Paul Ryan’s budget dramatically reduces the size of the federal government over the long run, which could be incredibly bullish for economic growth in the United States.
The current budget debate in Washington is among the most heated and partisan we’ve seen since the beginning of the Obama administration. On the conservative side of the equation is, of course, the Ryan budget, which was introduced two days ago by Representative Paul Ryan, the Republican from Wisconsin. Philosophically, the basis of the budget is simple: it both reduces taxes and dramatically reduces the size of the government over ten years, with a focus on restructuring the cost of health care.
The Congressional Budget Office, at the request of Representative Ryan, presented their analysis of his budget yesterday. In the introductory section of the analysis, the CBO stated:
“To prevent debt from becoming unsupportable, policy makers will have to substantially restrain the growth of spending, raise revenues significantly above their historical share of GDP, or pursue some combination of those two approaches.”
In theory, the budget situation is actually that simple: either raise taxes or cut costs, or both. Politically, and practically of course, the solution is far from simple, but the outcome of the Ryan budget, albeit at the expense of restructuring health care, may provide some real long-term economic advantages for the United States versus the fiscal status quo.
The key components of the Ryan budget are as follows:
- Health care — The Ryan budget would convert the current Medicare system to a system of premium support payments and would increase the age of eligibility of Medicare. On Medicaid, the federal share of the program would be converted to block grants to the states, which would grow with population and core inflation. The Ryan budget would repeal all components of last year’s health care reform law. Finally, several limitations of punitive damages in medical malpractice would be implemented.
- Other spending — Under the Ryan budget, mandatory and discretionary spending, other than that for mandatory healthcare (outlined above) and social security, is cut from 12% of GDP in 2010 to 6% of GDP in 2022 (this is below pre-World War II levels).
- Revenue — Under the Ryan budget, federal government revenues grow from 15% of GDP in 2010 to 19% of GDP in 2028, and remain at that level thereafter. For comparative purposes the long run average of federal government revenue as a percentage of GDP from 1960 — 2011 is 17.6%. So, in essence tax receipts in Ryan’s proposed budget are slightly above the long run percentage of taxes as share of the U.S. economy and ~27% above current levels.
Unfortunately, the CBO analysis didn’t offer a comparison of the Obama budget versus the Ryan budget, but it did offer a comparison of the Ryan budget versus its Extended-Baseline Scenario (normal scenario) and Alternative Fiscal Scenario (draconian scenario). In the table below, we’ve also included the CBO’s most recent estimates of the Obama budget, although the ten-year budget ends in 2021 and not 2022. The clear take away from the ten-year budget comparison below is that the Ryan budget effectively outpaces both the federal government’s current fiscal path and the proposed Obama budget in reducing the budget deficit over the next decade.
The longer-term fiscal benefits of the Ryan budget are even more compelling according to the CBO. By 2050, the federal government would be running a 4.25% budget surplus (as a percentage of GDP) under the Ryan plan versus -4% in the CBO’s normal scenario and -26% in the more draconian scenario.
In evaluating the long-term benefits of the Ryan budget from an economic perspective, we think three key factors are most relevant, which are as follows:
Long-term structural debt – The most thorough analysis of the impact of long-term debt is This Time is Different by Carmen Reinhart and Kenneth Rogoff. The key take away from their analysis is that, as sovereign debt balances accelerate and eventually reach the 90% debt-to-GDP level, growth slows dramatically.
In fact, their analysis of 2,317 observations has a statistically significant 352 observations at, or above, 90% debt as a percentage of GDP. The Ryan budget by 2050 has debt-as-percentage of GDP at 10% according to the CBO, while the CBO’s baseline and draconian scenario take debt-as-percentage of GDP to 90% and 344%, respectively.
Declining government spending – For starters, government spending is a large percentage of GDP (between 29% and 35% in recent years), so, in theory, cutting government spending dramatically could be a drag on the economy. Further, and as the argument of Keynesians, higher levels of government spending or stimulus are required in periods of below average GDP growth.
To test the impact of declining government spending introduced by the Ryan budget, we analyzed real GDP change from 1960 to 2009, and year-over-year government spending changes in the same years. Interestingly, in the five years with the slowest year-over-year growth in government spending, GDP in those years grew on average 4.74%. Conversely, in the five years with the largest year-over-year change in government spending, GDP grew 1.10%. The average of real GDP growth over the entire period was 3.2%.
Now, admittedly, this is a somewhat simplistic analysis, which we will be refining further. A key pushback is obviously that as GDP growth slows, certain entitlements naturally kick in, and vice versa. Interestingly, if we look at one year out after the five most dramatic ramp-ups in government spending, GDP growth does reaccelerate to 3.3% on average, which is just above the long run average. While this is no doubt encouraging for Keynesians, it is still somewhat anemic growth given easy comparables. So, while this analysis needs refinement, it does appear to lend credence to the idea that government spending does not have a comparable return to the same capital allocated to the private sector.
Long-term low taxation levels – Under the Ryan budget, federal government revenues grow from 15% of GDP in 2010 to 19% of GDP in 2028, and remain at that level thereafter. For comparative purposes, the long run average of federal government revenue as a percentage of GDP from 1960 to 2011 is 17.6%. So, in essence, tax receipts in Ryan’s proposed budget are slightly above the long run percentage of taxes as share of the U.S. economy. While this may seem less conservative, in reality, it’s quite conservative when compared to the current alternatives. For example, by 2022 the CBO baseline estimate has government taxes at 21% of GDP, and President Obama’s budget has government revenues as a percentage of GDP at 19.3% by 2021, while Ryan has this statistic at 18.5% by 2022.
So, the long run debate continues, are lower taxes better or worse for the economic growth? We know where we stand on that, but if you don’t believe us, take the CBO’s word for it, which in its analysis of Representative Ryan’s budget wrote:
“To the extent that marginal tax rates on labor and capital income would be lower as a result, future output and income would be greater in the long term, all else being equal.”
To many, the Ryan budget is scary. It dramatically attacks the long-term expenditures and structural deficits of the U.S. federal governments by cutting costs to unprecedented levels. The reality is, though, based on the fiscal history of the modern United States, this plan could be wildly bullish for the U.S. economy in the long run as it dramatically allocates capital away from the government and into private hands where it will potentially be much more efficiently allocated.
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