Bacon's Rebellion

Corporate income tax as a percentage of gross revenues reported to the IRS (2008):

United States: 12.9%
Virginia: 17.3%

Source: Internal Revenue Service Data Book (2008), Table 5.

Question: What does this tell us? How do we explain the fact that corporations account for a disproportionately large share of the federal income tax take in Virginia than in the United States as a whole? The same federal tax code applies across the country. Do Virginia certain industries disproportionately benefit from special tax breaks analogous to the oil depletion allowance? Alternatively, do Virginia businesses pay higher taxes because they are more profitable? Or, another theory: Do Virginia businesses pay higher taxes simply because we have more large tax-paying corporations domiciled in the state?

I’d like to see you braniacs out there weigh in on the issue. Perhaps you can bring some relevant data or analysis to bear.

For all the wailing one hears, especially in Virginia, about Barack Obama being some kind of radical with a socialist agenda, let’s take a reality check.

The Virginia Institute for Public Policy has published a must-read analysis of the impact of proposed health care reform on Virginia. Far from bringing the cost of health care under control, as its advocates assert it will, “reform” based on President Barack Obama’s principles will drive medical price inflation 5.2% above what it otherwise would be by 2019. Higher medical costs will run up both federal and state spending, costing every man, woman and child in Virginia $4,176 in net present value.

Virginia Tech has a great football program this year, but the team that gets me stoked is the squad of architectural-engineering students competing in both the U.S. and European Energy Solar Decathlons, the only U.S. team to do so. The challenge: to build the most attractive energy-efficient house. The solution: The Lumenhaus.

I don’t know whether or not there’s a mass market for the 800-square-foot house, even one as cool as this — Americans love their square footage like they love their cars — but many of the concepts described in the video are bound to enter the marketplace. I’m especially intrigued by the notion of “responsive architecture,” made possible by new information technologies.

Go Hokies!

The contrast between Virginia’s two gubernatorial candidates could not be more stark: Elephant clan candidate Bob McDonnell has thought long and hard about Virginia’s transportation issues and provides a detailed blueprint for how he would raise more money and spend it. Donkey clan candidate Creigh Deeds has very little to say about transportation at all. He conspicuously ignores the topic on the issues page of his website. And he has said little in his public pronouncements other than concede that, to quote the Washington Post, he would be willing to “sign a transportation plan that identifies new revenue to fix roads.”

Bottom line: McDonnell tells us with great specificity how he would squander billions of dollars in new revenue on transportation projects while Deeds asks us to take it on faith that he would squander the billions.

It appears that Deeds has little useful to say on the subject of transportation. Therefore we are left with the impression that either (a) he would pursue Business As Usual, or (b) he entertains ideas so radical that he doesn’t dare express them publicly for fear of not getting elected. In the absence of evidence otherwise, I will assume that the first explanation applies. Frankly, there is little more that we can say about Deeds’ approach to transportation.

McDonnell is much more complicated. His transportation platform does have a few good ideas. But a McDonnell transportation administration would focus on finding new money to inject into the system, not changing the way the money is spent. The phrase “land use” appears only once in his entire transportation treatise, and not in a context suggesting that he would build on the incremental reforms of the Kaine administration.

First, let’s talk about the good things in the McDonnell plan.

Prioritize traffic congestion and economic development. First, McDonnell would adopt the principle of prioritizing transportation projects based on their ability to reduce traffic congestion or promote economic development, in contrast presumably to projects flogged by lobbyists and politicians to open up new land for exploitation. “Just like any capital intensive business, we should invest in projects that make economic sense and are driven by demand, not projects that simply make it more likely for a politician to get re-elected.” (While this principle is fine in theory, I question whether it will be honored in practice, as I explain below.)

More technology, less asphalt. Second, McDonnell acknowledges that there are ways to mitigate congestion that don’t entail laying asphalt. He specifically mentions investing in traffic signaling technology. “It makes little sense … to skimp on technology investments because they may not offer the same kind of ribbon cutting opportunities that a new road does.”

