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The Demand for Government



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The following article is written in response to the ASPA President’s Column
published in the the March/April 2010 issue of
PA TIMES and written by then-President Paul Posner. To view Posner’s article, see the hardcopy March/April 2010 issue
of PA TIMES, or watch this website for the posting of that issue to our

Joseph F. Benning

Paul Posner, president of ASPA, posits a commonly accepted
duality in American politics–namely that we want the government off our backs
but still demand the services it provides. Further, we (the body politic)
insist on denying that there is an inherent contradiction between those
positions. New Jersey, where the public finances are in serious disarray, at
first blush seems to be a good example of this. In a recent Rutgers-Eagleton
poll, 57 percent of respondents indicated that they did not want to reduce
education spending and did not want to pay higher fees or taxes.

On the face of it, that would seem to strongly suggest that
Professor Posner’s thesis is correct: the public wants to have its cake and eat
it too. But that is only on the surface. There is, I think, a better
explanation for the apparent contradiction between demand for increased public
spending and the willingness to pay for it. It is this: the group that consumes
the bulk of public services, the middle class, pays only a relatively small
portion of the cost. That is an inconvenient truth that virtually no politician
will dare to utter, because the middle class is where the votes are.

To analyze this we need to ask what government does and who
pays the bill. A look at national level budget numbers shows that entitlements
and other human resource spending have been driving the growth of government.
According to the Office of Management and Budget, federal outlays for FY 2009
totaled about $3.5 trillion. Of that, about $2.1 trillion, or 61 percent, came
from human resource spending–Medicare, Medicaid, Social Security, Education,
Training and Veteran’s programs. It is important to note that for the most
part, government does not actually produce the service. It pays for the
service, meaning that these are income transfer programs. OMB estimates that by
2015 these programs will consume 64 percent of the federal budget. And they are
headed higher.

Now let’s take a look at the revenue side and ask: who is
paying for all this? It is a complicated question because there lots of
different types of taxes, direct and indirect, charged by different
jurisdictions. But on the whole, analyses by the Tax Foundation consistently
demonstrate that the bulk of the tax burden falls on the upper quintile of the
income distribution. For example, the top quintile (incomes over $99,502) paid
about $82,000 in total federal, state and local taxes in 2004, the year for
which the data were available when the study was done. By contrast the middle quintile
paid only about $21,000. These data strongly suggest that government is simply
redistributing cash from the upper quintile to lower quintiles of the income

In that vein, the Tax Foundation conducted a study in which
they sought to estimate how the benefits of government services were
distributed across various segments of the income distribution. They found that
the top quintile received benefits worth $0.41 for every dollar paid in taxes;
the second quintile received $0.77; the third got $1.30; the fourth took in
$2.51 and the bottom quintile received $8.21. In other words, the top 40
percent were net payers into the system while everyone else extracted net
benefits. Note that since much of the activity is income transfer, consumption
is rival. That implies that individual demand curves cannot be summed to infer
greater implicit demand for income-transfer. It is at best a zero-sum game.

To understand the political salience of these transfers it
is important to distinguish between income quintiles and the number of people
who populate those quintiles. Using data from the Statistical Abstract, the
middle class can be broadly described as the roughly 49 percent of the
population with household incomes that range between $30,000 and $99,999 as of
2007. Only about 4 percent of the population has household income in excess of
$150,000, and only 2 percent has household income in excess of $250,000. But it
is precisely those upper income groups that pay most of the freight. The top 5
percent of the population pays about 60 percent of all income taxes, with the
upper 2 percent paying around 40 percent.

Seen in that light, there is no contradiction at all between
increasing demands for government services and a desire for government
restraint. As Harold Laski famously put it, the question is: who pays and who
gets. Groups that benefit on balance from income redistribution can be expected
to call for more of the same; groups that bear the cost can be expected to
resist. That logic was not lost on candidate Obama who explicitly, if
disingenuously, promised to raise taxes only on either those individuals whose
incomes exceeded $200,000 or families whose incomes exceeded $250,000. After
all, he said it was important to “spread the wealth around”.

