Where Does the Increase in Entitlement Spending Come From?

September 19, 2013Danny Vinik 1 Comment

On Monday, I penned a post arguing that Sen. Orrin Hatch (R-UT) was wrong when he commented that we have a spending problem and more revenue is not part of the solution. I used Congressional Budget Office (CBO) data from its 2012 Long Term Budget Outlook to make my point, but that data is a bit out of date. Luckily, the CBO released its 2013 Long Term Budget Outlook two days ago and guess what it showed? Our deficit is magically disappearing!

That’s thanks to the Fiscal Cliff deal that raised taxes on the highest earners, which increased projected revenues. As for spending, health care costs are growing at a much slower rate than expected, not only due to the recession, but also because we seem to have bent the cost curve permanently. That’s a huge improvement. In addition, the sequester is looking more and more like permanent policy. Thus, overall spending has dropped significantly compared to last year.

Nevertheless, entitlement spending is still projected to rise from 9.6% of GDP in 2013 to 14.3% of GDP in 2038. That’s still a large gap. The only reason the budget deficit doesn’t rise a similar amount is because the CBO projects other spending – the stuff the sequester mostly cuts – to fall from 10% of GDP to 7.1%. The increase in entitlement spending (4.7 percentage points) in the 2013 report is less than in last year’s (6.2 percentage points), but it’s still substantial. So, what’s driving that increase? The CBO breaks it down:

54% Aging: This is an unavoidable aspect of our future budget. Baby boomers are retiring and will start collecting Social Security and Medicare. There’s nothing we can do about that. As America gets older, our retirement programs are going to cost more. Not surprisingly, that’s what the CBO found to be the largest driver of entitlement spending growth. Of that 4.7% increase, 2.5 percentage points is due to aging. It’s not out of control spending on entitlements. It’s just Americans getting older. We can’t pretend that’s not the case.
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28% Excess Cost Growth: Excess cost growth is the increase in health care spending beyond the rate of inflation. It’s an area we have made significant progress on in recent years, but we can still do better. However, this doesn’t require cutting benefits or changing the eligibility requirements for different programs. It requires bending the health care cost curve even more so that health care is provided more efficiently. Obamacare includes a number of different experiments to try to find ways to do just that.
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19% Medicaid Expansion and Exchange Subsidies: This is the area that conservatives are dying to cut. but of the main drivers of long-term entitlement spending, the Medicaid expansion and exchange subsidies account for less than one-fifth of it. In addition, excess cost growth is increases spending due to rising costs of programs. It doesn’t mean that seniors receive more benefits or that more people are eligible for the programs. It just means health care is getting more expensive. The Medicaid expansion and exchange subsidies do more than that though. They bring healthcare to millions of people. Eliminating them may have a positive impact on the long-term budget, but it has serious side effects as well.

Unlike my post on Monday, my main point here is not that we need more revenue. The main point is that we have solved a large part of our budget deficit and of the part we haven’t solved, most of it is due to demographic changes and millions of more people getting health care. Republicans can yell about how entitlement spending is running out of control, but the fact of the matter is that it isn’t. It’s on an unsustainable path, but one that is caused mainly by an aging population. Policymakers shouldn’t forget that.

Don’t Worry About the Revenue in Sen. Mike Lee’s Tax Plan

September 19, 2013Danny Vinik Leave a comment

Utah Senator Mike Lee unveiled a very promising tax plan yesterday. Like all Republican plans, it cuts rates, broadens the base and simplifies the tax code. But it also has a number of other very progressive elements and Lee says it is expected to take in revenues of approximately 18-20% of GDP. Overall, it’s a very intriguing plan and has rightfully been praised around the internet today.

But a couple of people have pushed back on the revenue amount. Business Insider’s Josh Barro, who titled his piece “Here’s a Republican Tax Plan that Doesn’t Suck,” calculated the amount he would pay under Lee’s tax plan and to his surprise, found himself receiving a tax break:

The question is, who pays more to offset those tax cuts? Lee hopes his plan would collect 18 to 20% of GDP in revenues, meaning it’s not a big tax cut overall. And as with a lot of Republican tax plans, he may have trouble hitting that target.

