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How budget shortfalls might best be addressed

By J. Richard Fredericks, Main Management

As Congress comes back from their recess, they will have a lot they want to accomplish, but they have an important must-do priority that can’t be ignored. The first piece of business they need to take up will be the country’s legal debt limit. The Bipartisan Policy Center (see here), the Congressional Budget Office (see here) and Treasury Secretary Mnuchin have all indicated that the country will no longer be able to meet its requirements in full, and on time, between early and the middle of October because the government will run out of its borrowing authority. That, in turn, would mean the United States would be in default of some of its obligations. The vote on the debt-ceiling, once again, could be contentious, as some members want to introduce conditions that would prevent a vote on a “clean” debt-ceiling bill. Even though the Republicans have control of the Executive and Legislative bodies, some in their party intend on attaching “conditions” to the bill by focusing on spending caps that are meant to address the country’s large, perennial budget deficits.

The President, the Republican leadership and the Republican party are consumed on making progress on healthcare, taxes and infrastructure, yet the overall budget picture still looms large in the background … as it always does.

The Congressional Budget Office (CBO) is the official “scorekeeper” for budget history and budget forecasts as they typically produce 10 year projections and even make forecasts on the budget as far out as three decades into the future. The current CBO outlook for 2027 calls for a deficit that rises to 4.3% of GDP, from 3.2% of GDP in the 2016 fiscal year, and its 30-year outlook anticipates further budget deficit deterioration to 9.8% of GDP in 2047. The pictorial history of deficits and surpluses, as well as the CBO estimates out to 2027, follows.

Total Deficits and Surpluses

The long term and shorter term graphs below have been assembled from the Office of Management and Budget in the White House (see table 1.2 from here). What can be seen is that since World War II, tax revenues as a percent of GDP have been very consistent. The visual dips in receipts around 2002, and especially 2008-9, were caused by recessions while the higher numbers in the late 1990s were created by an especially strong stock market that lead to oversized capital gains revenues. That said, tax receipts have been remarkably consistent over the years. As a percent of GDP, receipts have averaged 17.3% since 1950, 17.4% for the 50-year period since 1966, and 17.2% over the past 25 years. According to the CBO, tax revenues as a percent of GDP are projected to grind higher from 17.8% in fiscal 2016 up to 18.4% in 2027.

Government Receipts and Outlays as a percentage of GDP

Government Receipts and outlays as percentage of GDP

To the surprise of many, further analysis shows that despite tax reductions in the years 1964, 1983, 1986, 1997, or in 2003, for the three years following the reductions there was an improvement in the deficit in four of those five occasions. The lone exception was the three-year period after 1964 when the deficit relative to GDP remained essentially flat, going from -0.9% of GDP to -1.0% three years later.

On the other side of the equation, when taxes were increased in 1967, 1969, 1990, 1994, or in 2013, the deficit picture improved but was much less noticeable. Out of the five observations where taxes were increased, two of those occasions resulted in worse levels of deficits to GDP three years later and, in three instances, the deficit relative to GDP improved.

The intensity of the change over the measured periods, however, definitely favors tax cuts over tax increases, which, in general, means that the economy and the overall budget benefits more from lower tax rates.

The mix of government tax receipts by source is shown below. Revenues from individual income taxes has been remarkably stable over time, while revenues driven by corporate taxes have diminished, and lower amounts of revenues generated by “excise, estate, and other” taxes have been replaced by higher payroll taxes.

Sources of Federal Tax Revenue

In the title of these remarks, we mimicked James Carville who famously said … “It’s the Economy, Stupid”. In our mind, spending has been the primary culprit for the expanding the deficit problems to this point and will be the catalyst for expanding deficits far into the future.

We say that because projected long-term deficits in our country are not a function of revenues that are too low. As noted above, revenues are projected to rise higher than the 2016 results and are expected to rise above the 50-year average over the next 10 years. The real culprit is a much more rapid advance in outlays. The CBO projects that spending as a percentage of GDP will climb 1.5 points from the 2016 figure of 20.9% of GDP up to 22.4% of GDP in 2027 and then soar another 7.6 points to nearly 30% of GDP over the next few decades as can be seen below.

Federal Budget under extended baseline

As a result, the CBO expects deficits to balloon in the next three decades from 2.9% of GDP in 2017 all the way up to 9.8% in 2047, again, because spending growth is projected to far outpace the growth in revenues, as is evident in the panel above.

