Monty Pelerin's World

Leviathan Being Destroyed

Government is 79% of the Economy

Welcome to the world of dysfunctional, bloated and insolvent government.

CNBC recently reported on delayed income tax refunds: “…  cash-strapped states such as North Carolina, Alabama and Hawaii have been forced to slow down issuing income tax refunds to individuals and businesses because of a lack of funds in their budget.” These states are but a few that have slowed down refunds. How comfortable might you be awaiting a refund from Michigan, New York, New Jersey, California, Illinois, etc.? What do you suppose their condition will be when the federal stimulus teat runs dry?

The state tax problem is merely the first manifestation of governments unable to pay their bills. Municipalities are sitting on retirement time bombs that they will be unable to service. The Federal government is hopelessly in debt (see Spiraling to Bankruptcy) and pays its bills only because Ben Bernanke chooses to run his printing press. Governments at all levels are insolvent. They have grown bigger and made promises larger than taxpayers will or can support. Government spending, at all levels, now exceeds 40% (roughly 25% Federal) of GDP as shown in this chart.

The tax burden implied from the chart is about 45%. However, that is truly misleading thanks to the manner in which GDP is calculated. Fifteen percent of GDP is imputed.  Imputed means there is no market transaction. Some government statistician “imputes” a transaction, even though one did not take place. Although there are many different imputations, the largest is the “rental income” you generate by owning your own home. No, you don’t pay income tax on this “income,” but it gets added to GDP as if it were real. To learn more about imputed transactions, including “hedonics,” visit John Williams at Shadowstats.com.

If market transactions only were used to calculate GDP (you need real income to pay real money), GDP would only be 85% of what is reported. The real tax burden then becomes 53% (45%/85%). With huge deficits projected at the Federal level and state and local pension obligations coming due, this percentage grows in the future.

The equivalent of 53% of actual income must be taken in order to support today’s government. That does not imply a tax rate of 53% on all income because revenue is raised via other taxes (sales, property, use, etc.). It does mean that 53% of private income must be taken to support government.

In the words of a US infomercial, “But wait, there’s more!” Even that 53% understates the problem because of the accounting for unfunded liabilities. Unfunded liabilities include commitments for pensions, retirement health benefits, Social Security, Medicare and Medicaid. Government uses a cash basis of accounting rather than GAAP (generally accepted accounting principles). For the Federal government the difference in reported deficits is enormous. The data below are from the US Treasury via John Williams. This table summarizes the difference in accounting.

Williams’ footnote (3) states:

“(3) This is the official reporting. It reflects government bailout programs as investments, predates December 2009 guarantees of Fannie Mae and Freddie Mac and does not reflect PBGC or FDIC liabilities. Please note that mid-year accounting redefinitions for TARP knocked off roughly $500 billion from the reported formal cash-based estimate and contributed to a TARP “profit” in the GAAP numbers.”

That footnote suggests things are probably worse than reported, at least in Williams’ opinion.

The GAAP deficit is $4.3 Trillion (or more depending upon how you might interpret Williams’ footnote). This represents a deficit $2.9 Trillion larger than reported on a cash basis! The difference is due to the treatment of the unfunded liabilities.

Under GAAP, the unfunded promises are recognized as liabilities. This total liability now exceeds $100 Trillion (present value) according to the trustees of the programs. (For more on this, see Spiraling to Bankruptcy.) The $2.9 Trillion represents the increase in that liability from 2008 to 2009. Equivalent adjustments would have to be made for state and local pension shortfalls and other unfunded liabilities. Their pension shortfall has been estimated around $2.5 Trillion. An actuarial calculation would have to be done by state and municipality to accurately calculate how much spending would increase under GAAP accounting. For purposes at hand, we shall use a figure of $200 billion to reflect this GAAP adjustment.

With these figures, we can approximate the real burden of government. We start with last year’s GDP of $14.1 Trillion. From the graph, total government spending was 45% in 2009 or $6.4 Trillion. GDP is reduced to $12.0 Trillion to remove non-market (imputed) transactions. Next we add the $3.1 Trillion (GAAP adjustment at both Federal and lower levels for unfunded liabilities) to spending. Adjusted spending is $9.5 Trillion. That figure divided by $12.0 Trillion is an astounding 79%! That represents government as a percentage of GDP in terms of real market transactions.

Several comments can be made about this analysis.

1. The 79% is a staggering figure and not sustainable without massive tax increases or massive spending cuts at all levels of government. It is highly doubtful that citizens will tolerate much more in taxes, so virtually all of the adjustment necessary must come from reductions in the size of government.
2. Purists might argue that I have mixed up accrual and cash-based accounting in the analysis. I am not sure that is a valid criticism. On one hand, I reduced GDP by phantom transactions. In that sense, GDP was made more accurate on both a cash and accrual basis. On the other, I reflected unfunded liabilities on an accrual-basis. That puts both GDP and spending on an accrual basis. (There is no imputation of phantom items allowed in any real-world accounting.)
3. Accrual-based accounting shows a proper matching of revenues and expenses. It does not purport to show cash flows. It is possible for a company to report losses on an accrual basis and not be in danger of bankruptcy. Ultimately, accrual-based accounting will show profits or bankruptcy will result.

A legitimate objection might pertain to the current period, because the numbers are so unfavorable. GDP is low as a result of the recession and spending is high. That biases the 79% upward. Let’s explore that objection a bit. $14.5 Trillion GDP might be a more normal (non-recession) level than the actual of $14.1. But that change would produce only a few percentage points. Similarly, the 25% Federal Spending could be argued to be abnormally high. Adjusting that down might also pick up a few points (but remember the forecasted deficits).Thus, the 79% might be reduced to 72 – 73% after a few years. But that doesn’t take into account what is happening in the unfunded liability area. The GAAP adjustment for these programs continues to grow. They will overwhelm any of the aforementioned adjustments.

Unless the entitlements at all levels of government are cut, 79% will be too low a figure a few years out. The further out one goes, the bigger this problem becomes. If political action is not taken in this area soon, markets will act. Sovereign bankruptcy will force change, even if politicians are unwilling.

Watch Greece and the other PIGS (Portugal, Ireland and Spain) along with Britain. They will provide a preview of our future.