At first glance, it looks like his plan would raise taxes on affluent people without children. But I’m such a person, and when I ran Lee’s plan against my 2012 taxes I found I would have gotten a $1,400 tax cut. His plan raises my top marginal tax rate from 28% to 35% but more than offsets that because most of my income only gets taxed at 15%

Slate’s Matt Yglesias calculated his own tax liability under Lee’s plan too and found a similar result, leading him to describe it as “like smoke and mirrors.” The Atlantic’s Derek Thompson isn’t sure how Lee gets to a revenue-neutral tax plan as well and recommends that the freshman senator tax capital gains as ordinary income.

Here’s the thing: it doesn’t matter how much revenue this tax plan raises. What matters is the structure of it and that Lee is aiming for revenues between 18-20% of GDP. Once the Joint Committee on Taxation, the Tax Policy Center, Brookings and any other organization score the plan, we’ll have a better idea about how much revenue the plan actually raises and the distributional impact of it.

But we now know that Lee is interested in reforming the tax code in a way that helps the middle class. His plan also isn’t hugely regressive like all of the flat tax plans other Republicans have promoted. If the score comes back with revenues below Lee’s estimate, then he has to tinker with the rates or possibly add a third bracket. He could follow Thompson’s advice and tax investment as ordinary income. If he wanted to really be aggressive, he could lobby for a carbon tax.

There are plenty of ways Lee could increase the revenue totals in his plan. As it gains steam, how he does so will be vital. But right now, the important part is that Lee is putting forward an honest, smart plan that has huge potential. It’s been a long time since a Republican Senator has done that – especially someone as conservative as Lee is. He deserves credit for that.

The Fed’s Non-Taper Is All About Credibility

September 18, 2013Danny Vinik 9 Comments

In a surprising move today, the Federal Reserve announced that it was not going to taper its bond-buying program. The Fed has been purchasing $85 billion worth of assets every month – $40 billion of mortgage-backed securities and $45 billion of long-term Treasuries. For months now, investors and journalists had expected the Fed to begin to decrease those amounts in today’s Federal Open Market Committee (FOMC) announcement. At 2 pm when the September FOMC statement came out, everyone was proven wrong:

However, the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases. Accordingly, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month

The stock market, bonds and gold all soared on the news of continued easy money while the dollar crashed. Why was everyone so sure that the Fed was prepared to taper today? It all goes back to the June FOMC meeting when Chairman Ben Bernanke first hinted at tapering. The Fed also upgraded its economic forecasts and in the press conference, Bernanke repeatedly emphasized the improvement in the labor market.

“If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year,” Bernanke said. “And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year.”

Interest rates on the 10-year Treasury note skyrocketed while stocks and gold both fell. The market took it all to mean that easy money was coming to an end soon.

Except that wasn’t what Bernanke or the Fed was trying to say. They were trying to say that if economic data continues to come in positively, then the Fed will scale back its bond-buying program. But only if the economic data is good. From the June FOMC Statement:

The Committee will closely monitor incoming information on economic and financial developments in coming months. The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.

If you read it literally, that statement clearly indicates that the Fed will react to labor market conditions in determining whether or not to taper. But the market parses every single word Bernanke says and it soon became conventional wisdom that a taper was coming. Dallas Fed Bank President Richard Fisher and Minnesota Fed President Narayana Kocherlakota both tried to walk back Bernanke’s statement and assert that a taper was not necessarily coming.

It didn’t matter.

But today, the Fed proved everyone wrong who parsed the statement and everyone right who read it literally. Subsequent jobs reports have been underwhelming, the Fed reduced its economic forecast today and the federal government is threatening to blow up the economy. If you listened to all of Bernanke’s comments and read the FOMC statement without overthinking it, you wouldn’t have been surprised by today’s announcement. The Fed said it would only begin tapering if the underlying economic data improved. But it worsened so the Fed shouldn’t have been expected to reduce its bond-buying. Yet, journalists and investors alike assumed that the Fed was still set on tapering, despite the underwhelming economic data.

With its announcement, the Fed was not trying to correct anything Bernanke said. It was trying to correct the market’s blind reading of the Fed’s statements. “Don’t just read that we’re going to taper. Read the caveats as well and take them into account.” Markets had assumed that when Bernanke mentioned tapering, it was set in stone that it would begin today. They did not believe for a second that poor economic data could delay it. Despite attempts to walk back Bernanke’s comments, the Fed could not credibly convince investors that it was not necessarily going to taper in September. By surprising the market and adjusting its policy based on labor market conditions, the Fed regained its credibility today.