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Responding to the Smarter Liberal Critiques of Simpson-Bowles

November 18, 2010

By Josh Barro


A couple of months ago, I expressed my interest in seeing a budget plan that meets a four-part test: “(1) keeps the full Bush tax cuts and (2) gets the deficit down to a sustainable level (3) in a reasonable time frame so that (4) debt/GDP does not peak at an alarming level.” So, I was pleased to see that Ryan Ellis of Americans for Tax Reform put out a budget plan this week that purports to do that.

Unfortunately, his plan is unimpressive. Indeed, it is essentially the conservative flipside of the Jan Schakowsky plan: he relies on gap closing measures that don’t solve the problems with long-term government cost trends, and that would have serious negative consequences in the short-term. The only difference is that instead of tax increases, the Ellis plan relies on spending cuts and magical thinking.

Ellis’s plan basically works by “freezing” various aspects of government expenditure at FY08 levels. Social Security and Medicare are held harmless, but everything else is held at FY08 levels all the way through 2015—including means-tested entitlements, which generally get much more expensive in recessions.

Ellis would extend all the Bush tax cuts and the AMT patch and make a few other tax cuts. He assumes stronger economic growth due to these tax cuts and some unspecified tax reforms, generating added tax revenues. Finally, he makes some completely unreasonable assumptions about interest rates that allow him to cut debt service expense by about $200 billion in 2015 (more on that later). All told, this brings the budget to a small surplus by 2015.

So what’s wrong with this plan? Several things. First, a “spending freeze” isn’t really a policy. Because of inflation and caseload increases, the cost of providing the same government services goes up from year to year. If you want a program to cost no more nominal dollars next year than this year, you have to do less of something—pay workers less in real terms, serve fewer people, or what have you.

Ellis does briefly lay out how he would achieve a freeze: “freezing federal salaries and benefits, bureaucrat attrition, an earmark ban, and continuing the phased withdrawal of troops from Iraq and Afghanistan.” On the back of the envelope, it looks to me like these options would achieve roughly the discretionary spending savings that Ellis sets out, assuming he wants an attrition plan along the lines previously proposed by ATR (fill only 1 of 2 open positions) and that both the pay freeze and attrition program would apply to military personnel.

But this savings strategy doesn’t work indefinitely—once you’ve pulled out of Iraq and Afghanistan, you can’t save more money by pulling out again. And a pay freeze and attrition program can’t go on forever—eventually, federal pay and benefits would become uncompetitively low and the workforce too small to effectively perform federal functions. This is especially a concern with the military, which was having trouble hitting its recruitment targets in the middle of the last decade. (Indeed, while I am uncommonly open to taking a knife to military compensation, a four-year military pay freeze would cause a political firestorm.) A new strategy would be needed after 2015.

On the mandatory spending side, Ellis’s solution is again a freeze at 2008 levels, this time for means-tested entitlement programs: Medicaid, food stamps and other similar programs. He would block grant to states funds to run these programs, with no year-to-year increases. States would then have to choose between augmenting the programs with their own funds or cutting benefits each year—because, again, things get more expensive in nominal terms and caseloads rise.

Block grants are themselves a good idea, and block granting Medicaid is a key component of the Ryan-Rivlin entitlement plan that was released this week. But Ryan-Rivlin doesn’t freeze the block grants: it grows (or shrinks) them with the size of the Medicaid-eligible population, and with GDP plus 1 percent. This holds per-participant spending increases below medical inflation, forcing states to gradually cut benefits or find efficiencies in the delivery of care, but increases funding substantially in nominal terms.

Ellis’s plan is unsustainable for Medicaid because of both cyclical and long-term trends. Long-term, the Medicaid-eligible population can be expected to grow about 1 percent a year and medical inflation to run at 6 percent. Holding the long-term rate of Medicaid growth below 7 percent therefore requires tightening Medicaid eligibility or providing fewer services to enrollees.

This could be a good idea for a time, if Medicaid is wasteful or the eligibility requirements too loose. But eventually you reach a point where a freeze keeps Medicaid spending below a desirable level. After a seven-year freeze, assuming similar economic conditions at the beginning and end of the period, Medicaid would have the same budget in nominal dollars but would have to provide 38 percent fewer services per capita.

The cyclical problems are even greater. Unlike Medicare, the trendline for the Medicaid population is not basically straight; instead, enrollment swells in recessions because people lose their jobs or otherwise fall below Medicaid eligibility thresholds. In order to make a Medicaid freeze work in a recession, states would have to tighten Medicaid eligibility at exactly the times when more people need it. Alternatively, they could direct more state tax dollars into Medicaid, but this would require destimulative moves such as raising taxes or cutting other spending.

