Don’t Plan for Failure

by John Hood

Any plan for rejuvenating North Carolina’s economy by drawing down and spending more federal money is a plan for failure.

At most, it would generate a ripple of economic activity in the short run while damaging the state’s economy in the long run. And assuming that most consumers and investors aren’t irrational, it won’t even generate much a ripple in the short run because they know the arrangement isn’t sustainable and will adjust their decisions accordingly.

The facts of the matter are as follows. During the first few decades of the 20th century, the federal government raised and spent relatively little as a share of U.S. gross domestic product. The Great Depression and World War II changed the situation dramatically. After the war, while federal spending didn’t drop all the way back down to pre-war levels, presidents and Congresses at least avoided large-scale deficit spending. During the 1950s, 1960s, and early 1970s, Washington run several annual surpluses and typically kept annual deficits to about 1 percent of GDP, and rarely above 2 percent.

During the Ford and Carter administrations, both the legislative and executive branches began to stray from this relative discipline. Spending on entitlements, public assistance, and state and local grants began to surge, for example, without commensurate reductions in other federal spending or increases in revenue. The process accelerated again during the Reagan years, when federal spending began routinely to exceed 22 percent of GDP – what was then a peacetime record in American history. Federal revenues as a share of GDP averaged just above 18 percent of GDP, which happened to be the average during Nixon, Ford, and Carter years. Obviously, that revenue was insufficient to cover the higher rates of spending. Annual deficits averaged more than 4 percent of GDP.

Federal spending, revenue, and deficits all declined modestly during the presidency of George H.W. Bush. Then, during the Clinton years, the federal fiscal picture brightened a bit more. The causes included the end of the Cold War, rising revenues (particularly during the dot-com boom of the late 1990s), and bipartisan spending restraint in Washington. Federal spending dropped from 22.1 percent of GDP in 1992 to 18.2 percent in 2000. Federal revenues rose from 17.5 percent of GDP in 1992 to 20.6 percent in 2000 – which remains a peacetime record in American history.

It was not to last. The dot-com boom turned into a dot-bomb bust, reducing federal revenues as a share of GDP. Congress and the new George W. Bush administration pushed also enacted federal tax cuts and increased defense and security spending in the aftermath of 9/11. They also expanded Medicare and federal funding for education. During the Bush years, federal revenues averaged 17.6 percent of GDP. Federal spending averaged 19.6 percent. The resulting annual deficits weren’t ruinous. But they certainly didn’t help matters.

The onset of the Great Recession – and the response to it by new President Barack Obama and friendly majorities in Congress – inherited this legacy of deficit spending and doubled down on it. Actually, that’s an understatement. During the first Obama term, average federal spending reached a new peacetime record of 24.4 percent of GDP. Crashing financial markets, shrinking incomes, and tax cuts intended as economic stimulus pushed federal revenues to an average of 15.4 percent, very low by modern standards. The resulting average deficits of 9 percent of GDP were more than twice as large as those in the Reagan years and about four times as large as those in the Bush years.

Even as the national economy improves, federal deficits will remain high unless Congress and the president get their act together. The “fiscal cliff” tax hikes and current budget sequester will have only a modest effect over time, particularly as spending on health care and Social Security continues to soar.

What should we do to get Washington’s fiscal house in order? Here’s a short list:

• Reform the federal tax code to promote economic growth. Over time, this should help push federal revenues back into the range of 18 percent to 19 percent of GDP.

• Cut spending in virtually all areas of the federal budget, including corporate welfare and defense.

• Reform entitlements to reduce their projected rate of growth over time.

• Reform all programs that give state and local governments a perverse incentive to maximize federal funding (i.e., Medicaid). Either devolve these programs from Washington entirely or convert their funding to fixed block grants.

Sound austere? Well, as it happens, austerity and caution in the public sector will be necessary to produce growth and abundance in the private sector. If someone tells you a different story, don’t argue. Just giggle.

John Hood is president of the John Locke Foundation and an NC Spin Panelist