What is “Fair?”


The current debt-ceiling debate is cloaked in emotionally charged rhetoric and proposals characterized by undefined terms like “fair” and “balanced.” Who could be against programs that are “fair” and “balanced”?  In his television appeal to the public on Monday, President Obama stated that people needed to pay their “fair share” and that we needed a “balanced” approach to solving the deficit problem. 


Let us consider first what he seems to mean by the term “fair share.” He wants to raise taxes on the rich, including hedge-fund managers and private corporate jet owners to collect more money to cover spending.  But how much is a “fair share?”  People in the top 5% in terms of adjusted gross income (above $159K in income in 2008) paid 59% of the total personal income tax collected, and the top 1% paid 38%.  In contrast, the bottom 50% paid 2.7% of total taxes collected.  We all have seen such figures, and clearly people in higher income classes bear a larger proportion of the tax burden.  But they don’t help us decide whether the percentages are either too low or too high or whether the burdens are “fair.” Clearly, however, the perception depends upon whether one is paying or collecting.


Children have a very good idea of what “fair” is.  When I was growing up and my sister and I were faced with the problem of how to divide a piece of cake, one typically cut and the other chose.  Both of us received about half. The incentives are clear:  the cutter tried to make the pieces equal, and if they weren’t then the other had no problem with taking the bigger piece.  The rules were self-enforcing, they worked, and there were no arguments. 


In the President’s case, he proposes to both cut the cake and choose which piece he wants.  His motive is to seek more revenue to fund growing federal expenditures, rather than come to grips with the key issue; and that is the size and role of government.  But linking tax-burden distributional issues (which are important) with the desire to tax one group to subsidize another while avoiding the really hard choices, tends to obscure the main problem, which is spending, not revenue. 


Past history tells us that it is not clear that increasing the tax burden on the rich by upping the marginal tax rates will succeed in generating the hoped-for revenue.  Between 1952 and 1963 the highest marginal personal income-tax rate was 91%.  Total revenues collected were 17.7% of GDP.  Marginal rates on capital gains and corporate taxes also varied significantly at the same time.


Over the entire period from 1952-2010 government receipts as a percentage of GDP have averaged 17.8% with a standard deviation of about one percentage point (expenditures have averaged about 20% with a standard deviation of about 1.8 percentage points).  In other words, changing the marginal tax rates on high-income individuals and corporations has had little impact on revenues collected; and just because there is an effort to affect the distribution of tax burdens doesn’t mean it will be successful.  Nor should one believe the revenue-collection estimates associated with a change in tax policy, because the secondary tax-avoidance responses are typically ignored.


Looking at revenue and expenditure data and projections provides a clear picture of the true problem, which is spending.  In 2010, during the recession, revenues fell to 14.9%.  Revenues fell because of the hit that personal income took and not because of problems with the tax structure. At the same time 2010 expenditures were up to 23.8% and future expenditures are projected to increase almost without limit, unless changes are made in spending, especially on entitlements. 


What about other terms used in the current debate?  The results of the negotiations look very much like a variant of the classic business school inbox-outbox management problem.  In this case, however, in addition to the standard in and out boxes, there is an additional one labeled “too hard.” That is where most of the debt issues have been placed. 


They are in the “too hard” box for three separate reasons.  For some, the issues and risks are simply not understood, as John Mauldin suggests in his most recent “Outside the Box” letter of 7/26/2010.  For others, the problem is one of having to sort through the difficult tradeoffs, which require careful thought and prioritization.  For the third and probably largest group, the issues are hard because of the perceived political risks that votes for cutting programs or changing tax policy imply for re-election possibilities.


In discussing the debt issue, some even continue to confuse the debt with the deficit.  The deficit arises in a given year when expenditures fail to match revenues.  When there is a deficit, it has to be financed by issuing Treasury debt.  If we are already at the debt ceiling, reducing but not eliminating the deficit means that the ceiling will still be breached.  Proposals to “cut the deficit” by 2 or 4 trillion dollars and increase taxes or close tax loopholes are what some mean by a “balanced approach,” but they won’t eliminate the deficit they just change its size. 