As can be seen in the following chart, the cold reality is that deficit spending appears to be built into the psyche of Congress as spending (particularly entitlements), has increased faster than GDP in every period over the past 50 years! The overall growth in spending came even though President Clinton was able to bend the growth curve down from a reduction in defense spending after the large Reagan buildup at the end of the Cold War and when President Obama purposefully cut back even more on defense spending during his two terms. The overall trend is clearly unsustainable.

Growth Major Budgeting Items vs Inflation

The sources of the rapidly expanding future outlays reflect increases in Social Security, other major health care programs (primarily Medicare), and interest on the government’s debt. The spending growth for Social Security and Medicare, in turn, is the result of our nation’s aging population. As members of the baby-boomer generation continue to age, and, as life expectancy continues to advance, the percentage of the population which is 65 or older will grow sharply, thereby boosting the number of beneficiaries of the entitlement programs

The CBO projects that health care costs will rise more slowly than they have in the past, in part because of the effects of new medical technologies and rising personal income. Given the current stalemate on Obamacare and the continued rapid growth in the cost of healthcare, we are not confident in the CBO projection, as least as it relates to inflation and GDP. All one needs to do is view the two panels below from the CBO to see that health care and other social programs are having an outsized impact on the budget and then view the long term growth in Social Security and Medicare in the table that follows.

Drivers of Growing Spending

Average Yearly Growth

The CBO predicts nearly a double in the net interest cost on Federal debt between now and 2022. The cost of the debt was $240 Billion in fiscal 2016 and expected to be $276 billion in fiscal 2017. The expectation in 2022 moves up by nearly $250 billion to a level of $528 billion as the CBO factors in more debt and higher interest rates. The current Federal debt in public hands is $14.36 trillion, which means that every 100 basis points, plus or minus, amounts to $143 billion. Thankfully, the government has extended debt maturities from the bottom of the last cycle and the maturity now stands at around 70.8 months. What could help given the current low interest rates, would be a program to further extend maturities by selling 50 year or even 100 year obligations. We understand that strategy is under consideration.

Interestingly, when President Clinton was in office, he presided over four years of budget surplus, an accomplishment that benefitted from revenues that were higher than normal, at 19.3% of GDP, reflecting a very strong stock market with attendant high capital gains taxes. More surprising, however, was the level of expenses at the time, which were held to much lower levels relative to GDP, at only 17.9%. Shortly thereafter, the deficit eroded by 4.5 percentage points as revenues as a percent of GDP reverted to more normal historical levels by going down 1.5% points to 17.8% of GDP, while expenses soared, jumping 3.0% points relative to GDP, from 17.9% to 20.9%. Consequently, the country moved back into a deficit position in 2002 and has remained that way ever since, averaging 4.2% of GDP since 2002, with the expectation that deficits will continue and sharply accelerate from current levels.

Some pundits will no doubt call for tax increases to plug the budget shortfall by more heavily taxing “millionaires and billionaires”. The problem with that strategy is that it is becoming mathematically impossible to have much of an impact on the deficit by taxing the rich much more.

How can that be, one would ask?

If the government were to take 100%, or ALL of the INCOME earned by taxpayers in excess of $1 million, that extra amount would fund the federal government for less than three months (2.8 months by our calculations). If the government were even more aggressive and took ALL income above $500,000, it would fund the federal government by only an extra two weeks or so (calculated from “Statistics of Income (SOI) from the IRS – the 2016 report can be found here, page 28).

The reason that taking all of taxpayer’s income over $1 million would have such a small impact on the budget deficit is due to the progressive nature of the United States income tax code. While dated, the OECD noted in 2008 that the United States “has the most progressive tax system of all of its nations and collects the largest share of its taxes from the richest 10% of the population.” The higher taxes imposed by the Obama Administration on the upper income earners have made the tax code even more progressive.

Income and taxes for top 10 percent

Income tax progressivity

The reason our tax code is so much more progressive than other countries is because the rich of the United States pay more overall taxes as a percent of the total taxes received than the rich of other countries. In the US, the top 1% earn 19% of all adjusted gross income in the country, yet pay 38% of all federal taxes. Meanwhile, the bottom 50% of income earners in our country pay virtually no income tax at all (3%) so our country’s taxes are much more skewed to the rich than other countries.

