Hasik Analytic LLC

Defense and TaxesHow the long-term trend of federal taxation in the United States will hold future military spending to about $400 billion annuallySince the end of the Second World War, the United States has held to a broad consensus that the federal governmentʼs take by taxation, as a percentage of GDP, should lie in the high teens. If military spending is to be cut further than health care expenditures, as seems the case under the recent Budget Control Act, the Pentagonʼs take of federal revenues may decline to the mid-teens. In the long run, and possibly sooner, that is a formula for $400 billion defense budgets.

Defense-Industrial Research Memorandum #2011-03, 5 August 2011

James Hasik+1-512-299-1269www.hasikanalytic.com

THE BACKGROUND

Without nuclear weapons, the Soviet negotiator says in Lee Blessing's 1988 play A Walk in the Woods, the United States and the Soviet Union would be “nothing more than a rich, powerful Canada and an enormous Poland.” Today, the Russian Republic would do well to be an enormous Poland, and the United States' GDP per capita is only slightly higher than that of the neighbor to the north. Bad governance has featured prominently in the stumbling of both countries, if in completely different ways. Corruption and lawlessness afflict Russians; financial myopia is the problem for Americans (if Greeks and Spaniards and Portuguese, too). So, with the latest spasm of borrowing approved in the so-called Budget Control Act (BCA), the US is now not so much like Canada, but a large version of Italy or Belgium, because theirs is the ratio of federal debt to per capita GDP that the government is taking on.

The question we want to ask here is whether, in the long run, the US can manage to maintain military forces per capita that are more impressive than those of Italy or Belgium, countries not remarkably noted for vigorous interest in alliance obligations. American military spending would have a very long way to fall before it got to that point, but fall sharply it will.

For evidence, pull away for a moment from the self-congratulatory words coming out of Washington this week, and pay some attention to the theoretically dispassionate analysts. Fitch Ratings on Tuesday opined that the projected growth of the United States' federal debt, even with the BCA in place, “is not consistent with” the government's retaining its triple-A bond rating. Rather, Fitch wrote, further progress would need to be made soon to avoid a downgrade.1 Dagong Global Credit Ratings has already cut the US government from A+ to A, for “the raising of the ceiling does not reverse the trend of debt growing faster than the US economy and actually marks a decline in the ability of Washington to pay its debts.”2

Staying solvent, or just a going concern as a world power, means either raising taxes, cutting spending, or praying that the economy will grow like kudzu. If betting on economic growth sounds like employing hope as a strategy, then looking for tax increases isnʼt likely to be more sound. Senate Majority Leader Harry Reid says that the Democrats will use their six nominations to name people to the BCA Super Committee who are open to raising marginal tax rates, but the Republicans in the Congress are adamant that their people won't be. With one side intransigent and a backup mechanism for automatic cuts in place, the Tea Partiers are poised again to win the argument. Inefficient loopholes will likely die—particularly some of the more egregious, like accelerated depreciation for business jets—but marginal rates are not likely to increase. And taxes are core to the question of what happens to military spending.

THE HISTORICAL AND FINANCIAL ANALYSIS

Without an overall increase in the government's take from the economy, the government's outlays must decrease in the long run, because its borrowing, as Fitch and Dagong know, is still unsustainable. The planned expiration of some tax breaks will help, and possibly without pain lost to memory. Thatʼs because the federal government's take of late is actually, as shown in the figure on the next page, historically low for the post-WW2 era. In 2009 and 2010, the feds pulled in just 14.9 percent of GDP as tax revenue. Only twice in the last half century—in 1949 and 1950—has effective federal taxation been lower.3

Indeed, the pattern of taxation strongly suggests an enduring modern consensus over taxes: in the past sixty-five years, the federal government has averaged 17.9 percent, with a low of 14.4 percent, and a high (at the end of the Clinton Administration) of just 20.6 percent. If raising taxes seems hard, the track record suggests that it's time to stop trying.

That firm-fixed share of the economy does not bode well for military spending. Back in 2001, that tax take of 20.6 percent brought in $1,991 billion nominally, or $2,125 billion in FY2005

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1 Naftali Bendavid and Carol E. Lee, "Deficit Battle Shifts to Panel," Wall Street Journal, 3 August 2011.

