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Obama's Tax Hikes Won't Be Nearly Big Enough

Republicans want to reduce the size of the federal government, and they won’t take no for an answer. “I just want to shrink it down to the size where we can drown it in the bathtub,” Grover Norquist famously declared. And in negotiations over the fiscal cliff, they have insisted on cutting spending rather than raising taxes. “The President wants to pretend that spending isn’t the problem,” House Speaker John Boehner has complained.

Democrats, for their part, have responded defensively. House Minority Leader Nancy Pelosi warned that the Republicans would “cut out the prospects for job creation.” But other Democrats, including former Obama administration officials Austan Goolsbee and Peter Orzag have come out for “entitlement reform” to reduce government spending. And in his compromise offer to Boehner, Obama proposed reducing Social Security benefits over time by changing the way they were to be adjusted for cost of living increases.  

That’s politics, of course, but there are a set of unpleasant truths lurking behind this debate over the budget and taxes that policy-makers in Washington need to acknowledge. First, that in order to meet public demands for affordable health care, quality public education, and retirement insurance, government at all levels will need to grow and take up a larger percentage of the nation’s GDP. Second, any significant cuts to these programs’ funding will undermine their effectiveness. And third, the only way to maintain these programs is by raising taxes on income and wealth--and well beyond, the kind of increases that the Obama administration has proposed in negotiations over the fiscal cliff.

The government has grown dramatically over the last century. The federal government has gone from 2.47 percent of GDP in 1913 to 24.33 percent in 2012. Total federal, state, and local spending has gone from 8.1 percent in 1913 to 39.94 percent today. Military spending shot up during World Wars I and II, the Korean War, the Vietnam War, and Ronald Reagan’s military buildup in the 1980s, but it has remained between 4 and 6 percent of GDP over the last two decades. The largest federal, state, and local expenditures – which account for more of the growth over the last century -- are for pensions, health care, and education.

These programs exist, and have grown, because the public overwhelmingly supports them. Opposition to them is largely confined to a noisy faction of Ayn Rand disciples and business groups that view public expenditures, which they describe as “entitlements,” as a subtraction from private wealth. As my colleage Noam Scheiber notes, it’s true that many voters are wary of “big government” in the abstract, but a politician risks his career by proposing to cut Medicare or Social Security or to abolish the Department of Education. Government developed and expanded these programs, because private companies could not make a profit providing these services for all senior citizens or guaranteeing education to all children. And that wasn’t because the companies were insufficiently ingenious. It was because of the nature of these programs. That’s a point that economist William Baumol has made – most recently, in a book entitled The Cost Disease -- and it’s worth reiterating during the current debate over the size of government.

One needs to distinguish between productive and stagnant sectors of goods and service production. In the productive sectors, which include much of manufacturing, productivity has risen sharply over the last century. In these industries, fewer workers can now produce far more goods. But in the stagnant sectors, which include much of health care and education and also Baumol’s favorite example, the performing arts, productivity has risen much more slowly or not all. It takes the same number of musicians the same time to play a Beethoven String Quartet. And any attempt to increase productivity in these sectors – by, say, getting teachers to double their class sizes, or replacing the clerks who answer inquiries about Social Security with automated call centers – can degrade the quality of the service.

In the private sector, the average (though not necessarily the median) wage and salary has kept pace with productivity. From 1954 to 2005, real compensation grew 2.02 percent a year and productivity at 1.92 percent. That means that even though employers may be paying a larger total in wage and salary, the costs of producing an individual good or service has not risen. As a result, there is no impetus to raise prices on that good or service in order to meet new costs.  

But the situation in the stagnant services is different. Professionals, who are well represented in those services, are as highly trained, and their services are as sought after, as professionals in the more productive services. As a result, their wages or salaries have kept pretty much in line with those in comparable productive sectors. But because they don’t annually produce a larger number of brilliant students or healthy patients, an increase in their income is not neutralized by an increase in productivity. Instead, the costs of production rise in these services, putting upward pressure on prices. Tuitions at public universities or the price of an appendectomy rises.

Viewed as a whole, the society can afford to pay for these stagnant services. High rates of productivity in the private sector lower the prices of many goods, balancing out the rise in prices from the stagnant services. And average wage and salary increases match the overall prices of good and services. But those workers who make less than the average wage are often not in a position to afford health care, private pensions, or university education for their children. And that is particularly true in our society, where the median income of non-supervisory wage workers has not kept up with productivity, and where, as my colleague Tim Noah has written, the rise in income has been disproportionately concentrated at the top.

If the stagnant services were forced to operate entirely within the private market, then quality health care or education would only be available to the upper and upper-middle classes. No one else could afford it. If these industries tried to provide these services at a cost that was affordable to everyone, they would go out of business. In order to provide these services for everyone, they have to be subsidized by government. And because wages and salaries in these services increase faster than productivity, the costs of providing these services are constantly rising. Baumol estimates that by 2015, health care expenditures will take up 60 percent of the country’s GDP.

That means that government subsidies to these industries will constantly grow and that local, state, and federal expenditures are likely to take up a growing percentage of GDP. Over the next decade, in response to Obama’s healthcare program, and, perhaps to programs making college more affordable to everyone, it will probably rise dramatically again during this decade. But even without Obama’s program, it would rise because of the nature of these services, which are at once highly valued by society, but not amenable to dramatic increases in productivity that might lower their costs.

None of this is argument against rooting out waste, fraud and abuse in the delivery of services. Or automating those services in areas where it won’t threaten quality.  Nor is it an argument for creating larger government deficits. It’s quite possible, as the United States demonstrated in the late 1990s, for government to provide these services and balance the federal budget. But to fund these programs, governments will have to extract a share of income from those who are able to afford them and use the revenues to make the services available for everyone.  As it stands now, we have a top-heavy distribution of income that our tax code accommodates and reinforces rather than attempts to correct.

The alternative to paying for the rising costs of these services is not to provide the services, or to provide a drastically inferior version of them for the vulnerable--run-down clinics without x-ray machines or doctors, schools staffed by listless teachers who are barely literate, pensions that plunge the aged into poverty. The Republicans and conservatives who talk about shrinking government don’t say this would be the outcome – instead they crow about computers in inner city schools – but it’s exactly what would happen if they get their way.