Integrate growth, transportation planning. “Localities and regional entities should be encouraged to consider the relationship between land use policies and transportation policy when developing and assessing the impact of transportation plans.” Yes, McDonnell is right, regions should be encouraged to consider land use. Unfortunately, he has nothing useful to contribute on how they should be encouraged. The utter lack of detail suggests that a McDonnell administration would give no more than lip service to land use reform.

Now, let’s talk about the bad things in the plan. McDonnell, or the authors of his policy platform, have applied the vast majority of their creative energies into identifying new mechanisms for funding transportation that can’t be tagged as a “tax hike.” McDonnell’s proposals, if adopted, would create a flood of new revenue for Virginia transportation, which he would plow into a wave of new mega-project construction like Rail-to-Dulles, Interstate 81, the Coalfield Expressway, Interstate 66, the Hampton Roads 3rd crossing, high-speed rail and a host of others.

Apparently, McDonnell deems all of these projects to be high priorities. There doesn’t seem to be a regional mega-project that he doesn’t like. Based on his rhetoric, we can only surmise that he has already concluded without benefit of comparative cost-benefit studies that all of these projects make “economic sense.” So much for his core principle that transportation projects should be driven by “demand” — unless by “demand” he means the clamouring of lobbyists and special interests.

Here is a partial list of how McDonnell proposes to raise new revenues for transportation:

• Expedite the issuance of $3 billion in bonds authorized by the General Assembly in 2007.
• Issue another $1 billion in bonds for projects in congested areas.
• In years when General Fund revenue growth exceeds 5%, dedicate the surplus to transportation.
• Dedicate 75% of annual budget surpluses to transportation.
• Privatize the Department of Alcohol Beverage Control and funnel the estimated $500 million into transportation projects.
• Open up offshore oil and gas drilling and steer 80% of the royalties to transportation.
• Dedicate 30% of state revenue attributed to the growth of the ports of Hampton Roads to transportation.
• Slap tolls on Interstates 95 and 85 at the North Carolina border.

Ay yi yi! What do these measures have in common? They all support the illusion that transportation is an amenity that somebody else pays for. They have nothing to do with market-based principles whatsoever. At least with the good ol’ gasoline tax, the more you drive and the more gasoline you consume, the more tax you pay. It’s not perfect but at least there is a rational nexus between the tax and the benefit you derive from it. The same holds with tolls. McDonnell does endorse HOT lanes, but there is precious little else in his plan that squares with the user-pays principle.

While McDonnell says he would like to keep politicians out of the transportation decision-making mix, his financing schemes would only elevate their power. Who else would decide how to allocate bond monies, surplus General Fund revenues and the rest of the loose cash generated by McDonnell’s schemes?

In a nutshell, McDonnell would indiscriminately raise new transportation revenues from a variety of sources, sever the connection between those who use a transportation asset and those who pay for it, increase state indebtedness, make the system even more political than it is now, and plow billions into mega-projects favored by regional elites.

The nation is careening toward fiscal insolvency, and rather than tightening criteria for taxing and spending, McDonnell would open the money sluices for transportation. The globe is transitioning to an energy-scarce era of peak oil, and McDonnell would dump billions into projects conceived during an era of energy abundance. This isn’t mere Business As Usual, as bad as that would be — this is Business As Usual on steroids.

Update. Deeds has released his transportation plan, which he has packaged as part of a larger plan to jumpstart Virginia’s economy. Deeds supports the usual list of bridge-and-highway mega-projects, plus unspecified light rail and mass transit projects, without regard to social Return on Investment. Unlike McDonnell, he doesn’t say how he will pay for his “billion dollar transportation proposal.” I guess the money will materialize by magic. On the positive side, Deeds says he will promote telecommuting, flextime and ride sharing, and he would “connect transportation planning with smart land use decisions” by prioritizing growth in corridors already served by transportation infrastructure.

Virginia’s two gubernatorial candidates, Creigh Deeds and Bob McDonnell, vow to get more bang for the taxpayers’ buck. Deeds touts his plan to promote “government efficiency and budget reform” while the McDonnell platform promises to root out “waste, fraud and abuse.”

