan: it assumes that government will continue to make all its promises to all the people who are enrolled in tax-paid entitlement programs. This promise problem becomes acute under Medicaid and Medicare, two programs that provide people with tax-paid health insurance. As I have explained elsewhere, health-care costs rise by a certain amount per year simply because of the advancements in medical technology. Generally, if we wish to keep enjoying better health care, we need to let the med-tech advancements make their way to the frontline of our health care system.

We can – and should – use the free market for health insurance to mitigate the cost increases; he who does more with less will always grow his business at the expense of competitors who are not as innovative. Nevertheless, medical technology costs money, as does improvements in skills among medical professionals. Therefore, we have to let the cost increase over time.

Under a government plan, this problem becomes even more serious. There is no real incentive built into a tax-paid program to do more with less, hence the tendency of cost hikes to hit taxpayers unmitigated. But even if we can trim the programs to some degree, costs will still go up.

Under Paul’s Penny Plan, there would have been zero cost hikes from 2011 to 2019.

What medical technology advancements; what gains in health-care skills and treatment methods; should enrollees in Medicaid and Medicare forfeited under his plan?

There is, of course, an answer to this question. It is part of the answer to the broader question: “If the Penny Plan doesn’t work, what do we do instead?” That answer has to do with structural spending reforms, which we will discuss in Part 4.

When will Part 4 be posted? Click the Follow button to get an update the instant it is available!

Tax Cuts or Spending Cuts: Part 1

There are some very good organizations out there fighting to keep taxes down. Americans for Tax Reform is at the forefront, with others not far behind. They all fight the good fight: it is always preferable to have lower taxes than higher taxes.

Many economists propose tax cuts as a way to reduce the budget deficit. The idea, known as supply-side economics, is based on the premise that lower taxes generate stronger economic growth, which in turn generates more tax revenue.

Supply side economics is a valid theory and the Laffer Curve – almost the hallmark of supply-side theory – has strong empirical support. I recently published an article where I reported data for the European economy, showing a solid Laffer effect on tax revenue. However, I also cautioned:

There is another side to the Laffer Curve, of course. If government does not cut spending in tandem with the tax cuts, but if entitlement programs are allowed to continue to grow, then the rise in revenue collections will be inadequate and fail to fully fund the welfare state. Therefore, the Laffer Curve must not be used as a simple go-to solution when deficits get out of hand; it is an instrument that should only be applied as part of a structural transition from a big welfare state to a small government focused on its core functions.

Once the welfare state grows past a certain point, the Laffer effect, while still visible, will be far too weak to close deficit gaps. Plain and simple, the supply-side mechanism ceases to function insofar as the government budget goes. Tax cuts still generate more economic growth and thereby an increase in tax revenue, but without adequately affecting the government budget.

The reason is as simple as it is brutal: too much spending. Having grown increasingly frustrated with the lack of focused attention to the spending side among libertarians and conservatives, in the next few days I will be rolling out a series of articles on the dynamics between tax cuts and spending cuts.

While fiscal conservatives do pay attention to spending, it is almost always in an ad-hoc manner. A common idea for reform is a penny-plan style reform that slows the growth of government spending. This is not a bad idea in and of itself, but as we will see in a coming article it does not solve the underlying structural problems that drive government spending. A penny-plan style spending reform buys us time, slowing the growth of government enough to let Congress piece together a major entitlement reform agenda.

What we need is a master plan for the structural overhaul of our welfare state. We need to reform it away until government is out of the business of economic redistribution.

This is no easy task. It is in fact more daunting than it was back in the 1960s putting the first man on the moon. That, however, is no excuse not to do it. Leaving an unaffordable welfare state for our children to pay for, and asking them to do so while also funding our consumption of the welfare state in the form of a big government debt, is nothing short of collective egoism.

It is also a safe way to ruin the country and the future of generations of Americans.

To see why the master plan is the way to go, and supply-side economics no longer works, we will work our way through a stack of data. We start today with a review of state and local government finances. Specifically, the review will show that the absence of an income tax does not help in terms of containing government spending. Bluntly: states with no income tax have just as big governments as states where income taxes provide a large share of government revenue.

