Cutting the Budget’s Gordian Knot

Posted by & filed under CGR Staff, Rochester Business Journal.

Kent GardnerThe financial problems of the nation and many large states—California, Illinois, New Jersey and certainly New York—present a problem that is challenging economically and hazardous politically. Since it’s impossible to separate the economics from the politics, it is truly a Gordian knot – rather than untying the knot, Alexander the Great sliced the Gordian knot in two with a single, bold stroke of his sword.

The Congressional Budget Office forecasts the federal deficit to decline from about $1.5 trillion in 2009 to $608 billion in 2014, then rise to nearly $800 billion in 2020. This is a hefty deficit, particularly when you consider that we had a surplus as recently as 2000. Then consider that the cumulative public debt, which currently stands at $7.5 trillion, is expected to nearly double by 2020 to $14 trillion.

Years ago, as a young economics professor, I was rather sanguine about the debt. “We owe it to ourselves,” I’d say. No longer. In 2009, nearly half of our debt was held by foreign interests—with China and Japan as our largest creditors at 11% and 10% of our total debt, respectively. Foreign ownership increases the risk that debt poses to our economy.

How can we live within our means? In November, The Economist summarized some of the available options. I found the list rather depressing. Does raising the retirement age under Social Security to age 70 seem a bit draconian? Sad to say, it only cuts the deficit by $4 billion. Same for raising the Medicare age to 67. That only pulls in about $3 billion.

We gain more by eliminating some deductions. Do you like deducting state and local taxes on your 1040? Or the interest on your home mortgage? The deficit falls by $65 billion for the first and $147 billion for the second. Eliminating the favored tax status of employer-provided health insurance would raise a good bit more cash—$215 billion (no wonder it has been a topic of discussion in the context of health reform).

And, of course, we can add new taxes. A 50-cent per gallon gas tax would pull in about $62 billion. A value-added tax (VAT), effectively a national tax on consumption (a kind of national sales tax), would bring in some real money. If set, for example, at 5%, a VAT would raise about $324 billion.

We face similar struggles in New York State. If spending continues on its current trajectory, the Division of the Budget projects a cumulative deficit of $61 billion over the next four years. Even after the changes proposed in Governor Paterson’s 2010-11 budget, the four-year deficit is only cut in half. That may sound like chump change compared to the federal deficit, but remember we don’t have the right to print money here in New York.

How to cut the state deficit? Remember that 53% of the budget is either Medicaid or K-12 education. You can bet that the hospitals are lobbying hard to roll back the $500 million cut recommended by the governor. Nursing homes and home care agencies are fighting the potential loss of another $600 million. Despite the fact that aid to K-12 education is up 42% since 2003-04, the public schools are lobbying aggressively to reverse Paterson’s modest $423 million cut from being imposed.

With the entire Legislature up for re-election in November and political control of the Senate within reach of both parties, candidates will be under pressure to find money for popular projects and avoid unpopular cuts, while still being able to claim to be fiscally responsible.

Is there a solution? Just as the problem is a tangled knot of politics and economics, so must the solution address both spheres. The political solution must provide cover for incumbents running for re-election, some kind of “plausible deniability” to shield them from the anger of special interests and the attack ads of challengers and their proxies. After a recent Supreme Court ruling eviscerated restrictions on campaign spending by businesses and unions, the need for political cover has never been greater.

Republican Senator Judd Gregg and Democratic Senator Kent Conrad are trying to establish a bi-partisan commission that would make recommendations to Congress that could only be voted up or down by members – modeled after the successful military base-closing commissions. This allows the “plausible deniability” incumbents seek—“Hey, you know I support your cause. But the cut to you, Mr. Special Interest, was part of the package. I just couldn’t vote down the whole thing.” Columnist George Will dubs this the “hold-hands-and-jump-off-the-cliff-together” school of government. It may be an inelegant, even cowardly, approach to balancing our budgets, but we don’t live in a perfect world.

Might a similar approach work in New York? We managed to close a number of hospitals and nursing homes using a similar model. The Berger Commission “took the heat” for legislators, letting sensible cutbacks become law without forcing state legislators to take a stand on individual facilities.

Yet we need an economic solution, too. Every one percent increase in the growth rate of the U.S. economy adds about $250 billion in revenue. It works both ways—if the growth rate falls by one percent, the deficit goes up by $250 billion instead. And the same principle applies to New York State. Whatever we do to fix the budget, remember the dictum from medicine: First, do no harm. For if, in our attempt to balance the budget, we chase business from our state or from our shores or we limit the ability of technology to improve productivity, we may fill one hole by digging ourselves another. Only economic growth truly cuts the Gordian knot.

Kent Gardner, Ph.D. President & Chief Economist
Published in the Rochester (NY) Business Journal February 19, 2010