Dig into the specifics and you’ll see some decent ideas. Both Deeds and McDonnell would institute regular performance audits of Virginia state agencies. (Deeds’ audits would cut across government functions, a nice touch.) Deeds also backs zero-based budgeting, energy efficiency in government buildings, steering more education dollars into the classroom and reforming VITA. McDonnell serves up an interesting idea on setting up a pay-for-performance pilot program for state managers.

There’s nothing to dislike here, and I hope the new governor, whomever he is, carries through. But we’ve been down this road before. Does anybody remember the “Warner commission”? Does anyone recall that Virginia, for all the flaws so manifest to us who live here, has been consistently rated either No. 1 or No. 2 as the best managed state in the country for years? By the (admittedly low) standards of state governments around the country, Virginia does not have a lot of waste, fraud and abuse. By the time Gov. Tim Kaine and the General Assembly finish whacking an estimated $1.3 billion out of next year’s budget, they’ll be scrounging nickels out of soft drink change dispensers.

It’s always a good idea to keep a close eye on payroll and process improvements, but let’s not deceived. We won’t find big money in cutting government administration. We need to dig a lot deeper. Here are the real drivers of the state budget (FY 2009 numbers):

Medicaid – $ 2,7 billion (General Fund only)
Corrections – $1.0 billion (General Fund)
Transportation – $4.6 billion (non-General Fund)
K-12 schools – $5.6 billion (General Fund, direct aid to localities)

We can’t bring these numbers under control by tinkering on the margins of expenses. We have to think through the programs from the ground up. In future posts, we’ll see how Deeds and McDonnell are doing in that regard.

Looks like the United States will have plenty of competitors in the race to fiscal insolvency. According to the European Commission’s May forecasts, public debt in the eurozone will soar to 77.7 per cent of GDP this year and 83.8 per cent in 2010, reports the Financial Times.

Against the backdrop of the federal march to insolvency, it is fearful to see that many states are following the same path. As Indiana Governor Mitch Daniels wrote in the Wall Street Journal yesterday, “State government finances are a wreck.”

I’ve always envisioned the fiscal end game of the federal government as similar to the fate of, say, Circuit City, where creditors simply stopped lending to it because they no longer believed they would get repaid. The federal government cannot “go out of business,” however, so national leaders would have to soldier on, slashing spending to match the level of incoming revenue, regardless of the social or economic cost.

But the federal government does have options that Circuit City never had. Among those options: inflating the currency and/or repudiating the national debt. Economists are beginning to seriously explore these end-game scenarios.

One example is “Why Default on U.S. Treasuries Is Likely,” by Jeffrey Rogers Hummel, an economics professor at San Jose State University, writing in the Library of Economics and Liberty. Writes Hummel: “I believe … that the United States will be driven to an outright default on Treasury securities, openly reneging on the interest due on its formal debt and probably repudiating part of the principal.”

Hummel doubts that the government can inflate its way out of its dilemma: “Today’s investors are far savvier and less likely to get caught off guard by anything less than hyperinflation.” Unfortunately, he doesn’t fully explain the point. My argument is that financial capital is so hyper-mobile that investors will respond to any strong whiff of inflation by shifting capital to other nations that offer better risk-reward ratios. Any benefit of inflation to the federal government would be short lived. I suspect that Hummel would agree.

Regardless, as the U.S. approaches the financial end game some 15, 20 or 25 years from now, our central bankers undoubtedly will try the inflation strategy out of pure desperation. Thus, we can predict that the final meltdown will be accompanied by inflation, capital flight, a plunging dollar and skyrocketing interest rates as investors demand compensation for higher risk. However, we can be equally certain that an inflation gambit will buy only a few months or years of respite.

One other solution would be to raise federal taxes from the 20%-of-income level that has prevailed since World War II to something approaching European levels. Hummel is skeptical that will happen. Public resistance to higher taxes is so intense that politicians will follow the path of least resistance — borrowing — until investors foreclose that option. I tend to agree.

Of course, debt repudiation is a stop-gap solution, too. Repudiating principle or interest payments on our national debt might bring down the cost of carrying that debt, but it also means that no one will lend anymore money. In sum, no matter what flailing acts of desperation the federal government is driven to, the end result eventually will be the same: A drastic curtailment of the size of the federal government with all the disruption and pain that implies.

