The Ramble: A balanced approach to balancing the budget (Part 1)

After my last Ramble, several people commented that they'd like to know where we should cut spending and how we should raise taxes to balance the budget. I'd like to know that, too, actually. It's a tough problem and I definitely don't have all of the answers on this issue because a lot of it comes down to personal opinion rather than hard facts. Rather than give a prescription of what to do, what I'd like to do is lay out a framework of how I think about these issues.  That will be the meat of the post.  I'll also give a couple of suggestions based on that framework of where I think spending should be cut and how I think taxes should be raised, but I'll be up front right now and tell you that that section will be more my opinion.  I do think that there are a few sensible things that can be done, and that both parties can agree to. I'll split this over two posts--spending cuts in this one, and tax increases in the next.

Before we can have a rational discussion of where government spending should be cut, we need to lay out just what the government should (and should not) do. From an economist's perspective, the government's role can be broken into three parts:

1. Enforce the rule of law: Pretty straightforward, but vitally important.
2. Fix broken markets:  There is a lot of evidence that free markets are extremely efficient, so when markets work well government should not interfere at all.  Markets generally break down when one party has more information than another party (called "asymmetric information") or when there are externalities.  Regulators like the SEC or FDA force businesses to disclose information to reduce asymmetric information problems.  An externality occurs when an action that I take affects others (either positively or negatively), but I don't take that into account when I make my decision. Common examples include secondhand smoke (your smoke is hurting those around you) or maintaining your house in good condition (having nice houses in the neighborhood increases the value of your home). I won't go in to more detail than that for now, but the point is that the government needs to tax things that have negative externalities (like smoking), and subsidize things that have positive externalities (like education). Without the government doing this, we would do too much smoking, and provide too little education. Some externalities are so extreme that it makes more sense for the government to provide them completely: military defense, highways and roads, etc. These are called public goods.
3. Redistribute wealth from the rich to the poor (via needs-based welfare programs): Obviously, the extent to which the government should do this comes down to opinion mostly.  This seems to be a major line which divides Republicans from Democrats. Or, even more extreme, capitalists from socialists. Nevertheless, redistribution is an important role of the government.

I'm sure that political science and philosophy academics would argue with this framework, but economists tend to think along these lines.  When I hear arguments about where to cut spending I default to this framework, because often I can put an item that is on the chopping block in one of the three buckets. For example, Brittany mentioned that Sarah Palin wants to cut funding for the National Endowment for the Arts. I ask myself, "Why does it make sense for the government to have a National Endowment for the Arts?" Looking at the list, I'd put it in category #2. When an artist creates a particularly moving piece, we all benefit, even though in many cases we pay nothing or very little for it. This is a positive externality, and economic theory tells us that the government should subsidize it. The question you should ask yourself is, "would enough good art be created if the Endowment were smaller?" Of course, I have no idea what the answer to that question is (how much is "enough"?), but it's the right question to ask. Rational people can disagree as to how much the arts create positive externalities, and therefore can also disagree about the extent to which the government should subsidize them. But putting it in this framework helps me think about the problem in a clear way, instead of just bickering about whether the arts are valuable.  

So, that's the meat behind this post, really.  In bucket #2, the government can help ease information asymmetries by mandating disclosure or regulating in other ways.  Externalities can be handled by taxes (for negative externalities) and subsidies (for positive ones).  We can argue about the size of these programs, but from an economic standpoint it's difficult to argue that they should be fully eliminated.  Further, by asking the right questions, typically we can gather data and at least produce estimates of how large these programs should be.  Like I said before, some of this will always come down to opinion, but with careful analysis we can often get to a reasonable range of values to argue over.

Now, if we're talking about redistribution (bucket #3), that's much more perilous.  To what extent should we take from the rich and give to the poor?  What is fair?  Are the poor lazy, or just unlucky?  We all have an opinion on this, but none of us really knows the answer.  The correct answer is almost surely somewhere in the middle.

