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Friday, August 4, 2017

Right and Wrong about Spending Cuts

Now that we have both Senate President Bebout and Senator Peterson, Chairman of the Joint Revenue Committee, on record saying that they prefer spending cuts before tax increases, it is time to focus the discussion about our state budget on just that: spending cuts.

First, though, let me make one point about taxes, one that addresses one of the main arguments for a Gross Receipts Tax (GRT).
Proponents sometimes say that we need a more stable and sustainable way to fund government, and that the GRT would provide that stability. As a counterpoint, consider the following numbers on corporate income-tax revenue in North Dakota:

In the 2011-13 biennium, General Fund revenue from the corporate income tax amounted to $385.8 million;
In the 2013-15 biennium, the same tax produced $435.2 million in revenue;
In the 2015-17 biennium, revenue from this tax plummeted to $159.9 million;
In the 2017-19 biennium, North Dakota's corporate income tax is expected to deliver $102 million to the state's general fund.

From one biennium to the next, the revenue from this tax dropped by 73 percent. The total revenue loss from 2013-15 to 2017-19 is an estimated 76 percent.

A Gross Receipts Tax is closely comparable to a corporate income tax (income taxes in general, in fact, except they do not apply to government employees), which makes the North Dakota experience highly relevant for Wyoming. All taxes fundamentally rely on the same underlying economic activities: private sector production, consumption and investment. It matters less if we call the tax a "sales", "property", "severance" or income" tax - at the end of the day the revenue is collected from the very same pockets.

Which brings us back to what really matters: spending cuts. Let us use a government union boss from - you guessed it - North Dakota as a segway. The Bismarck Tribune reports that the legislators up in the Peace Garden State have made a concerted effort at reducing spending. They have succeeded to some degree: total state government appropriations are down $424 million for the next biennium. This is a small but nevertheless respectable amount given that total appropriations are $13.5 billion. In response to state employee layoffs, the newspaper interviewed a public employee union representative:
Nick Archuleta, president of North Dakota United, the union for public employees and teachers, worried that government services will be affected by fewer people providing them. “All of these people are working for the public good,” he said. “Just because there’s nobody in those positions doesn’t mean the work stops.”
Mr. Archuleta is making a very good point, one that is all too often overlooked in the debate about government spending cuts. There are two reasons why we have government employees: a) because government has made promises it tries to deliver on; and b) because it lives off taxpayers' money.

The second reason leads to inefficiencies, over-staffing and in some cases (having worked at public universities I can personally testify to this) the creation of new positions and new spending programs just to try to get even more money from the legislature. This motive for government employment costs taxpayers a lot of money, and we need to address it as part of a strategy to reduce government spending.

The big cause of government employment, though, is the first reason: government promises. In order to get spending cuts right, we need to recognize the tie between promises and government payroll.

Take, for example, a government hospital. Suppose it serves an area with (just to use random numbers) 100,000 residents and has 200 employees. Some of these employees - let us say 40 - have been hired for the second reason mentioned above: taxpayer funding makes it easy to expand operations with no regard to efficiency and productivity. The rest, we assume, are actually there to deliver health care and provide necessary administrative services.

Suppose the cost of delivering health care goes up by five percent per year. This is for salary advancements and related costs; for simplicity, let us assume that all costs are "baked in" to the cost item we call staff salaries. 

In year 1, it costs - say - $1,000 per employee to run the hospital. The next year the total budget of $200,000 will rise to $210,000.

Suppose that in year two we tell the hospital that we will cut their budget by ten percent. Instead of having $220,050 - an increase by five percent - they will have $189,000 to work with. 

The budget cut is equal to the cost of ten percent of their staff, or 20 people. Who will be laid off? Again, we have two categories of employees: those who are directly involved in delivering health care and providing necessary paperwork related to that delivery; and those who have jobs that were added simply because this is a tax-funded operation.

Based on organizational theory, public-choice economics and many people's experience with working at government agencies, it is fair to assume that the latter category of employees will be well suited to protect their employment. Since they are employed primarily for other reasons than to deliver the intended service, they can lobby the organizational leadership to protect themselves against budget cuts. 

With a general budget cut that does not come with micromanaging ties, the hospital leadership can then choose to make cuts where it hurts organizational culture the least - namely in the operations part. By letting go of 21 health care providers and administrators, they can make the hospital fit within the new, slimmer budget, but they have also reduced the quality of the product that taxpayers expect. 

The community of 100,000 people now have 139 health-care delivery staff to rely on, as opposed to 160. This means that there are now 719 potential patients per health care staff, as opposed to 625 earlier. In plain English, this means longer waiting lists, less time with the doctor, a higher rate of inaccurate diagnoses...

Now, after the ten-percent budget cut, the decline in health care quality is the only thing that has changed. The next year, costs go up five percent again, putting the total budget at $198,450. Costs will continue to go up along the same trajectory.

This year, though, the legislature decided to implement an efficiency enhancement program. All government agencies are asked to follow certain guidelines to make sure that the money they receive in appropriations is maximized for operations and that overhead and secondary functions are kept to a minimum. In this case, the hospital management does not have a choice: they simply must take on the category of employees that are not primarily there to produce health care. 

Suppose all 40 of those are laid off. The cost of the organization now drops to $156,450, a significant decline. Assuming that the efficiency program did its job completely, this budget reduction has not affected the delivery of health care. The 100,000 community residents still have only 139 providers to rely on, but at least the cost of that health care has gone down by 21 percent.

Quite an accomplishment, right? Indeed. There is just one problem: the cost of delivering that health care still continues to climb by five percent per year. Remember: we have not changed the actual government promise. We have made government deliver more efficiently, but this is still a government-run hospital. It delivers health care as a monopolist. Alas, next year costs go up by five percent year to $164,273. 

Since the cost trajectory remains unchanged, the hospital remains the same long-term challenge for the community. The efficiency enhancement slimmed down government operations, and it therefore gave us some valuable room to cut taxes and give some money back to the private sector. However, over time the cost trajectory of government, which remains unchanged, will gradually climb the total cost of government back to where it was before. 

If we are smart, we use the fiscal breathing room that the efficiency program created, to execute a structural reduction of government. This means permanently removing the promise that government has made.

What does this mean?

Privatization and competition. By giving health care providers the right to open clinics and hospitals on their own terms, government takes a step back and gives the private sector the room it needs to provide a better, lower-cost product than government is able to do under monopoly.

In other words, the best strategy for permanently reducing the size of government is to:

a) enhance its efficiency and thereby create fiscal breathing room for long-term reforms, and
b) permanently remove promises that government cannot keep or cannot deliver with the same quality and cost efficiency as the private sector.

If we follow this two-step reform model, we can accomplish a lot in terms of spending cuts. We can, in fact accomplish so much that there will be no need for higher taxes. On the contrary: over time, taxes will come down and the private sector will get even more room to thrive.

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