May 24, 2017

Sustainable Budget Solutions 1: Defense

Before I return to the single-payer health care proposal in California, here is another matter that fits into the same narrative (exactly how will be explained later). It is a proposal for how to shield defense spending from the ups and downs of the federal budget, as well as from short-term political, partisan preferences.
While many government functions fill important needs in people’s lives, some of those functions are more important than others. It is essential to protect those functions from the booms and busts of the business cycle. The need to protect those programs is further elevated under a balanced-budget amendment: in recessions when tax revenue is tight, limited borrowing capacity leads to tough priorities - or sequester-style across-the-board spending cuts.

Social Security is of major importance, not just to Democrats in Congress, but to Republicans as well as millions of Americans whose daily livelihood depend on the program. It has, over time, become as essential to our nation as defense spending. Thanks to its independent funding mechanism, it is to some degree shielded from the annual swings in Congressional fiscal policy. This does not mean the program is solvent for the foreseeable future – quite the contrary – but there is a great deal of common sense to the basic idea of an independent funding arm for the program.

Defense spending, again, is also essential. Given the major role that the U.S. armed forces play not just for our nation, but globally, it is important to secure its funding for the future. Specifically, Congress should develop a funding model that protects the Department of Defense from disruptive, sequester-driven cuts.

One way to make defense spending immune to sequester cuts is to develop a funding model mimicking Social Security. Tax revenue can be guaranteed by a dedicated Defense Tax. Since 80 percent of federal tax revenue comes from taxes on personal income, it is reasonable to carve out a share of those tax revenues and dedicate them as a tax specifically set aside for national defense. The tax could consist of the first dollars of a person’s federal tax liability. For example, if a person owes $2,000 federal income taxes, and the Defense Tax would be 20 percent of a person’s federal tax liability, then the first $400 that the taxpayer pays for that year would go unabridged to funding national defense.

Once the Defense Tax was paid, the rest of the personal income tax revenue would go toward general-fund expenditures. The share going to the Defense Tax would vary based on a mechanism described in Equation 1 below.

Reasonably, the Defense Tax should be governed by no other factor than the global geo-political and other factors taken into account when Congress determines the defense budget. Ideally, this would require a forecasting mechanism to provide Congress with a formula for setting the Defense Tax. However, the past quarter century has proven that such forecasting is very difficult. The end of the Cold War and the collapse of the Soviet Union and its satellite states redrew the global map in more ways than one. The 9/11 attacks led to a fundamental transformation of the Middle East, with repercussions as far away as Tunisia and Africa’s Horn. In the past few years, the economic and political erosion of the European Union has led to instability, uncertainty and shifting political alliances on a continent often regarded as the epitome of political, social and economic stability.

With these experiences on record, it is more prudent to base a Defense Tax not on forecasts of future military needs, but on a trend in historic defense spending. As an experiment, the consider the following equation:
where TD is the total revenue from the Defense Tax in one year, the sigma numerator is the sum total of defense spending over the past five years, and M is a mark-up coefficient. Equation 1 thus determines the current-year Defense Tax as the average of defense spending over the past five years, multiplied by a mark-up.

The mark-up is important. It brings past spending up to current levels in terms of inflation and technological progress. It means, simply, that this year’s Defense Tax will be 20 percent higher than the average for the past five years.

By tying the Defense Tax to past defense spending in this manner, Congress takes a big step toward independence in the funding of national defense. There is just one more step needed.

Equation 1 provides stability and progress in defense funding, but it does not in itself allow for contingencies that require rapid increases in defense spending. The response to the 9/11 attacks would not have been possible without extraordinary appropriations; if Congress must rely on such mechanisms in times of rising international tensions or conflicts, then defense funding will eventually be put alongside other budget items. That defeats the purpose of the Defense Tax.

A Defense Trust Fund would guarantee full funding independence for our national defense. It would have a simple construction: whatever surplus there is from the Defense Tax when national defense has been funded will be deposited into a fund. As that fund grows, it provides extra money available on tap, should Congress determine that there is a need for a rapid increase in defense spending. (To prevent frivolous spending increases, driven by political concerns unrelated to national defense, it is appropriate to attach a three-fifths majority threshold to any bill tapping into the Defense Trust Fund.)

Figure 1 explains how the Defense Tax and the Defense Trust Fund would have worked if they had been instituted in 1969. Actual national defense spending numbers are used throughout. (The year 1969 is chosen based on availability of appropriate data.)