As a first step, Figure 1 reports the combined fiscal balance for general revenue and expenditure for 2018 in all the 50 states. The vertical axis represents the difference between general revenue and general spending as percent of general revenue. This metric varies from year to year, with the majority of states swinging between surplus and deficit. However, the picture is almost always mixed, as reported here:

Figure 1: State and local government fiscal balances

Source of raw data: Census Bureau

Over the long term, states and local governments have had about the same problem with balancing their books as the federal government has. The deficit problem is not as pervasive, but there are years when almost all of them run deficits.

It is important to remember that these numbers include both states and local governments; the local-government share of spending varies significantly across state lines. In other words, to ignore local governments would be to give an unfair, even skewed representation of the role of government in our states’ economies.

Most of our government spending is allocated to the welfare state, i.e., programs that provide government benefits to people for the purposes of economic redistribution.* Two thirds of federal spending is for the welfare state; in 2018 the average for states and local governments was 56 percent. This share has increased over time, slowly increasing the stress on government finances. A spending program for economic redistribution is driven not by what taxpayers can afford, but by the definition of the entitlement embedded in the program. Medicaid, e.g., provides health care to its enrollees, giving them access to a portfolio of medical services the quality of which is defined by medical technology, and the quantity by patient health conditions.

I have discussed the discrepancy between health-care costs and tax revenue in a previous article. The same principle of independent cost hikes applies to education, income-security programs, housing and everything else provided under the welfare state.

This point is almost universally overlooked in the fiscal-conservative movement. Too much focus is no tax reform, specifically to keep taxes as low as possible. While, again, a respectable ambition in itself, it does not help with containing the growth of government. For example, if a state eliminates its income tax, it will most certainly not reduce the size of its government. Again based on 2018 Census Bureau data on state and local government finances,

-In the nine states where the personal income tax contributes 0-1 percent of total revenue, government spending amounted to 21.9 percent of total private-sector economic activity, a.k.a., private-sector GDP;

-In the 12 states where the personal income tax provided more than 15 percent of total revenue, government spending was equal to 21.2 percent of private-sector GDP.

The 29 states in between had roughly similar-sized governments. In other words, it does not help fiscal conservatism to abolish the personal income tax.

But does it harm fiscal conservatism to do so? That question is not primarily a matter of economic analysis, but there is one point that can contribute to the answer. Table 1 reports the revenue share of the personal income tax (Typ) and the revenue share from non-tax sources:

Table 1: Government revenue sources

Source of raw data: Census Bureau

In short: when governments cannot rely on the income tax they seek out other revenue sources instead. To take one of the favorite examples among opponents to the income tax, in 2018 government in Wyoming got 75 percent of its revenue from non-tax sources. This is the highest share in the country. Contrast this to Connecticut, where the personal income tax provided 22.3 percent of total government revenue and non-tax sources added one third of total revenue.

Government spending as share of private-sector GDP was 16.6 percent in Connecticut – and 29.9 percent in Wyoming. In other words, the supposedly low-taxed Cowboy State has the fourth largest government in the country. And this is a reasonably generous measure: if we use private personal income instead – the most proper tax base measure available – Wyoming has consistently ranked in the top two in the country.

However, more important than these factoids is the problem with political effort. It takes a lot of work to advance policy reform – spending of political influence capital – which means that every such effort must be designed to yield the best possible outcome. If we use proper metrics for that outcome (rolling back the welfare state) then it is unquestionably better to focus on spending reform instead of tax reform.

In Part 2 of this series we take a detailed look at why supply-side tax cuts are no longer effective, and why spending reform is the only way forward.

*) This category of spending includes social programs, income maintenance, health care, unemployment benefits, housing and community development and education. The last item is often overlooked, but regardless of whether or not one defines education as an essential government service, it does belong in the redistribution category. Government provides the service based on criteria defined by government, not decisions made by individuals; funding is also independent of the use of the service.

Reform Spending, Not Taxes!

In my latest op-ed for InsideSources I explain:

While the Democrat House leadership touts a very irresponsible plan for even more COVID-19 stimulus spending, the White House is signaling its equally irresponsible alternative. In an October 6 op-ed for the Wall Street Journal, Steve Moore, a member of President Trump’s economic recovery task force, proposes a 100 percent suspension of all federal personal and corporate income taxes for 2021.