Federal Income Taxes and Adjusted Gross Income earned in 2013

By contrast, other countries tax their richest citizens at similar rates or even slightly higher rates than the United States, but the big difference between the US and places like Europe is that ordinary people pay much higher taxes in Europe.

That brings up the perennial question … how much is “fair”? How progressive should our country’s taxes be? The top 20% of all earners pay 88% of all income taxes paid in our country. Is it “fair” to go even higher? How about all the way to 100%? Is that where we are heading? Or should there be some modest taxes levied against all American workers?

Many believe that Europe is the model that should be emulated. What is not widely known, however, is that Europe’s taxes approximate the percentage that the cohort earns, i.e. the top quintile pays 20% of total taxes and on down for each quintile. That said, the “headline” tax rates look progressive in Europe, but they should be viewed in the context of the overall picture. For instance, in Germany, the posted income tax rates range from zero on incomes below $10,500 up to a 45% rate on the highest income earners which, on its face, appears quite progressive. But, as the Wall Street Journal points out (see here), “if you look at the proportion of gross household income paid in all forms of tax, the rate varies by only 25 points. The lowest earning 5% of households pay roughly 27% of their income in various taxes – mainly VAT – while a household in the 85th income percentile may pay total taxes of around 52%, mostly in social security taxes that amount to nearly double the income tax bill.” That means the real difference between the taxes paid by the rich and poor is only a 25% difference as opposed to the 45% spread in the posted rate. The majority of “collected” taxes stem from VAT and social taxes. The consequence of country’s dependency on VAT is that the poor are penalized the most as they spend a higher proportion of their income and because the social taxes tend to kick in at lower income levels than income taxes, and extract a higher and more uniform proportion of income.

Few in the United States would favor such a system since so many pay no taxes at all and would become taxpayers for the first time. The contrast between the US and the OECD countries is stark. The chart below shows the dependency on VAT and social insurance taxes in the OECD countries at 59%, which is 45% higher than the 40.6% level for those two sources in the United States. The individual taxes are the highest source of federal government revenues in the United States at 37.7% of the total and the vast majority (88%) of those funds are paid by only 20% of the population. That contrasts with 24.5% for the OECD countries.

US Sources of Revenue Compared to OECD Average

Where do we go from here?

All the above suggests to us that while there might appear to be some room for more or different forms of taxes, we are reaching a point where revenues are close to maximum levels relative to GDP. First and foremost, a faster pace of economic growth than what prevailed over the past 10+ years would help in revenue generation. Prior to the past 11 years of sub-3% growth, our country has never had a period longer than 4 years where there was no 3% GDP expansion. Additionally, a thoughtful tax cut could both help to both accelerate GDP trends, but also positively impact the amount of collected tax revenues. Our 4/18/17 memo entitled “Thoughts on Taxes” examined in great detail the positive results of three countries which lowered tax rates – England, Canada, and Ireland, as well as the positive results of the Reagan tax cuts (for a copy of this report, contact Main Management).

Turning to the outlay side of the equation, Congress has recently focused on infrastructure and regulations … and they should. We look at both as expense bottlenecks and heavy burdens to our nation’s future economic well-being. 72% of budget outlays and 15% of GDP are currently in what the Office of Management and Budget labels as “human resources” (Social Security, Medicare, Education, Training, and Social Services, etc.). Those areas have grown at a compound growth rate of 4.6% over the past five years, which is 3.5 times the current 1.3% rate of inflation. While the OMB predicts that the next 5 years will expand by “only” 3.5%, it still means that the 72% portion of total budget outlays is on a pace to double in 20 years. That will come at a time when there is an effort to rebuild the military and when net interest costs will be rising rapidly. It is therefore imperative that expenses be controlled where they can.

The government has the capability to save significant amounts of money … the question is always the will to do so. Since 1993,The Competitive Enterprise Institute (CEI) has generated an annual report entitled “Ten Thousand Commandments” (see here) which delves into the cost of regulation in our country as they believe that “reducing overspending and relieving regulatory burdens are vital to the nation’s health”. Their document analyzes the “hidden taxes” stemming from America’s regulatory state and puts a number on those bloated costs within our government. Their overall estimate, based on federal government data, is that the burden of regulatory costs to our country totals $1.963 Trillion.