Ryan and Rivlin recognize the need for automatic stabilizers by tying the Medicaid block grant to Medicaid enrollment, not to population growth. But if you block grant in this manner, you don’t save nearly as much money as Ellis does with a freeze. And Ellis would take his freeze beyond Medicaid to other means-tested entitlements, including Unemployment Insurance, which also see recessionary caseload increases.

The cornerstone of Ellis’s plan to control mandatory spending, basically, is the elimination of all automatic stabilizers in American fiscal policy. If this policy were enacted, instead of talking about whether to extend unemployment benefits, states would be looking at shortening them in recession in order to stay within the frozen UI budget while the number of claimants rises—or, alternatively, jacking up taxes to pay for them. This is a very bad idea.

Ellis compares a freeze in block grants for means-tested entitlements to the 1996 Welfare Reform law that created Temporary Assistance to Needy Families, a cash assistance program that is operated by states and partly funded with federal block grants. But there are two problems with this comparison.

One is that TANF’s predecessor, Aid to Families with Dependent Children, was a terrible program that fostered dependence; a drastic reduction in caseloads was therefore desirable. It is not at all clear that we want to drastically cut caseloads for Medicaid or, especially, UI. The other is that TANF funding has not been frozen—federal spending on TANF grew from $10 billion in 1997 to $13 billion in 2007, even as caseloads fell by more than half.

While these spending policy choices are dubious enough, an even bigger problem for the Ellis plan is its reliance on wishful thinking. By 2015, because of lower spending levels, Ellis hopes to achieve a level of public debt that is 15 percent lower than CBO projects in its baseline. But he estimates that he would reduce government spending on debt service by 59 percent, for a savings of $290 billion per year, or over 1.5 percent of GDP.

I asked Ellis how he hoped to achieve this, and he said he just took the debt service figure for 2011 and kept it flat, as debt doesn’t grow much after his plan. Of course, debt service expenses in 2011 are low because interest rates are at historic lows, and a peek at the Treasury yield curve shows you that’s not likely to be true anymore in 2015. True, lower government borrowing would take some upward pressure off interest rates, but higher economic growth expectations (which Ellis believes his tax proposals would create) would put upward pressure on rates.

It’s more plausible to assume that a 15 percent cut in debt held by the public means a 15 percent savings on debt service compared to the CBO baseline—for net interest savings of $74 billion, not $290 billion. That means another $216 billion in gap-closing measures that Ellis is left needing to find.

Ellis also includes dynamic effects from the tax reforms he proposes. He believes that his plan will drive GDP upward, resulting in $225 billion in extra tax revenue in 2015, offsetting about one-third of the foregone to tax cuts.

This is an aggressive estimate. A Tax Foundation paper from Robert Carroll looked at the excess burdens of some of the taxes Ellis would repeal or keep repealed (an expiration of the Bush tax cuts for high earners and the high-income taxes in the Affordable Care Act) and found dynamic effects of about the one-third magnitude that Ellis predicts, or slightly higher.

But other tax cuts Ellis would extend, such as the rest of the Bush tax cuts and the AMT patch, would have much smaller dynamic effects. Some, like extending the increase in the Child Credit, would actually have negative dynamic effects. Overall, it would be hard to hit the $225 billion target.

Additionally, economic behavior is not driven just by current tax rates, but by expectations of future tax rates. Because Ellis’s plan holds Social Security and Medicare harmless, it has essentially same problem I discussed yesterday in Jan Schakowsky’s budget plan—you achieve balance in 2015, but you do nothing to address long-term entitlement imbalances. So, market participants would continue to expect future-year tax increases, reducing the positive dynamic effects from low tax rates.

So, in sum, I don’t think much of this plan. I was going to say that the plan is symptomatic of the backward logic of ATR’s tax pledge, where you start with the conclusion that a tax increase is the worst possible option, and then reverse-engineer a policy that fits with that. But that is actually too charitable to the plan—a budget sustainability plan that rules out tax increases could be way smarter than this if you got some actual policy experts to put some thought and time into it. For one thing, such a plan would touch Medicare.

So far, conservative analysts and politicians are reacting positively to the Simpson-Bowles and Domenici-Rivlin deficit plans, despite their inclusion of tax increases. If ATR wants Republicans to hold to a no-new-taxes pledge, they’re going to have to come up with a better no-tax-increase plan than this.

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