Moore’s crazy idea is to simply suspend federal income-tax collections for 2021. In response, the U.S. Treasury would have to borrow $2 trillion from the Federal Reserve, on top of what the central bank is already supplying to fund the welfare state.

Moore, whom I know and who is a good and enthusiastic economist, seems to be unfettered by this increased practice of Mad Monetary Theory in Washington. To his credit, though, he has produced the same idea for abolishing the income tax in another context. Here is what Moore said back in July:

Stephen Moore, a member of President Trump’s economic recovery task force and an economist at FreedomWorks, has a bold idea for how to reinvigorate the economy: abolish the federal income tax, and replace it with a national sales tax. On the face of it, it may seem like a radical notion especially since essentially all Americans nowadays have grown up having a chunk of their income pulled out by the IRS every year. But Moore notes that the income tax is a relatively new invention in the U.S. — having only been introduced in the early 20th century.

This idea has been on the table for a long time. It has been called many things and is sometimes referred to as a “fair tax” reform.

Moore is right in that a sales tax is preferable to an income tax, and all other things equal this is a good reform to pursue. The problem is that all other things are not equal – especially not government spending. Right now, we need spending reform more than we need tax reform.

Take a look at Figure 1. It reports the shares of total government spending in the United States, federal, state and local added together. The numbers are the “rawest” you can get, with no adjustment for inflation or seasons. The message is unmistakable:

Figure 1: Shares of total government spending

Source: Bureau of Economic Analysis

Ever since the 1960s, government consumption has declined in importance. This is the kind of spending that goes to national defense, law enforcement, education, infrastructure and other outlays where a person is paid to do work for government (including on a contracting basis). In the past decade, social benefits – cash paid out under entitlement programs – has surpassed consumption as the most important function of government.

A point of order, before we move on: some consumption spending also qualifies as entitlements. For example, when government pays for health-care services through Medicare and Medicaid, it provides medical-service entitlements. We also refer to them as “in-kind entitlements”. This is a small but important note, because it helps us understand what is happening behind the numbers in Figure 1.

Before we get down into those details, let us first take a closer look at the same numbers for the federal government:

Figure 2: Shares of federal government spending

Source: Bureau of Economic Analysis

The trend from Figure 1 is even stronger here: social benefits overtake consumption already in the 1970s. Before the stimulus spending in 2020, this type of spending was already claiming more than half of the federal budget.

Which brings us back to the point about entitlements. Again, social benefits are one entitlement type – cash entitlements – but some consumption also falls in the entitlement category. Health care and education stand in the forefront, but any consumption (also known as “government services”) that is not for national defense, law enforcement and infrastructure qualifies as in-kind entitlement.

If we add up cash and in-kind entitlements, we get the welfare state. Its share of the federal budget was around two thirds before the Covid-19 stimulus craze. It remains to be seen what it will be going forward, but it is a rather safe bet that it will be higher.

Herein lies the real problem with spending: entitlements grow not because Congress keeps adding money, but because of their design. Each entitlement specifies an eligible population and how much they are entitled to. This is the entitlement value of the program, and it grows for two reasons:

  1. The eligible population grows;
  2. The product offered to them changes in character.

The second point sounds abstract, but its actual meaning is simple. In terms of services, the entitlement program promises the eligible population a portfolio of benefits with the explicit or implied promise that those benefits will be of a certain quality over time. In health care, this means that entitlement spending must grow with the rising cost of high-quality health care.

For cash entitlements, the cost driver is partly in the protection of the benefits against inflation. However, there is also the eligibility threshold: one example is the Earned Income Tax Credit, which tapers off with rising income but also expands its reach as its thresholds increase.

In short: once Congress has designed an entitlement program, it gives up control over its cost drivers. It can claim that control again, but it takes legislative action. One such action would be to bring entitlement spending out of the “permanent” section of the federal budget and into the “discretionary” fold. It is only an administrative maneuver and won’t make any difference in itself to the costs of the program, but it is the one step Congress needs to take in order to be able to reform entitlements.

Once that practical problem has been solved, Congress can move on to the next step, namely reforming the programs themselves.

How do they do that? Here is some food for thought to start with.