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Tuesday, January 3, 2017

The Structural Budget Problem, Part 2

In the first part of this article series I explained how we got ourselves into our state's budget mess:
Once minerals prices deflated, a grim reality, hidden behind smoke screens of oil, coal and natural gas prices, was suddenly painfully visible from our (not yet renovated) state capitol. At that point, though, the prevailing opinion (not shared by all legislators) was that it was more important to save state spending than to bring the size of government in line with what the tax base could sustainably provide for. 
I also explained how entitlement spending runs away from tax revenue, and how the gap between the two continues to grow over time. 

Today, let us take a closer look at Wyoming and identify the so called "structural deficit" in our state budget. 

First of all, though, we need to clarify some terminology, specifically the difference between two types of deficits: structural and cyclical. The difference is absolutely fundamental if we want to find a sustainable solution to our state's budget problem. 

Budget deficits are as old as government itself; back in the good old days kings used to start wars literally to conquer more taxpayers. You do not have to go all the way back to the Roman Empire to find examples of this, shall we say, assertive fiscal policy. It was common practice in Europe in the 16th and 17th centuries; at one point, Sweden conquered almost all coastal land around the Baltic Sea because the Swedish kings of that era wanted to expand the nation's tax base.

In more modern times, budget deficits have become less of a military matter and more of a headache for economists and legislators. The Great Depression and the macroeconomic crisis of the 1930s sparked lots of new research into how politicians could address, and avoid, deficits. 

For the most part, in the mid-20th century deficits in European and American government budgets were cyclical: they were caused by a recession and went away as the recession ended and the economy started growing again. However, in the 1970s a new trend emerged: to an increasing extent deficits outlasted recessions. These new deficits proved immune to all fiscal and monetary policies that governments and central banks threw at them. 

The U.S. government went into deficit a couple of years after Congress approved President Lyndon Johnson's Economic Opportunity Act (the founding document for the modern American welfare state). With some fluctuations, the deficit remained until President Clinton's second term, when he hashed out four balanced budgets together with John Kasich, then budget chair in the Republican-controlled House of Representatives.

Two factors helped the Clinton-Kasich duo in their fiscally conservative endeavor: a tight grip on spending, and strong growth in tax revenue. Both those factors went away under Bush Jr., who is not to blame for the slowdown in growth but is responsible for the fact that non-defense spending on his watch grew by 6.4 percent per year, on average. 

Herein lies a clue to the endemic deficits in the federal budget: the War on Poverty not only marked the launch of the American welfare state, but it also marked the beginning of perennial deficits. The non-defense spending growth under President Bush Jr. was entirely driven by welfare-state entitlements. 

The deficits under President Obama have been driven by the same type of spending. In other words: the welfare state inevitably creates a structural budget deficit. 

There is only one route to the elimination of a structural de cit: to permanently change the balance between expressed spending obligations and the macroeconomic tax base. In theory that change can consist of permanent spending reductions, permanent tax increases or a combination f both. However, as predicted by the Laffer curve and corroborated by both American and global experience, permanent tax increases erode the tax base and therefore take a toll on tax revenue. In a nutshell, they defeat their own purpose.

Our deficit here in Wyoming is predominantly structural in nature. This is hardly surprising, given that our state is not a small-government state. We have the highest government employment ratio in the country, and the welfare state is alive and well in our state budget. The funding and the operation of entitlement programs (which includes, e.g., public K-12 education) consume approximately two thirds of the state budget.

Based on a so-called performance definition,* we have a structural deficit embedded in the Wyoming state budget of 40 percent of state spending. 

This does not mean that the state actually only pays for 60 cents of every dollar it spends, nor does it mean that our actual state budget, here and now, is 40 percent of total outlays. But it means that without discretionary measures - including but not limited to capital gains, drawdowns and dividends from state savings - and without excessive inflation in, for example, minerals prices, our state government would quickly fall flat in trying to fund its ongoing spending commitments.

The structural deficit in the state budget is identifiable back to at least 2007; the deficit that our state lawmakers are dealing with now is essentially the top of the deficit, laid bare by a non-cyclical decline in revenue. The problem is that the anti-deficit measures they have thus far proposed will not do much to solve the structural deficit problem. Returning again to the white paper from the school-funding subcommittee of the Joint Education Committee, here are the foremost proposals of spending reductions:
  • Continued decreases in total funding. This is a good idea in theory, but as I explained yesterday it does not address the cost drivers that are already built into education spending. If the legislature address those cost drivers instead, this measure will be redundant. 
  • Recalibration of cost formulas for "non-personnel elements". A potentially good idea, as it addresses one of the structural-growth parameters in education spending. However, to have an impact on state spending anywhere near the structural deficit, the legislature as a whole needs to apply this kind of approach on a broad, systemic scale. At an estimated $22 million in savings, this application is right in kind but wrong in quantity: it is barely an accounting error.  
  • School district consolidation, statewide school-bus purchases and reduction of central-office administration salary costs. Again, right kind of thinking with the wrong kind of application. Instead of having school bureaucrats and themselves - our elected officials - determine what size and kind of administration our schools need, why not let the free market do that job? The savings potential is far bigger than the few millions estimated by the subcommittee.

It is time for our legislators to ask the right question. That question is not about how we can save big government in Wyoming. 

The right question is what government Wyoming can afford in the first place, then prioritize functions based on their essential and non-essential nature, and allow the private sector to take care of everything else.

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*) Economic theory is a bit unclear as to exactly how to measure a structural deficit. I prefer the performance-based definition because of its empirical applicability. For further reading, see: 
Larson, S: A Dynamic Definition of the Structural Budget Deficit; Discussion Paper for Compact for America; December 2014; or:
Larson, S: Estimating the Structural Deficit in Wyoming; Republic Free Choice; May 2015.

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