Redistribution of gains and losses based on political calculus
rather than competitive markets is a central feature of the modern welfare
state. It taxes success and subsidizes failure; it encourages the type of rent
seeking behavior that now permeates modern politics; it is a drag on
innovation, and it distorts market forces, thereby reducing economic
efficiency. The majority is harmed for the benefit of the few. The quadrennial
spectacle of Presidential candidates pandering to Iowa corn farmers by pledging
to increase ethanol subsidies says it all. Somehow forgotten are the poor
around the world for whom corn is a staple, and who now pay higher corn prices
to subsidize Iowa farmers.

Both theory and empirical evidence strongly suggest that the
growth of government has been driven not by general consumer demand, but by the
political incentives embedded in the structure of the welfare state. Social
security is sacrosanct because elderly citizens vote, and because it provides
politicians with off-budget financing. Agriculture policy is driven by
coalitions of farm state legislators who demand price supports and urban
legislators who agree to support high agricultural prices in return for more
money for food stamps.

Not all of us think that this is a good idea. I, for one,
think that we would be far better off with a less expansive view of government;
that government should stick to the basics of enforcing contracts, providing
for the public safety, intervening in private markets only reluctantly, and as
a last resort. To be sure, this is a minority opinion, and in academia, a
relatively small minority at that.

What is truly unfortunate is that enthusiasm for government
intervention seems to have become epidemic in public administration schools and
departments. To some degree this is not surprising because the profession needs
expansion of government to employ the graduates of public administration
programs. But the predisposition in favor of governments over markets appears
to have been accompanied by scores of graduates who are poorly trained, if at
all, in markets and how they work–even though they will be the regulators and
public administrators of tomorrow.

Across the country, the management, if you want to call it
that, of local public finances is amateurish, riddled with conflicts of
interest, and opaque–enabling special interest groups to extract economic rents
from government while leaving citizens in the dark. State and municipal
governments have disguised their true financial picture by using derivatives to
plug current budget holes, selling future revenue streams in return for cash
today. The City of Chicago, for example, recently sold the right to future
revenues from its parking meters to a group of investors. That’s operating
income that won’t be there in the future because it is already pledged.

Similarly, many States have already spent the cash proceeds
of bonds backed by future tobacco revenues. Recently, the Pew Center on the
States published a study that estimates that state public pension obligations
are underfunded to the tune of $1 trillion in present value terms. Pay-to-play
is still alive and well in the municipal bond market. Interest rate swaps that
state and municipal governments have on their books in huge size are not
marked-to-market, are subject to cash margin calls, and may contain significant
counterparty risk. And the chance that local treasurers, much less citizens,
understand the nuances of these instruments is, to put it mildly, low. So much
for the median voter theory.

These devices have sustained an orgy of government spending
that is driven by interest-group politics and income-redistribution schemes
whose goal is the transfer of wealth to voting coalitions rather than the
production of public goods. The current recession is not the cause; it is a
sideshow. The Social Security System was insolvent a long time before the
recession began. The cause of the deterioration in public finances is the moral
hazard that is an inherent feature of welfare state politics: giving one group
of people the right to spend another’s money. The predictable result is
out-of-control spending.

There is no conceivable way that either the federal
government, or state and local governments can meet their obligations given the
structural imbalance between revenue sources and uses. The debt overhang, in
the form of publicly traded bonds, unfunded pension liabilities and entitlement
spending, is too great. It is by now a near certainty that governments are
going to effectively default by scaling back already promised pension benefits
and entitlement spending. Some municipalities and other public sector issuers
will default on their outstanding bonds. Local public finance in the United
States is starting to look a bit like Greece’s.

For decades governments have borrowed recklessly, on the
books and off, to finance entitlement and other special interest spending
because that’s where the votes are. Now the bill is coming due. The likely
result will be significant tax increases across the board including a VAT tax,
years of suboptimal GDP growth, and effective defaults on entitlements.

This decidedly grim picture ought to prompt Schools of
Public Administration to think long and hard about the incentives built into
public finances. Good intentions are not enough. The profession should demand
transparency, accountability and competency in the management of the public
finances. Truthfulness by politicians wouldn’t hurt either, but that is
probably asking too much.

Joseph F.
Benning is chief economist for MesoMetrics Consulting. Email:
[email protected]




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