Okay, so where should we cut spending?  Here's where I get to tell you my opinion on the matter, and you are free to agree or disagree.  The fact of the matter is, cutting funding to small programs like the National Endowment for the Arts is not going to get us anywhere close to making a difference. They're just too small.  In an ideal world, maybe we could examine each dollar spent and decide if it is worth it or not, but that's just not possible.  The big ticket items in our spending budget are defense spending and entitlement programs like Medicare and Social Security. If we're really honest with ourselves, we're going to have to cut in these areas if we want to get anywhere close to a balanced budget. How do these programs fit in to my little framework?

National Defense is a public good (bucket #2); it makes the most sense for the government to run the whole thing. The question, then, is how much national defense is too much? Here are some facts: According to the Source of All Knowledge, in 2009 the US military budget accounted for 40% of global arms spending. The other Source of All Knowledge tells me that we spend $1,630 per person per year on military expenditures, more than twice as much as the UK, and more than eight times what they spend in Japan. I couldn't find a country that spends more per capita than we do (Israel was close, at $1,400/person). If you're like me, your eyes are bugging out like a cartoon character's eyes while reading this.  That's a ridiculous amount of money spent on defense!  While I recognize the need for a strong military, I can't see any justifiable reason for spending so much. I think there needs to be a pretty good-sized reduction in the defense budget. In particular, I would decrease spending on antiquated programs like manned fighter jets and aircraft carriers (drones are replacing them), and I would decrease the military presence in legacy locations like Japan and Germany. WWII got over a long time ago; it's time to move on. We've also got a few wars going on right now that we need to carefully wind down.

What about Medicare and Social Security? I would put these in bucket #3; they are safety systems that provide benefits mainly for the poor (richer people could provide these items without the government's help). Unfortunately, I don't know nearly enough about Medicare to know how to fix it, but I do know that this is another category where the US spends more per person than almost anyone else, despite having no better health than most developed countries. Something needs to be done here, but I just don't know what that is. My suggestion for fixing Social Security is twofold: (1) Raise the retirement age. This needs to happen because we're living longer (a big part of the reason why SS is in the red in the first place), and doing so would have huge benefits with low costs. (2) Create national programs that help people save for retirement themselves, so that we don't need as much Social Security. The Save More Tomorrow program has been proven to work, for example. Why not just mandate that every employer must offer it?  (Note: I'm not arguing that we should force everyone to do it, just that we should offer it to everyone.)

Serious cuts in these two areas alone would go a long way towards helping the budget.  Aside from defense and entitlement, it's my general opinion that the government is pretty inefficient in a lot of areas.  Most government programs aren't bad, they're just very poorly run.  For example, have you been to your local DMV lately?  I'd be willing to bet it was a miserable experience.  Is the DMV a good thing?  Absolutely.  But it could be so much more efficient, which would cut down dramatically on costs.  I worry that most government programs are run like the DMV--full of red tape, overlapping functions, and unclear directives.  (Here's another example of government inadequacy I ran across the other day.)  It shouldn't surprise us that this is the case because the government is a monopoly.  Competition drives efficiency, and without competition it's hard create an efficient organization.  I would suggest a major push towards forcing higher efficiency from each government department.  This would be super complicated, hard to enforce, and hard to measure.  I fully recognize that.  That doesn't mean we shouldn't demand better.

Lastly, a quick word on where not to cut spending. It's vital not to cut spending on areas that are going to drive our economic growth for the next 20-30 years. Doing so would be shooting ourselves in the foot, because strong economic growth will solve the budget deficit all by itself. In particular, we need to find ways to do a better job on education (from kindergarten on up through university, and especially on retraining programs for working adults), where we seem to be falling behind. Doing better will likely cost a bit more money to begin with, so we can't afford to cut education funding right now. Also, anything that the government can do to promote entrepreneurial activity will hugely benefit the economy. That means providing grants for research and development, supporting small business loans and/or venture capital lending, and making it easy to start a company here. We have to keep spending in these areas if we want to have a vibrant economy in the future.

Up next: How to raise taxes.  It might take me a few weeks to get it written, but it will come!