TCS Daily

What Cutting the Federal Budget Entails

By Josh Barro - September 29, 2010 6:00 AM

The Center for American Progress released a report earlier this month on ways to shrink the federal budget deficit with spending cuts. A Thousand Cuts, by Michael Linden and Michael Ettinger, lays out specific program cuts of $255 billion per year by 2015 (about 7% of total federal spending), and is a valuable contribution to the discussion of the coming fiscal adjustment.

In this column, I highlight three areas where I don't believe the report has identified as many cuts as it could have: Medicare, military employee compensation, and tax expenditures. At the end, I will also discuss whether balancing the federal budget is "simple."

Two caveats should be noted to the report's presentation of a "spending cuts only" program. One is that it starts from a baseline of President Obama's proposed budget, meaning that the expiration of part of the Bush tax cuts is baked into the proposal. The other is that it treats the elimination of tax expenditures (credits and deductions offered through the tax code) as the deletion of spending items, a view that I endorse but will be controversial with some people.

While the authors intend the report in large part as an exercise to demonstrate the draconian steps needed to balance the budget on the spending side of the ledger, I am with Reihan Salam in two regards: I'm prepared to take the report's recommendations in broad strokes, though I would add and subtract specific items; and I think the adjustment it recommends is not large enough overall.

Regarding Medicare: really, this report could be called "How to Cut The Federal Budget While Touching Very Little Mandatory Spending." While 62% the federal primary budget (i.e., excluding interest) is expected to consist of mandatory spending in 2015, only 14% of the report's proposed reductions come from mandatory spending, and mostly not from the core mandatory programs. While the report includes a 1.4% reduction in Social Security spending, it does not touch health care entitlements at all.

The report notes that the recently passed health care law already includes significant reductions in Medicare reimbursement rates. That's true, and as the authors note, further reductions in reimbursement rates could make it difficult for seniors to receive care, because doctors will take fewer Medicare patients.

But the report then concludes that "there appears to be little more that the federal government can do by 2015 beyond what it has already accomplished to hold down health care spending in the federal budget without significantly compromising the quality of care." This is not true -- significant savings are available through avenues other than reimbursement rate cuts. Effectively, these would reduce the quantity of care paid for by government.

One such proposal, advanced last year by three scholars at the American Enterprise Institute, is competitive pricing for Medicare Advantage and traditional Medicare Fee-for-Service plans. Currently, about 20% of Medicare participants receive coverage from private insurers through Medicare Advantage and the remainder are on traditional Medicare Part A and B plans. In some parts of the country, the former plans provide richer coverage at a lower premium, and in others choosing the latter is advantageous; seniors may pick which they prefer and they will generally choose the better deal.

The AEI reform would set these plans on a level price playing field, so seniors who wish to buy up to the richer plan (whichever that is in their area) would have to pay an additional premium, reducing Medicare costs by about 8% or about $50 billion per year.

This would reduce the generosity of the average Medicare plan, and therefore the quantity of care paid for by government. But all seniors would be on plans already judged to be acceptable by Medicare's own standards; in most cases, they would start having to pay for add-on benefits they are currently receiving for free. In addition to saving money, such a reform would modestly reduce demand for health care services, which would help bend the cost curve downward and make reimbursement rate cuts more sustainable.

But this is just a specific example of a broader principle -- at a time when "everything is on the table," from the National Institutes of Health to various defense programs to higher income taxes (and, simultaneously at the state level, education and public safety spending) we should also be questioning the affordability of health care entitlements we currently provide to seniors. Beyond reforms to Medicare premiums, means testing and a rise in the retirement age should also be on the table in the near term.

On the defense side, the report lays out a number of specific defense program cuts. I am not an expert on the defense budget, though I am generally sympathetic to the view that we buy more weapons than we need (or, in many cases, different weapons than we need) and conduct more military operations than is wise. So, I believe that we can appropriately achieve defense budget savings along the lines outlined in the report, if not with the exact moves recommended.

But while Ettinger and Linden propose to trim $96 billion from the defense budget, just $5.5 billion of that comes from cuts to employee compensation, or roughly 2% of the Pentagon's total personnel spending, through a change in the formula for employee pay increases. (Other salary and benefits savings are achieved by employing fewer people and deploying them less.) But even while treading cautiously, larger savings than this may be available.

