The Sequester

The "sequester" is an ingenious (though, it seems, unlikely to be successful) device for forcing a compromise between President Obama (and Democratic legislators) and the Republican members of the House of Representatives. The federal deficit is too large—everyone agrees about that. Obama wants to cut it by a combination of tax increases and spending cuts. The Republicans want to cut it by spending cuts alone—larger spending cuts than Obama wants, larger because the cuts must do all the work, with no assist from higher tax revenues. The Republicans can't make up their minds whether they hate taxes more, or deficits more, though taxes and deficits are interrelated.

The sequester imposes steep cuts across the board, though not proportional cuts—for example, the military cuts are the steepest, and the entitlement cuts the shallowest. No effort was made to distinguish between essential federal agencies with no significant bloat, such as the Federal Aviation Administration and the Food and Drug Administration, and the federal agencies that either have unimportant functions or are overstaffed and the federal grant programs that are just interest-group handouts. But arbitrariness of the sequester is essential to its efficacy as a device for pressuring the opposing sides to compromise. The cuts would impose real hardship on government workers and beneficiaries of government spending. The sequester resembles a game of chicken.

A majority of House Republicans believe that the federal government is simply too large, must be shrunk radically, and realize that it will be shrunk by a dollar less every dollar in additional tax revenues. Suppose the government spends 10 percent more than it should. If there is no tax increase, government spending must simply be cut 10 percent to achieve the desired shrinkage. But if tax revenues are raised by 10 percent, government must be shrunk by 20 percent in order to achieve a net reduction of 10 percent in government expenditures, and a spending cut of that magnitude would undoubtedly produce a severe recession.

From a deficit standpoint, tax revenues are as good a device as spending cuts; a 10 percent increase in tax revenues has the same effect on the deficit as a 10 percent reduction in spending. But the radical Repulicans are less concerned about the deficit than about the size of government. Hence their adamant opposition to tax increases.

So I must consider whether the federal government is indeed too large. I don't think so. Nor have the House Republicans, to my knowledge, provided evidence or reasons for thinking it is. We need to distinguish between two kinds of "excessive largeness" in government. One is excessive bloat—too many government employees and, what often goes with that, excessive regulation of the private sector. Bloat in the sense of overstaffing is characteristic of all large organizations, public and private, and reflects imperfect control of large organizations by their managers, or in short "agency costs." There probably isn't much that can be done about that. And although excessive regulation is a problem, the financial crisis of 2008, from which we are still suffering the aftershocks, was caused not by excessive regulation but by insufficient regulation by the Federal Reserve, other banking regulators, insurance regulators, the SEC, and private regulators such as the rating agencies and FINRA (Financial Industry Regulatory Authority).

The other kind of "excessive largeness" in government is spending. Major spending programs include Medicare, Social Security, Medicaid, and other welfare programs; support of research; subsidy programs such as farm subsidies and ethanol subsidies; the financing of infrastructure, such as the interstate highway system; environmental expenditures; the cost of the military; the cost of regulatory agencies such as the Food and Drug Administration, the SEC, and the EPA; the cost of law enforcement and the judiciary; tax expenditures (for example, the subsidization of charity); and national security intelligence (the CIA and the multiple other intelligence agencies). None of these programs is easy to cut. Many of them should not be cut; in that category I would put (along with environmental expenditures, including measures to deal with global warming, and basic regulatory functions) the military and national security intelligence. We live in a very dangerous world, in which the usual geopolitical threats have been enhanced by the rise of international terrorism; and our allies are of limited dependability and resources in dealing with security matters. Much that passses for "waste" in the defense budget is a rational response to profound uncertainties concerning current and future threats and current and future capabilities of potential enemies.

Medicare and Social Security are bound to grow as a function of increased longevity, and Medicaid as a function of increasing economic inequality. Some reforms seem attractive and even feasible, but the best and simplest would involve tax increases rather than spending cuts: higher Medicare and Social Security taxes for the affluent, and higher copays for Medicare (copays for government health insurance are a form of taxation). That are many subsidy programs, such as agricultural subsidies, that should be eliminated, but they are protected by powerful interest groups.

