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No Free Lunches: The Hard Arithmetic of Economics

By ·September 28, 2018
Wellesley College

The Issue:

Key policy initiatives often are presented to the public as providing benefits with no real costs. While sugarcoating may be a useful political strategy, such narratives mask the difficult tradeoffs implicit in many economic policy decisions and the invariable presence of budget constraints. Such promises defy the hard arithmetic of economics.

The Facts:

  • Two recent examples of narratives that importantly downplay the role of budget constraints have been particularly prominent. The first is the promise that the $1.5 trillion tax cut passed at the end of last year will “pay for itself” and not boost the federal budget deficit. Second, the promise that implementation of “Medicare for All” (M4A) would lower overall health care costs, while providing near universal coverage. Although proposals for the tax cut and M4A come from different ends of the political spectrum, they share the common element of promising a “free lunch” – lower taxes without raising the deficit or expanded health care coverage without any additional costs.
  • It is possible to cut tax rates without increasing the federal deficit — but this typically happens by expanding the base (that is, scope of personal and business income that is taxed). The government provides goods and services like national defense, infrastructure such as roads and bridges, and a social safety net. It must raise revenues to pay for these expenditures. If adequate tax revenues are not forthcoming, then the government borrows to cover the shortfall and its debt rises – but this just means that taxes are deferred to the future. A tax reform that does not expand the deficit, which economists call "revenue neutral", typically works by closing loopholes and by reducing rates but simultaneously expanding the tax base. Roughly speaking, tax revenues equal the tax rate times the tax base. Thus, a tax cut today that does not change the base of taxable income will require a tax increase in the future if the economy does not grow sufficiently to provide a bigger tax base.
  • To the extent that a tax cut stimulates economic activity, then actual federal revenue would fall by less than calculated strictly on the basis of the cuts. In December of 2017, Congress approved and the President signed a large cut in corporate and personal taxes. Many economists would agree that reducing tax rates is a worthy goal if done in the context of a broad tax reform that does not boost the deficit. What about the Trump Tax Cut? The direct reduction in federal revenue over the next 10 years is about $1.5 trillion. However, the Trump administration made the case that extra growth would be so great that it would generate an additional $1.8 trillion of revenue over the next 10 years, more than enough to offset the direct cost of the tax cuts.
  • The question is whether additional economic growth, by itself, is sufficient to make up for the revenue loss induced by the cuts. The most likely answer is no. While tax cuts can temporarily juice the economy, the ability of the economy to sustain faster growth over a longer period is limited by the numbers of workers available and the rate of productivity growth. The Congressional Budget Office (CBO) estimated that the tax cut would boost budget deficits by $1.9 trillion from 2018-2028 even after accounting for faster growth stimulated by the tax changes (see here, page 106). And, the conservative Tax Foundation estimated significant revenue losses even with faster growth. More recently, the CBO highlighted that the federal budget deficit has surged in the months since the tax cut and a deal to boost federal spending were enacted, with the deficit jumping 33 percent (to $895 billion) during the first 11 months of the fiscal year compared with a year earlier.
  • Previous tax cuts predicated on the basis that economic growth would be sufficient to cover the losses in federal revenue did not bear out. A similar pattern was exhibited by the large tax cuts passed in 1981: pre-enactment promises that the cut would pay for itself followed by a post-enactment surge in the federal budget deficit (see here). One legacy of the 1981 episode: large budget deficits became a regular feature of the economic landscape from the early 1980s through the mid-1990s.
  • Another case in which the political narrative sidesteps the issue of budget constraints is universal health care. This year, many Democrats have advocated for "Medicare for All" as a way to achieve the objective of nearly universal health care coverage (which would bring the U.S. health care system more in line with those in other developed countries). Advocates have suggested that this goal could be achieved while actually lowering overall health care costs. To the extent that households were willing to pay higher taxes that matched their drop in premiums, federal budget deficits would be little affected by adopting M4A according to this argument. To buttress this position, supporters of M4A point to an evaluation of Senator Bernie Sanders’ M4A proposal done by the free-market oriented Mercatus Center at George Mason University. This study highlighted the large increase in federal government expenditures that would be associated with M4A, with estimates that are similar to those from other analysts such as the left-of-center Urban Institute. Supporters of M4A point to estimates in the George Mason study indicating that — while M4A would boost federal expenditures on health care — it would reduce overall health care expenditures, even while expanding access and increasing utilization.
  • What would it take in order to be able to provide nearly universal health care coverage while lowering costs? The estimates implying lower overall expenditures on health care are based on several assumptions including (as specified in Sanders’ plan) that payments to health care providers would be reduced by more than 40 percent relative to those currently paid by private insurers. But, a 40 percent reduction in payments could be difficult to achieve, especially given that demand for health care would increase with M4A. If the large reductions in payments to providers did not come to pass, overall health care costs actually would rise as coverage expanded. Unless taxes went up by even more than premiums went down, the federal government would pick up the tab and federal budget deficits and future debt would be even higher.
  • There are no historical precedents for a health care reform of this type in the United States that could provide lessons from past experience. Researchers have looked to the experience of other countries instead. Canada — which has a single-payer, mostly publicly funded system — provides universal access to health care but has lower per capita medical expenditures than the United States. However, there are broader differences between the systems. While there are lower administrative costs associated with factors such as billing and documentation in Canada, costs are lower also because Canadian doctors have lower incomes on average and patients in Canada tend to have fewer interventions and fewer complicated procedures. In some cases, these differences could reflect waste in the U.S. system that could plausibly be eliminated by reforms. In other cases, these differences may reflect differences in the quality and style of care. For instance, the more frequent use of cancer tests and screenings in the United States is associated with more successful detection and early treatment of some forms of cancer (see here).  In addition, higher administrative costs in the United States could partly reflect concerns about billing fraud as well as a desire to monitor the appropriate use and quality of care (see here). All in all, it seems that the jury is still out on how easy it would be for reforms to significantly reduce per capita health care expenditures in the United States.

What this Means:

While solid cases can be made for tax reform and for expanding health care coverage, the arguments that such policy changes would pay for themselves rely on implausible assumptions. While these “free lunch” arguments may appeal to supporters, the policy process would be far better served if more likely tradeoffs and costs were acknowledged. Not doing so could lead to poor choices now, with a reckoning later in the form of higher federal budget deficits and debt and their attendant risks. In particular, higher federal debt levels would boost interest payments on the debt — which already are on track to be more than 7½ percent of total federal spending this year — and further squeeze other government programs. In addition, the resulting higher debt could limit the government’s ability to respond aggressively to a national emergency such as a natural disaster or security crisis. And, the associated government borrowing will, in time, put the squeeze on private borrowing that could be financing economy-growing capital. Again, the goals of tax reform and expanded health care coverage have much to recommend them. But, it is important to be realistic about the costs. Moreover, promises made but not kept also are likely to further fuel distrust in our political institutions and partisan polarization. Put another way, diners assured a free lunch are likely to get angry when asked to pay the full bill and well may argue vociferously about who should pay it.

Topics:

Economic Policy / Federal Budget Deficit / Government Debt
Written by The EconoFact Network. To contact with any questions or comments, please email [email protected].
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