Most importantly, simply reducing the deficit is a non-solution since the ceiling will still be exceeded and more debt will have to be issued. Thus, any proposal that contains a deficit necessarily has to be accompanied by an increase in the ceiling.  Regardless, any such proposal fails to address the true underlying spending problem. Passing such a measure without a clear, credible, and enforceable plan to eliminate the deficit is simply a stop-gap proposal that kicks the can down the road.


What about the “Grand Bargain”?  Again, the plan proposes to cut the deficit but not eliminate it.  Any proposal that doesn’t eliminate the deficit but extends the debt ceiling, such as those proposals that extend the ceiling beyond the current administration’s term in office, is just a ploy to let current politicians off the hook and get out of Dodge when their terms are up, before the public discovers the true consequences of their actions.


So what needs to be done?  It really isn’t that hard.  The true issues are the size of government and spending.  We have lived for the past 70 years or so with revenues averaging about 18% of GDP and government expenditures slightly more. Why isn’t a number about 18% for both revenue and spending good enough?  It was sufficient to fund several wars.  Government grew at approximately the same pace that the economy did, and the economy prospered.  So, why not simply cap both government revenues and expenditures to be about 18-19% of GDP? Revenues might be increased slightly while spending reduced to “balance revenues.”


Would that it were quite that easy.  To provide a credible constraint, the cap would have to cover both on-budget and off-budget expenditures. If it didn’t, then politicians would see to it that off-balance-sheet activities would explode.  Keep in mind that Freddie and Fannie were off both the budget and the balance sheet, and look what that got us. 


In addition, the cap should also be based upon the past year’s GDP or, even better, the average of a couple of years’ past GDP.  By basing the cap on an historical number, politicians would know exactly how much money was available to spend in the next period; and there would be no ability to fudge the budget revenue and expense forecasts, which when not realized could result in a significant deficit.


Lastly, faced with a truly binding constraint, budget and funding incentives would change.  First, the limit takes the issue of the relative size of government off the table and simplifies the discussion. Right now there is no agreement on either the size of government or how to eliminate the deficit.  Trying to resolve both simultaneously is like trying to decide on taking a bus trip from New York to either Seattle or to San Diego and get agreement among all the passengers on the route to be taking before the destination is finalized.


Second, politicians would be incented to look for efficiencies and eliminate waste to generate needed funds for other projects, without reducing existing programs.  At some point, however, politicians would be forced to devote their energies to addressing the difficult tradeoffs among competing interests. 


Third, earmarks would become difficult to justify.  Politicians would have reason to question the demands of special-interest groups that proposed spending increases.  These increases could only come at the expense of other programs, and the advocates would be faced with the burden of justifying their needs relative to others. 


Fourth, new programs would still be possible as the economy grew, but other programs might be faced with having their growth curtailed.  The key to growing the size of the cake and funding new initiatives would be finding ways to increase productivity and growth, while keeping inflation low to limit the cost of funding outstanding debt. 


Fifth, during those periods when revenues exceeded receipts, the debt would be paid down, since new programs couldn’t be funded out of excess revenues.  Finally, and most importantly, the outstanding debt would gradually shrink as a proportion of GDP.


Putting such a credible plan in place clearly could not be done overnight.  It would be necessary to provide for a transition that called for a specific but reasonably short timetable, perhaps four years, to reduce the proportion of spending-to-GDP to the desired level.  Given the present gap, which is partly a function of the recession and expenditures that had been undertaken to stimulate growth and jobs, it would be appropriate to provide for a temporary increase in the debt ceiling to ensure that the country did not default on its debt. This would be done, however, with a clear plan in place to get the country’s finances in order.


Such a plan would answer the question of whether the destination is San Diego or Seattle and provide the path to financial stability for the country.  Politicians could then focus their attention on the route to take by making the tough tradeoffs they have avoided for years.