Over the last decade, as it became clear that the United States was going to deploy soldiers more often to fight wars overseas, recruitment became more difficult. While the recently soft job market has helped the military to meet its recruitment goals again, military pay has had to rise faster than it otherwise would to account for the reduced appeal of enlistment. For this reason, in Fiscal 2010 the government abandoned its longstanding practice of military-civilian pay parity: while civilian workers got a 2% COLA, military workers got 3.4%. (Both of these figures, you may notice, significantly exceeded the near-zero inflation rate.)

Conversely, as troops are drawn down from Iraq and Afghanistan and the Obama Administration pursues a policy that keeps fewer troops abroad and in harm's way, the supply of people interested in joining the military will rise and the government's demand for soldiers will fall. The implication, though this will be politically unpopular, is that military pay should grow more slowly than wages in the economy as a whole.

The President's commission on fiscal reform is discussing military compensation reforms, indicating that they are a plausible avenue for savings by 2015. The exact level of pay restraint will need to be calibrated to allow the military to hit its recruitment targets, but potential savings are likely in the billions or tens of billions of dollars per year on top of what is proposed in the CAP paper.

We should also turn a critical eye to civilian employee compensation. However, unlike state and local governments, employee compensation is a small component of the cost of most federal programs. The key exceptions are the military and the postal service, which is mostly financially self-supporting. So, civilian compensation savings won't form a large component of a fiscal adjustment.

Regarding the report's cuts in tax expenditures, most of these recommendations are good but they aim small by cutting just $52 billion. Literally hundreds of billions of dollars in new revenues are available by ending larger unjustified tax expenditures, particularly those for health insurance, mortgage interest, and state and local taxes.

According to the Joint Committee on Taxation, the tax deduction for state and local taxes (including property tax) will cost $74.8 billion in the current fiscal year. The mortgage interest deduction reduces revenues by $119.9 billion. The variety of tax advantages for health care expenditures (including but not limited to tax-free health insurance benefits) are valued at $176.1 billion. All of these are bad policy and should be abolished.

I think the authors are mostly right in their decision not to call for ending these tax expenditures yet. Indeed, eliminating every undesirable tax expenditure would raise far too much revenue, and should be mostly offset by cuts in tax rates, probably as a tax reform package to come after the fiscal adjustment. But these changes should be on the medium-term radar.

Finally, a note on whether or not it is "simple" to balance the federal budget. A key argument of the CAP report is that achieving significant budget savings involves making hard choices about what the government will stop doing. Dan Mitchell of the Cato Institute argues the opposite, stating that "it is simple to balance the budget without higher taxes."

Mitchell notes that you could balance the budget by 2015, even while extending all the Bush tax cuts and indexing the AMT, simply by holding federal expenditures flat. Allowing 2% expenditure growth, roughly in line with expected inflation (though not accounting for population growth) would balance the budget by 2020.

The trouble with this calculation is that, every year, it costs the government more money to do the same things. For example, from 1998 to 2008, Medicare enrollment grew 17% as the population got larger and older. Over the same period, national health expenditures per capita rose by 79% (6% per year, compounded).

So, health care inflation and population growth required a 108% increase in Medicare spending just to keep benefit levels constant. (Actual Medicare spending growth was 124%, in significant part because of the new prescription drug benefit.) Limiting Medicare spending growth to 2% per year would have required cutting Medicare eligibility by 41%, providing 41% less costly benefits to each participant, or a combination thereof. This may have been possible, but it would not have been simple.

Other government programs do not face the same structural challenges that Medicare does, but they still face caseload increases and inflationary rises in cost. Holding federal budget growth to a target below this level requires real cuts in services. Conservatives are right to challenge the federal budget mentality that congratulates Congress on "cuts" when they just slow the rate of growth in spending, but that does not make holding federal spending growth to 2% per year simple -- if it were, Congress might already have done so.

In fact, the solutions to the unsustainability of the federal budget are not simple, and will require making difficult choices about paying more and/or getting less. I'd be remiss not to note that Cato has been doing excellent and highly specific work here with its Downsizing Government project. CAP's report also helps to move that ball forward.

Hopefully, think tankers on the Left and Right can flesh out these choices enough so that, mid-decade, when politicians are ready to tackle the fiscal imbalance for real, they will have a menu of options before them that are as painless as possible. But they will never be totally painless.

This article first appeared on RealClearMarkets.

Josh Barro is the Walter B. Wriston Fellow at the Manhattan Institute.


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