How Badly Will Federal Spending Cuts Hurt? Not as Much as You Might Think.

by James A. Bacon

Virginia’s economic growth in recent years has been fueled by a surge in federal government spending, and that surge soon will come to an end, warns William M. Shobe in the May issue of the Virginia Newsletter, “Beyond the Great Recession: Preparing Virginia for Expected Cuts in Federal Spending.” Writes Shobe: “It is now likely that both the military and non-military components of federal spending will not just decelerate but will fall in absolute terms.”

Just what I’ve been saying for a long time as I sounded the alarm about Boomergeddon. Federal direct expenditures now account for 32% of Virginia’s economy, compared to 22% for the country as a whole. Virginia is far more vulnerable to federal cutbacks that most other states.

Shobe, who is director of the Center for Economic and Policy Studies at U.Va.’s Weldon Cooper Center for Public Service, does not speculate how big the inevitable cuts will be. Instead, he focuses on the “new equilibrium” that will be achieved when those cuts take place.

Cuts in federal spending will hurt Virginia’s economy, he says, but not as much as people might think, and not in the ways commonly talked about. The biggest losers will be (a) state/local government, whose tax revenues will fall faster than expenditures, and (b) residential and commercial property owners, the price of whose assets will fall as demand shrinks. Wages, which are based on worker skills and productivity, should not suffer in the long run.

Shobe ran a scenario through an econometric model that assumed a 100,000 reduction of federal workers, equally divided between military and non-military employees — a 30% drop in federal employment and a 2% drop in total employment. His findings:

As theory would suggest, the immediate effect is a fall in employment, GDP, taxes, state and local government spending, and population, among other things. Private non-farm payrolls fall, in this case by about 127,000 workers, so a 30 percent reduction in federal workers causes an immediate drop of 3 percent in private non-farm payrolls. Since some people will choose to migrate out of the state, the optimal size of the housing stock falls and housing prices follow. Because of the suddenness of the drop, state revenues fall by more than state expenditures, which for Virginia would mean either a reduction in services or an increase in revenues (taxes, fees and charges), or some combination of both.

This is what you would expect. What you might not expect is that within ten years, the loss in non-farm payroll falls to under 100,000, and while wages fall some, this reduction is less than the fall in housing costs, so by the end of the decade, those living and working in Virginia have lower unemployment and higher real per capita disposable purchasing power (or income adjusted for cost of living) than they did before, plus they have shorter, less congested commutes. The higher purchasing power grows over time. Finally, taxes and state and local government expenditures adjust to the new lower demand for government services at a lower absolute level but similar in comparison to the size of the state’s economy.

These results are counter-intuitive, to say the least. I never forget the admonition, “garbage in, garbage out.” I have no way of appraising the value of his econometric model or his findings. But Shobe’s perspective is interesting and worth considering.

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