Some perspective on that figure follows:

• The size of the estimated regulatory cost would equivalent to the world’s seventh-largest economy … just behind India and ahead of Italy

• Were the cost of federal regulation to flow all the way down to households, US households would ‘pay’ $14,809 annually from the regulatory hidden taxes

• The cost of the regulatory compliance exceeds the $1.82 Trillion collected by the IRS in individual and corporate taxes; would equate to over 50% of the 2016 budget outlays; represents about 10.5% of our nation’s GDP; and rivals corporate profits of approximately $2.14 Trillion.

• The regulatory costs obviously come from regulations. The Federal Register finished 2016 with 95,894 pages, a new record. During 2016, Congress passed 214 laws while Agencies issued 3,853 rules, so there were 18 rules issued for every law passed thereby delegating powers to unelected agency officials. There were also 3,318 regulations in the pipeline, of which 193 were deemed ‘significant’ meaning it would potentially have more than a $100 million impact on the economy.

• The Mercatus Center at George Mason University estimated that “if regulatory burdens had remained constant since 1980, the 2012 economy would have been 25% larger or, put another way, the economy grew by at least $4 trillion less each year than it could have”.

The point in all of this is that there are tremendous amounts of expense savings that can be achieved because the base is so large. Everyone has examples of areas where the government could do a better job. A few quick examples that we feel are illustrative are:

• Entire agencies could be looked at and streamlining of efforts should be on the table everywhere. For instance, the original intent when the Department of Energy was established to reduce our dependency on foreign oil. Now that we are ‘effectively’ energy independent because of fracking, do we really need to spend $32.5 Billion there?

• An industry example of where governmental regulatory red-tape abounds in housing. Per the National Association of Home Builders, on an overall basis, the regulatory cost as a share of a new single-family home price is 24.3% (range 14.0 to 30.3%) or $84,671, of which 60% can be attributed to regulations impacting the price for a finished lot, including its development, while the other 40% would be attributable to the cost of construction after the purchase of the lot (see here). On average, they say, the regulatory process typically adds 6.6 months to the development process (ranging from no time to as long as 5 years)

• From an income disbursement basis, the United States annually makes improper payments that aggregate in the billions (see here). For the fiscal year 2016, improper payments totaled $144 billion, up from $137 billion the previous year.

The overall error rate was 5.1%, up from 4.0% as recently as four years ago. While that may seem like a “small number on a large number” story, it is disconcerting to note that the Department of Veterans Affairs (VA) had an extraordinarily high  75.9% error rate in their Community Care effort. It is also noteworthy that the US Treasury had a 24% improper payment error rate in disbursing Earned Income Tax Credits. Approximately 75% of the errors are made through overpayments which means the burden of proof is on the Government to claw back those funds. Could a private sector collection agency do a better job for a small incentive fee? We think so.

The cumulative improper payments now total $1.4 Trillion since 2003.

• Internal accounting capability seems that it could be suspect area as well. In a March 1, 2017 Inspector General’s report (which can be found here), the IG found that “the total amounts of errors corrected in HUD’s notes and consolidated statements were $516.4 billion and $3.4 billion, respectively” (emphasis is ours).

While the errors identified may not have changed HUD’s financial position, it is unbelievable that the department downplayed the errors by saying that “The accompanying notes are integral to these statements.” Of course they are, but shockingly the footnotes contained errors of $516.4 billion. One can only wonder how many entries the bookkeepers at HUD got right, or whether they had any time left in the day to put in an accurate entry! Everyone has their own examples of bureaucratic inefficiencies within the government. As a last example, we believe a picture is worth 1,000 words. Consider the schematic below which shows how the 80+ programs which allocate $1 Trillion in annual welfare payments are managed (?). It cries out for reorganization!

We don’t demand perfection … but is it too much to expect the federal government to represent its taxpayers with a modicum of competence! We can do better!

Benefits services low income individuals

J. Richard Fredericks is founding partner at Main Management, a participant in the ETF Strategist Channel.

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A pioneer in managing all-ETF portfolios, Main Management LLC is committed to delivering liquid, transparent and cost-effective investment solutions. By combining asset allocation insights with smart implementation vehicles, Main Management offers a unique approach that translates into distinct advantages for our clients, including diversification, cost efficiency, tax awareness and transparency. http://www.mainmgt.com