2 Wei Tian and Hu Yuanyuan, “Chinese agency downgrades US credit rating,” China Daily, 4 August 2011.

3 Numbers herein are drawn from the Tax Policy Center of the Urban Institute and the Brookings Institution.

terms. In 2010, the 14.9 percent brought in $2,163 billion nominally, or $1,919 billion in FY2005 terms, which is rather less than ten years back. In 2001, the Pentagon's expenditures of $297 billion (in nominal terms) were the equivalent of 16 percent of federal tax revenues. In 2010, its $617 billion were the equivalent of 20 percent (though a large portion of that was obviously borrowed).

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1946 1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010

US federal tax revenue as a percentage of GDP, 1946–2010

That's a huge run-up in spending without a huge increase in financial wherewithal. Between 2001 and 2010, real GDP increased only 15 percent: in FY2005 terms, from $11,336 billion to just $13,088 billion (nominally $14,527 billion). It was also a huge run-up during a decade in which the government was repeatedly expanding federal largesse for medical care. So, unless the Committee of Twelve choose to tear disproportionately into Medicaid and Medicare, the Pentagon will take at least its share of budget-balancing.

It's also important to remember that 2001 was the last year of financial surplus, and the last year at least partly without a major war. As such, it is reasonably a model for the level of resources that will be devoted to military forces in the long run, though probably without the historically high tax burden, which helped put George Bush in the White House. So, unless something kickstarts US economic growth towards old school Asian Tiger levels, or some scary new enemy emerges after withdrawal from Iraq and Afghanistan, the Pentagon will be looking at a drastically lower budget than it has today. More specifically, if the citizenry blanches at overall taxation much above 18 percent, and the military taking more than 16 percent of that, the long-run real level of military spending is not much more than

$14,527 billion × 18% × 16% = $418 billion

That number might make admirals and generals themselves blanche. Itʼs a figure about twenty percent lower than the Pentagonʼs base budget—the part that theoretically omits direct spending on the campaigns in Iraq and Afghanistan—is today. Stretched over ten years, itʼs rather more than the $850 billion kicked around in the press; itʼs nearly $2 trillion below the Pentagonʼs hope-for plan.

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Average: 17.9% • Low: 14.4% • High: 20.6% • Std dev: 0.9%

To be fair, it may not turn out to be quite that low. It may increase with time as the economy grows. It is, admittedly, $40 billion more in real terms than military spending from 2001, but that sum is roughly equivalent to the difference in the Pentagon's spending on health care then and now. The regular increases in pay—in excess of inflation and GDP growth—that the Congress has awarded the troops have torn further into the budget, though it's reasonable to think that better pay might attract better troops. But whatever the case, what's left will ultimately pay for rather fewer troops than in 2001—or a lot less of something else.

So let us be reasonable—the United States can obviously be defended on $400 billion a year, and that would rather get finances back on a sound footing. Such a figure truly is the start of a recipe for much more than a Belgian military, though one that does a lot less than it does now. This week, Inside Defense breathlessly titled its article on the subject “Debt Ceiling Will Force Revisions in New Military Investment Plans”.4 That seems painfully obvious, and so the mismatch between reality and preparation shows how the process may be painful bureaucratically.

But as Defense Secretary Panetta insisted this week, this can and should be done with national strategy as a core input. Quite tangibly, as USAF Vice Chief of Staff General Phillip Breedlove told the House Armed Services Committee in late July, cuts of the magnitude now foreseen would force a fundamental rethinking of not just how the military goes about its business, but what it does at all. One can search for efficiencies, cut headcount, postpone of cancel programs, or retire current equipment. The uniforms may not like much of this, but as in Britain earlier this year, they will eventually salute and carry on.

Given the deadlines in the BCA, it is likely that what must be done in the long run will at least substantially be done in the short run. As the next several months will thus be a frantic time for sorting out what will stay and what will go, I will be devoting considerable time to analyzing the range of possibilities for Defense, and how those might differentially affect the industries supporting it. As always, I ask for comments, both for constructive feedback and to help me craft the research agenda.

This memorandum is for private circulation and distribution, and is provided for information only. Hasik Analytic LLC makes every effort to use reliable, comprehensive information, but does not represent and cannot warrant that it is necessarily accurate or complete. The views in this publication are those of Hasik Analytic LLC and are subject to change without notice. At the same time, Hasik Analytic LLC undertakes no obligation to update its opinions or the information in this publication.

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4 Inside Defense, 4 August 2011