All in all, then, the opportunities for spending reductions are limited. Therefore if the deficit is to be reduced, it will have to be reduced mainly by imposing higher taxes, whether in the form of higher rates on income tax or—what is a superior solution because it is more efficient than higher marginal tax rates, which are distortionary—tax reform mainly in the form of reducing deductions from income tax. The problem is that the main deductions, such as mortgage interest, charitable contributions, and state and local taxes, are extremely popular. And so there may be no feasible alternative to higher rates. Fortunately, slight percentage increases in marginal rates can generate large increases in tax revenues; and the negative effects of slightly higher marginal rates— effects on emigration, work effort, investment choices, movement of money overseas, concealment of income, and schemes of tax avoidance—are likely to be modest. An increase in the marginal income tax rate from 35 to 75 percent would have dramatic negative effects; an increase from 35 to 40 percent on high-income taxpayers (say $200,000 and up), coupled with taxing capital gains, dividends, and interest at the same rate as ordinary income, probably not.

My short answer is "no", and the longer answer follows.

The Transportation Secretary and other government officials have claimed on television that government cutbacks would have catastrophic effect on airline travel, various other government programs, and overall employment if no deal with Congress is reached prior to March 1 when the so-called "sequester" starts. At that time, a series of cuts in government spending will automatically begin according to a schedule laid out over a year ago.

Although the set of agency cuts in spending mandated by the sequester is far from the best way to cut federal spending, as I discuss later, a few calculations show that in the aggregate the spending cuts will not have disastrous consequences. The Congressional Budget Office estimates that if the sequester goes into effect, actual federal spending, which lags appropriations, would decline by about $44 billion over the next seven months. Budget authorizations would decrease by about double that amount, to $85 billion, in the fiscal year ending in September. That is a huge amount of money to you and me, but even the authorized cuts are only a little over 2% of the projected federal budget during this fiscal year. Officially, government spending would continue to be cut for several years under the sequester plan, but no one expects the plan to be continued even for a year, let alone for several years.

The federal government is not the most efficient spender of taxpayers' money, so slight improvements in efficiency of spending would easily compensate for much of the mandated decline in appropriations in most agencies. Even without improved efficiency, the 2 per cent decline in overall spending by different agencies would not have a major impact on most government services-I discuss possible exceptions later on. For comparison, a similar cut to families with $60,000 annual income would require them to get by for a year with $58,800. Adjustments would be required to be sure, but spending would not fall catastrophically. Of course, for political reasons, federal agencies might intentionally cut activities that would cause the most inconvenience to consumers in order to create the most complaints against the cuts, and put pressure on House Republicans.

The federal budget was already quite large in 2008, and spending has grown by many hundreds of billions of dollars since then. This implies that even after the first year of the full implementation of these budget cuts, the federal government would still be spending far more than it did a mere 4 years ago. Of course, the increase in spending since then has not been uniform across agencies, with Medicare and Medicaid, and government welfare programs expanding more rapidly than most other forms of spending.

The best way to cut overall government spending is to reduce spending on those programs that can be done almost as well, or even better, by the private sector, and maintain, or even increase, those programs where private spending would be poor substitutes for government spending. The latter include defense, spending on infrastructure, such as roads and good teachers, safety nets for low-income persons, and basic research, such as trying to find ways to sequester carbon emissions, and trying to find cures for various cancers and Alzheimer's disease. The sequester program requires half the cuts to come from national security and military operations. I do not know if too much or too little is spent on the military, but government spending in these areas obviously cannot be effectively replaced by private spending on protection against terrorism and other threats. Yet even spending on the military would only fall by 3.8% during the next 7 months.

Various other activities of the government can be done much better by the private sector without government subsidies, such as production of ethanol, fossil fuels, and alternative energy sources, such as solar and wind power. It also suggest scaling back some of the welfare programs that expanded rapidly during past few years, programs that contributed greatly to the sharp decline in the labor force of lower skilled and younger workers (see Casey Mulligan, The Redistribution Recession).

The sequester-mandated cuts in spending exclude social security and Medicaid, and requires senseless cuts in Medicare. In light of the greater health and life expectancy of older Americans, one effective way to cut spending on social security and Medicare would be to raise the eligibility age gradually over the next decade to 70. Additional savings on Medicare can also be achieved if a voucher program replaced the current system. The richer elderly should get smaller vouchers, and everyone should be allowed to top up their vouchers with private spending, presumably most of that covered by private insurance.

Some economists have argued that the mandated cuts in government spending are particularly inappropriate at this time since the US is not fully recovered from the financial crisis. Since reduced government spending of $44 billion over the next seven months only a little over ¼ of 1 percent of GDP, this is not likely to have a major effect on the economy, even without any replacement of reduced government spending by greater private investment and other spending. The $85 billion decline in appropriations would be more disrupting, but still would not amount to a lot, especially since the private sector appears to be picking up more steam.