In my last blog post, “From the U.S. to Argentina in 20 Years,” I noted that interest on the national debt will amount to $829 billion a year by 2019, if we are to believe the Office of Management and Budget’s most recent 10-year budget forecast. That projection assumes, however, that 10-year Treasury bond yields increase to no more than 5.2% and stay stable for most of the decade. How realistic is that assumption, and what happens if the forecast is wrong?

To provide some perspective, let’s look at the history of Treasury bond yields. Using Federal Reserve Board data, I’ve charted the past 30 years.

As you can see, the current 10-year Treasury bond yield of 3.4% is about the lowest it has been for an entire generation. The Obama administration does allow for a slight uptick in long-term rates to a level consistent with the experience of the past decade. The question then is this: Is the last decade’s experience of low interest rates likely to persist in the future?

If we experience more of the same, Obama’s interest rate forecast is reasonable. If interest rates climb to levels seen in previous decades, the forecast is too optimistic, deficits will be worse, and the glide to insolvency will be steeper.

As far as interest rates go, I believe that we are living in the best of times. To quote Federal Reserve Board Chairman Ben Bernanke, when addressing the German Bundesbanke in 2007, the world is experiencing “a global savings glut.” He attributes that glut largely to a savings surge in large developing countries like India and China. (I have seen estimates from other sources that the Chinese save 40% of their income. As their economy has grown and incomes have soared, so have their savings.)

Far be it from me to tell Mr. Bernanke his business, but I would humbly hypothesize that this glut will dissipate in the mid-term future. Most of the advanced industrial economies in Europe, North America and the Asian Rim, as well as China, are growing old. Households save (or governments save for them) in order to provide for their retirement. When the working-age population is a large percentage of the whole, the savings rate is high. When large segments of the population reach retirement age and people begin drawing down their savings to support themselves, the savings rate declines.

Nowhere is this trend clearer than in Japan, long known for the frugality of its population. The Organisation for Economic Cooperation and Development (OECD) tracks the savings rate of member nations here (see “Saving, Household Saving Rate”). The data show that Japan, which attained a formidable household savings rate of 15.0% in 1990, has experienced a steady decline as its population has aged. (Japan has the oldest average population of any country in the world.) This year, Japan’s saving rate is a mere 3.5% — almost as pitiful as the U.S.’s rate. The savings decline has been equally marked in Korea, which also is aging rapidly.

The major European economies are maintaining high savings rates right now (with Finland a bizarre exception — it seems to be dis-saving). But, if my conjecture is right, as their working-age populations begin retiring in large numbers, their savings rates will decline. Most importantly, the same is true of China, which, with its one-child policy, may be aging the most rapidly of any society on the planet.

These trends will take 10 or more years to become manifest, but they are more or less inevitable. So, in the year 2019, just as U.S. budget deficits are growing by $1 trillion a year or so, the world will be transitioning from Bernanke’s global savings glut to Bacon’s global savings gap.

The Obama administration understands the implications of the domestic Age Wave for the purpose of forecasting U.S. spending on entitlements, but it has ignored the implication of the global Age Wave on savings and capital formation. I’m not singling out Obama here — almost everyone has overlooked it. But Obama is the one making the 10-year forecast. For the past 20-30 years, every major industrial and developing economy in the world has been injecting savings into the global pool of capital. Within 10 years, every major economy will start drawing down that savings to support an aging population. And that draw-down will accelerate with each passing year.

Bacon’s bottom line: It takes a collosal act of faith to believe that the interest rate picture 10 years out will resemble the interest rate environment of the past decade. It takes an ostrich mentality to believe Obama’s OMB forecast that 10-year Treasuries will remain stable at 5.2% for the next decade. If my analysis is correct, the U.S. interest rate burden will exceed the $829 billion a year in the official forecast by a wide margin. If yields return to the 8.0% level seen as recently as 1991, interest payments could well consume $1.3 trillion a year. At that stage, the debt burden will grow uncontrollably, taking on a life of its own.

The U.S. cannot long continue down that path before foreign lenders stop lending to us and the final fiscal crisis consumes us. How will Virginia be positioned to weather that final crisis? Will we follow the example of California in its slide into the abyss, or will we remain a rock of fiscal rectitude? Do either of our candidates for governor even recognize the magnitude of the challenge?