Figure 1
Sources: Bureau of Economic Analysis (personal income) and Office of Management and Budget (defense spending).

The build-up of defense spending under the Reagan administration would have tapped into the Defense Trust Fund for several years, even led to a complete depletion of the fund. This has to do with the starting point: in this simulation the fund had not existed very long at that point. A similar depletion episode after 9/11 allows for a doubling of defense spending over a decade.

The depletion episodes could in theory be a matter of concern. However, the construction of the Defense Tax is such that once defense spending accelerates, the tax increases with a lag. This has three advantages:

1.     The drawdown of the Defense Trust Fund has a limit in time, ending when the Defense Tax catches up with defense spending;
2.     The rise in the Defense Tax is gradual, saving the economy from rapid, disruptive tax increases;
3.     The availability of the Defense Trust Fund allows Congress to focus on the necessary defense build-up without getting caught up in a political battle over tax policy in times of global uncertainty.

The construction of the Defense Tax also has a balancing mechanism. When a period of global tensions is over and defense spending flattens, or even decreases, the tax does the same in a lagged fashion similar to its increase. This prevents excessive build-up of the Defense Trust Fund; as the historic account above indicates, the money stored away in the fund will be enough to allow for the reserve needed in times of national uncertainty.

Single-Payer Health Care in California, Part 1

The question of what the American left is going to do after they lost the 2016 election has been answered: expand the welfare state.

Ever since the War on Poverty began in 1964 they have used the federal government as their vehicle for advancing egalitarianism in America. With delightful help from Republicans, they have grown entitlement spending under every president since Lyndon Johnson; it remains to be seen if Donald Trump will break that trend. (Given that his first budget includes an entirely new entitlement program, loaded with a structural deficit, that appears to be unlikely.) But even if he wants to do that, it is likely that he will run into tough resistance from Congressional Republicans.

Meanwhile, the liberal strategy for expanding the welfare state has shifted toward states. It is very likely that we will see multiple efforts, in multiple states to create three types of entitlement programs: paid family leave, single-payer health care and universal child care.

The third program has yet to materialize as a major issue on the liberal agenda; paid leave exists in California, New Jersey, Washington state and Washington, DC, and is being aggressively promoted by egalitarians in Colorado.

As for single-payer health care, egalitarians have now turned California into Ground Zero. From the Sacramento Bee:
State Democrats’ three-day convention had a raucous start Friday, as liberal activists booed and heckled Democratic National Committee Chair Tom Perez after marching from the state Capitol to promote a universal heath care program. The leader of the nurses’ union that opposed Perez’s recent election had just warned California Democrats that they would put up primary election challengers against lawmakers if they don’t support a bill to create public-funded, universal healthcare. “They cannot be in denial anymore that this is a movement that can primary them,” RoseAnn DeMoro, executive director of the California Nurses Association, told hundreds of nurses and health care advocates gathered for a rally at the Capitol.
Evidently the radical left wants to trounce the less radical left by out-entitling them. The strategy seems to be "highest bidder wins":
The showdown over health care exposed deep rifts within the party that may have scabbed over, but have not healed, since last year’s primary fight between Hillary Clinton and Bernie Sanders, a favorite of the nurses union, which also backed Perez’s opponent in the chair’s race, Rep. Keith Ellison. Sanders has called for a national single-payer system, and earlier this month called on Californians to adopt the model at a speech in Los Angeles.
Under a “single-payer” system like Canada’s, the government would pay health care bills instead of multiple insurance companies. Private hospitals and doctors would provide the care. Premiums, copays and deductibles would disappear. The money would come from state and federal governments and new taxes, likely on earnings, and paid by employers and employees. It’s the same way Medicare functions, essentially. Proponents say it’s a practical way to rein in rising health care costs, expand access and improve quality. Critics argue that such systems lead to unacceptable levels of taxation, rationed care that can make people sicker and long wait lists for primary and specialty care appointments.
There is probably a mile's worth of bookshelves with literature showing how bad single-payer health care works in the countries that have tried it. My own small contributions consist of, among other items, an entire chapter in my upcoming book The Rise of Big Government (Routledge, due out in October), and my book from 2010 where I chronicled the Swedish single-payer disaster 

For now, though, let us just concentrate on one of the challenges that will be facing California's egalitarians. Among their selling points for a state single-payer system is that it will contain the costs of health care. As with every other single-payer system in the world, it is unclear exactly how those savings will materialize, other than in the form of system-wide rationing and other means to restrict and prevent people from the health care they need.