Sometimes commentators scold our political leaders for running up deficits that will have to be repaid by our children and grandchildren. I suspect that many politicians would gladly foist our nation’s obligations onto the next generation if they thought they could get away with it. But they can’t. Our nation’s profligacy will come back to haunt us while most of us are still alive. The day of reckoning — the day the U.S. federal government can no longer fund its programs through taxes and borrowing and is forced into making cataclysmic cuts — is at most 20 years away.

I am not making a prediction based on partisan prejudice. There is plenty of blame to go around. With Vice President Dick “Deficits Don’t Matter” Cheney providing cover, the Bush administration ran up the national debt from $5.7 trillion to $10.6 trillion during an eight-year recess from fiscal responsibility. Having castigated President Bush for saddling future generations with a massive debt, Barack Obama is now on pace to double the rate of debt accumulation. After less than eight months in power, Obama has increased the national debt to $11.8 billion. And his Office of Management and Budget has just issued a revised forecast stating that the federal government will add another $9 trillion to the national debt over the next 10 years.

Of course, that $9 trillion number assumes no significant changes in taxes and spending (Quick, someone call Nancy Pelosi!), and it assumes an up-beat economic scenario: a strong economic rebound, no recession over the next 10 years, low inflation and stable interest rates. (To review those assumptions, click here and go to the “economic assumptions” tab.) I think we can safely describe that $9 trillion number as a “best case scenario.” A worst-case scenario would be too hideous to contemplate.

A look at the graph above from the Office of Management and Budget (OMB) shows how deficits continue ballooning in the out years. By then, Baby Boomers will be retiring en masse. To pay for Boomers’ pensions, the Social Security Administration will have started drawing down the big pile of Treasury bills it accumulated when it was running a surplus. To pay for Boomers’ health care, Congress will have to do something not contemplated in the Obama forecast. According to Medicare’s trustees, the program is scheduled to run out of money by 2018. As long as the federal government is still solvent, however, Congress will find some way, by hook or crook, to keep the program afloat.

Projecting beyond 2019, the deficit numbers get even uglier as more Boomers retire and entitlement spending ramps up rapidly. A $1 trillion budget deficit will be a good year.

Of course, the Obama forecast depends upon a number of rosy assumptions. Let’s look at just one: interest rates. The Obama administration assumes that 10-year Treasury notes will creep up from 3.6% this year to no higher than 5.2% at the peak of the next economic cycle. In other words, even with the Treasury Department borrowing ever more massive sums and with the economy growing at annual rates of between 4.5% and 6.1%, with all that implies for private-sector borrowing, 10-year T-bills will remain stable at 5.2% for eight straight years. Do you believe that? I don’t.

Moreover, I will make the case in a future post that the U.S. is the beneficiary of a global capital surplus, which keeps interest rates low, but that the world economy will shift over the next 10 years to a global capital shortage, which will push interest rates higher. You can agree or disagree with me on that point, but there is one thing beyond dispute: Changes in interest rates will become a prime driver of government expenditures.

According to the Obama administration’s forecasts, interest payments on debt in 2009 will be $173 billion. By 2019, the administration says, interest payments will soar to $829 billion. Remember, that’s assuming 5.2% interest rates. But what happens if interest rates return to the level prevailing in 1990 when the 10-year note yielded 8.08%? Under those circumstances, interest rates would be roughly 60% higher and the interest on national debt would grow by an $500 billion a year over and above the forecast.

Using the Obama administration’s own numbers, we can reasonably conclude that the federal government will reach a state of chronic budget crisis within 10 years. Beyond the OMB’s 10-year time horizon, growing entitlements, the ballooning debt burden, the impending global capital shortage and an inevitable recession will push the federal government toward insolvency. At some point, the U.S. will reach the ultimate crisis in which foreign investors are no longer willing to purchase our sovereign debt at any price. When the federal government can no longer fund its spending, the fiscal crisis will precipitate the greatest political and economic upheaval since the Great Depression. We will have become Argentina.

Have a nice day!

(Chart credit: Wall Street Journal.)