The cost containment problem sits right in the intersection between health care costs and the suggested funding model, which - according to the Sacramento Bee - in part consists of a new tax on personal income. Starting with health care costs, there are many different ways to track them. The most honest way to do it is by itemization: using the standard system of national accounts, employed by the Bureau of Economic Analysis (BEA) in measuring GDP, we can estimate the costs for assorted pieces of medical technology.* Similarly, the Bureau of Labor Statistics (BLS) offers comprehensive data on employment and earnings of medical professionals. 

BLS data is broken down elegantly by state, while BEA industry data is not. Therefore, there is a moment of inexactness in estimating the costs of producing health care in California. We have to assume that the costs of medical equipment, as reported nationally by the BEA, are representative of the costs in California. With this caveat in mind, we can add up the costs, then let them evolve as they actually did from 1999 and on.

We then add personal income, specifically for California, and assume that we put a tax on it to pay for the two types of health-care operating costs in the Golden State. We then compare the growth rates of health care costs and of the tax base, personal income. Starting in 1999. we assume that we raise $100 in taxes to pay for $100 worth of of medical equipment, and equally $100 of personal-income tax to pay for medical staff salaries. Figure 1 explains how the tax revenue would keep up with costs: 

Figure 1
Sources: Bureau of Economic Analysis and Bureau of Labor Statistics

Medical equipment costs would outrun its tax base already in 2001, while staff costs would exceed the tax base from 2007 and on. By 2010, equipment costs would exceed tax revenue by 27.2 percent; staff salary costs would outrun tax revenue by more than one third. 

This is, of course, an incomplete account for all health care costs. One big item, pharmaceuticals, is not included. One of the problems with including that part is that your typical single-payer system comes with centralized, bulk-purchased medicine, where one government agency decides what medical drugs to buy, and which ones not to buy, and then negotiates prices with pharmaceutical companies. This makes it somewhat difficult, though by no means impossible, to include pharmaceuticals here. However, to do that part justice, I will return in a Part 2.

For now, let us note that single-payer advocates in California are playing with fiscal fire.  
*) In tracking the costs of medical equipment, the following items in industrial accounts were chosen (numbers representing IO codes): 333314-15; 334514-16; 339112-16; 233210; 325411-14; 334510. Changes in costs, staff salaries and personal income are all in current prices.

May 16, 2017

Frank Knight, Finn Kydland and a Flat Earth

How refreshing it is to open a book and read that the author's object is
a study in "pure theory". The motive ... is twofold. In the first place, the writer cherishes, in the face of the pragmatic, philistine tendencies of the present age ... the hope that careful, rigorous thinking in the field of social problems does after all have some significance for human weal and woe. In the second place, he has a feeling that the "practicalism" of the time is a passing phase, even to some extent, a pose; that there is a strong undercurrent of discontent with loose and superficial thinking and a real desire, out of sheer intellectual self-respect, to reach a clearer understanding of the meaning of terms and dogmas which pass current as representing ideas.
I am, of course, quoting the preface of Frank Knight's Risk, Uncertainty and Profit. So many times have I had this book on my reading list, only to see it bumped to the side by more pressing literary needs. No more...

Frank Knight belongs in the same category of brilliant thinkers in political economy as Keynes, Hayek, Mises, Shackle, Alchian, Okun, Paul Davidson and Axel Leijonhufvud. These are people who took seriously the social and political relevance of economics. Their thinking runs the whole path, from questions of high theory and complex methodology down to the practical difference that those theoretical and methodological questions will ultimately make. They are no one-trick-ponies, like most modern economists - sadly - have turned out to be. 

It takes time, and a lot of hard work, to build this kind of holistic ability of reasoning. Today's economists are too busy cranking out articles asking about "the effect of X on Y", for which I do not blame them. If you choose a traditional economics career in academia, that is what is expected of you. Nevertheless, one of the consequences of the fragmentation and - to be perfectly honest - trivialization of economics is that it has lost its ability to produce systemic thinkers. 

Or, as we should preferably call them, political economists.  

There is an important, practical side to the question of systemic thought. As an illustration, let me use one of the most famous articles in modern macroeconomics: Time to Build Aggregate Fluctuations by Finn Kydland and Edward Prescott. Published in 1982 in Econometrica, this article investigates the role of sequences in the production of capital goods, and what role those sequences play in the business cycle. The theory they contributed to is better known as Real Business Cycle theory. 

For the research they did, both for this article and subsequently, Kydland and Prescott were awarded the Nobel Memorial Prize in economics in 2004. In other words, some of the world's most influential economists believe that their contributions were at the absolute forefront of the economics discipline. There is nothing wrong with that, per se, but what is striking about Kydland and Prescott is that their path-breaking contribution also illustrates the methodological flaw that runs like an artery right through modern economics. 

This, in turn, illustrates what happens to an academic discipline when it becomes too "practical" in Knight's words, and loses its connection to systemic thought.

In their 1982 article, Kydland and Prescott (1982) assume that the production of capital goods takes several time periods. Those periods are distinctly separated from each other, with a unique part of the construction of capital goods taking place in each period. 

There is nothing wrong with this assumption. The problems begin when they assume that the rest of the economy is operating under traditional Walrasian assumptions of auction pricing, flexible prices and - by logical consequence - perfect foresight (for a brilliant, in-depth examination of this point, see Shackle: Epistemics and Economics). In the Walrasian system, flexible prices set by an auctioneer are to everyone's benefit; we all enjoy our lives the most when prices are acution-determined and ex ante completely flexible.

In practice, this means that you do not know from one day to the next what the prices of milk, bread, beef and tomatoes are going to be. You will find out only when you are at the grocery store and the goods are auctioneered off on a market with many sellers and buyers. 

At the same time, as an employee of a shipyard building oil tankers you get paid under a completely different price regime. It is necessary, namely, for producers of capital goods to secure a set of fixed, contracted prices throughout the production process of each and every capital good they manufacture. If they have no idea what the cost of production is going to be in each of the X time periods it takes to build an oil tanker, they cannot finance the production of their ship. 

Part of securing production costs is to sign a contract, explicitly or (see Arthur Okun: Prices and Quantities) implicitly, with subcontractors, suppliers and workers. The workers will then have a wage they can predict for the next five periods of time.

Yet at the same time as they have a fixed wage, their cost of living is determined on Walrasian auction markets.

The difference in time sequencing, and the consequences thereof for not just pricing but the existence (or absence) of uncertainty, risk and profits (see Alchian: Uncertainty, Evolution and Economic Theory), is a significant problem. It is comparable to a physicist studying gravity by assuming that gravity operates in a universe where Earth is round and revolves around the sun, while the other laws of nature exist in a universe where Earth is flat and the center of the universe.

With this level of methodological creativity, you can claim to prove anything, yet at the end of the day you prove nothing, except that with enough implicit axioms in your pocket, you are impervious to the restrictions that reality imposes on us all. 

This is, in a nutshell, the point that Frank Knight makes in the preface to his book. But his book is also a defining contribution to the discipline of political economy. 

That, however, is a point we will have to return to later. 

Colorado: The Egalitarian Frontline

This article is an independent sequel (if the term is permitted) to my article of October last year about the attempts to create a single-payer health care system in Colorado. It was originally published on my blog Wyoming Prosperity. This is a slightly revised version.
Last year voters in Colorado were given the chance to create a state single-payer health care system. The effort failed, but that has not deterred some Coloradans from going after two other, major entitlement programs: paid family leave and a state-run pension system for low-income workers. 

It is a safe bet that we will get the chance to return to the single-payer health care issue later on. Welfare statists do not give up that easily. In the meantime, the egalitarian campaign for more economic redistribution in Colorado will continue. Here is, for example, the bill that would create a paid-leave entitlement program:
The bill creates the family and medical leave insurance (FAMLI) program in the division of family and medical leave insurance (division) in the department of labor and employment (department) to provide partial wage-replacement benefits to an eligible individual who takes leave from work to care for a new child or a family member with a serious health condition or who is unable to work due to the individual's own serious health condition. 
It should be noted that this bill has not yet left the Senate committee it was assigned to. That, however, is very likely only a temporary road bump. Therefore, it is essential to examine this idea in detail. For example, take a moment and listen to what Vanessa Brown Calder of the Cato Institute has to say about the paid-leave program.

The benefits are to be paid out according to a step-down scale where the benefit declines with rising income:
  • For a worker who earns no more than 20 percent of the annual mean wage in Colorado, the entitlement will replace 95 percent of his income;
  • For a worker who earns more than 20 but not more than 30 percent of the annual mean wage in Colorado, the entitlement will replace 90 percent of his income;
  • For a worker who earns more than 30 but not more than 50 percent of the annual mean wage in Colorado, the entitlement will replace 85 percent of his income;
  • For a worker who earns more than 50 percent of the annual mean wage in Colorado, the entitlement will replace 66 percent of his income.
There is, however, a cap on the weekly benefit at an indexed $1,000 per week. 

So much for the entitlement side. Now for the funding part:
Each employee in the state will pay a premium determined by the director of the division by rule, which premium is based on a percentage of the employee's yearly wages and must not exceed .99%. The premiums are deposited into the family and medical leave insurance fund from which family and medical leave benefits are paid to eligible individuals. 
As always with entitlement programs, the first order of business is to calculate the maximum entitlement value and compare it to the maximum expectable tax revenue. Here is how the entitlement benefits would be paid out, provided every eligible person maxed out his annual ration of 12 weeks of paid leave at the income replacement rates reported above:

--For the group making less than 20 percent of the annual mean wage: $283.6 million;
--For the group making at least 20 but less than 30 percent: $344.1 million
--For the group making at least 30 but less than 50 percent: $1,066.4 million
--For the group making at least 50 percent of annual mean wage: $14,302.3 million. 

In other words, the maximum entitlement value is $16 billion. Based on the 0.99 percent income tax designated to fund this program, the revenue would cover 8.4 percent of the maximum entitlement value. 

This enormous discrepancy between designated funding and maximum entitlement value is symptomatic of how state-level income replacement programs are designed. It threatens the long-term fiscal solvency of the programs, especially when people become aware of them, yet proponents carefully avoid talking about this consequence of their agenda

Since they don't, we will. Experience from California is telling: in the first decade of its existence, the costs of the California paid-leave program grew by 87.5 percent - despite the fact that during that period only about half of all eligible Californians knew of the program's existence. 

In time for its ten-year anniversary, Governor Brown signed into law a major expansion of the paid-leave program. This is likely to skyrocket the costs for it to taxpayers.

Interestingly, the sponsors of the California paid-leave program appear to be well aware that their program is not, and probably never will be, funded by the tax that is supposed to pay for the program. Back to Colorado House Bill 1307:
The director may also impose a solvency surcharge by rule if determined necessary to ensure the soundness of the fund. The division is established as an enterprise, and premiums paid into the fund are not considered state revenues for purposes of the taxpayer's bill of rights (TABOR).
In other words, an open road to tax hikes in the name of the egalitarian welfare state.

As of May 3, the bill aimed at creating this massive entitlement program is stuck in a Colorado State Senate committee. Hopefully, the senators down in the Centennial State will come to their senses; if they don't, we up here in Wyoming will be happy to welcome all productive, honest, hard working, God-fearing, entrepreneurial Coloradans. After all, if the utilization rate of this paid-leave program came even remotely close to its own maximum entitlement value, the consequences for Colorado taxpayers would be quite serious. 

Add to this the risk that the state will go for single-payer health care (or at least something closer to it than what they have today) and the idea of a low-income state-run pension system, and the long-term outlook for the Colorado economy suddenly got a bit dimmer.

The one question to ask is why this aggressive push for new entitlement programs is taking place in Colorado of all places. In the past several years, the trend in state legislation has been in the other direction, at least no the tax side. (We still have not repealed a single major entitlement program in this country.) There are two plausible explanations:

1. Colorado has been a magnet for Californians tired of the excessive taxes out there. After having voted their state economically uninhabitable, those Californians leave for a better life in the Rocky Mountains. True to their political DNA, though, they immediately start working for all the things they vote for, but could not live with, in California. 

2.  Colorado is a swing state. If Democrats can top off the welfare state with the last few entitlement programs still missing in the American version of egalitarianism (compared to, primarily, its Scandinavian peers) and do so in a swing state, the calculation is that other swing states will give in to the egalitarian ideology, embrace Elizabeth Warren (or whoever the Democrats nominate in 2020) and even swing Congress in a progressive direction. 

One explanation does not exclude the other. But regardless of what is motivating this egalitarian offensive in Colorado, it is absolutely essential that it be countered with thoughtful, principled thinking, persuasive arguments and solid analysis. 

I grew up in the world's most egalitarian welfare state. There is a reason why I do not live there anymore.