budget and-fiscal-policy-gale-5-12-10-2

The U.S. Budget and Options for Fiscal Policy

William G. Gale Brookings Institution/Tax Policy Center

The Mintz Economic Policy SeminarC.D. Howe Institute

May 12, 2010

222

The Situation • Huge short-term deficits.

– But they aren’t the real problem

• Large and growing medium-term deficits.– Tax increases probably needed over the next decade– In the meantime, deficits will reduce growth

• Growing and unsustainable long-term shortfalls. – Will require controlling spending and increasing taxes

333

Increasingly Urgent Concerns about Federal Debt

• Chinese officials have publicly questioned the security of U.S. Treasury debt.

• Credit markets see a non-zero probability of default on senior U.S. Treasury debt in the next five years.

• Medicare trust fund to go bankrupt by 2017.

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Fiscal Problems Elsewhere, Too

• Almost all states facing significant fiscal shortfalls. – California in particular

• Europe has its own fiscal problems.– S&P recently warned of a possible downgrade of UK debt– UK’s debt trajectory not significantly worse than the US – Greece, etc.

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Outline

• Why and how does fiscal policy matter?• How did we get here?• Where are we headed? • What should we do? • The President’s Fiscal Commission.

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Why and How Does Fiscal Policy Matter?

7

Macroeconomic Growth: Two different concepts

• In a weak economy, “growth” means reducing the output gap, which occurs by raising aggregate demand.

• In a strong economy, “growth” means raising the economy's capacity, which occurs by raising aggregate supply.

• In both cases, deficits work to raise aggregate demand and reduce national saving. – Those effects help an economy reduce an output gap.– But they reduce an economy’s ability to expand capacity.

8

Deficits and Growth In a Weak Economy

• In an economy where unemployment of workers is high and utilization of existing capital (machines, etc.) is low, the economy is not producing as much as it could.

• The primary goal of policy is get people back into the labor force and capital in use again.

• Doing so raises GDP and hence is called "growth", but it is better thought of as reducing the gap between potential output and actual output.

• KEY POINT: A budget deficit can help an economy with an output gap. Higher government purchases spur demand by government; tax cuts can spur demand by households. These changes raise the demand for workers and the use of capital.

9

Deficits and Growth in a Strong Economy

• If unemployment is low and capital utilization is high, then resources are fully employed and the economy's output is at potential output.

• The goal of policy in this case is to raise the capacity of the economy –more workers, better workers, more capital, better-applied capital, etc.

• Raising the capacity of the economy is economic growth.

• KEY POINT: In this case, a budget deficit hinders growth. The increase in demand caused by the deficit can't be met on a sustained basis since resources are already fully employed. Moreover, in order to finance investments in more and better workers and capital, the economy needs saving, and higher budget deficits represent lower government saving.

10

Consequences of Sustained Deficits –The “Crisis” Scenario

• Sharp change in investor's attitudes and willingness to hold U.S. government debt.

• Marked by some combination of: – Higher interest rates– Lower value of the dollar – Sharp outflow of capital from the U.S.

• Will it happen? When? How?– Could be triggered by any number of events. – May never happen– But even if a “crisis” is not likely, there is still a big problem….

11

Consequences of Sustained Deficits –The Gradual Scenario

• Lower national saving, which leads to: – Higher interest rates – Less national investment – Less future economic growth – Lower future living standards

OR

• Significant capital inflows from abroad, which leads to:– Less of an increase in interest rates – Less of a decline in national investment – BUT still leads to lower future living standards, because we effectively owe more to

other countries and have to pay it back

• KEY POINT: Lower future living standards = the burden on future generations.

12

Magnitudes• Considerable variation in the literature.

Reasonable rules of thumb (for the US) are: – Each percent-of-GDP in current unified deficits

reduces national saving by 0.5 to 0.8 percent of GDP

– Each percent-of-GDP in anticipated future unifieddeficits raises forward long-term interest rates by 25 - 35 basis points, and

– Each percent-of-GDP in projected future primarydeficits raises forward rates by 40 - 70 basis points

More on Magnitudes

• Calculations using a simple neoclassical growth model or Ball-Mankiw “debt fairy”calculations suggest that a sustained 1%-of-GDP deficit: – Reduces output by 1-2%; and – Raises interest rates by 30-80 basis points.

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How Did We Get Here?

From Ernest Hemingway, The Sun Also Rises

“How did you go bankrupt?” Bill asked.

151515

How Did We Get Here?

From Ernest Hemingway, The Sun Also Rises

“How did you go bankrupt?” Bill asked.

“Two ways,” Mike said. “Gradually and then suddenly.”

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2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Percent of GDP

Net Federal Debt, 2001 CBO Projections

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2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Percent of GDP

Federal Deficit or Surplus, 2001 Projections and Actual and Prospective Outcomes

January 2001 CBO Baseline Projections

ProjectedActual

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2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Percent of GDP

Federal Deficit or Surplus, 2001 Projections and Actual and Prospective Outcomes

January 2001 CBO Baseline Projections

Projected

Observed Deficit or Surplus

Actual

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What Happened?

Three Factors:1. The Economy2. Policy3. The Great Recession

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2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Percent of GDP

Federal Deficit or Surplus, 2001 Projections and Actual and Prospective Outcomes

January 2001 CBO Baseline Projections

Projected

Economic and Technical ChangesPolicy Changes

Observed Deficit or Surplus

Actual

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2

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2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Percent of GDP

Federal Deficit or Surplus, 2001 Projections and Actual and Prospective Outcomes

January 2001 CBO Baseline Projections

Projected

Economic and Technical ChangesPolicy Changes

Observed Deficit or Surplus

Actual

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2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Percent of GDP

Federal Deficit or Surplus, 2001 Projections and Actual and Prospective Outcomes

January 2001 CBO Baseline Projections

Projected

Economic and Technical ChangesPolicy Changes

Observed Deficit or Surplus

Actual

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2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Percent of GDP

Federal Deficit or Surplus, 2001 Projections and Actual and Prospective Outcomes

January 2001 CBO Baseline Projections

Projected

Economic and Technical ChangesPolicy Changes

Observed Deficit or Surplus

Actual

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2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Percent of GDP

Net Federal Debt, 2001 and 2010 Projections

CBO, Actual and Projected, March 2010

CBO, January 2001

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Where Are We Headed? The Next 10 Years

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Alternative Deficit Projections, 2010-2020

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2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

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CBO Baseline

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CBO Baseline

• Assumes current and future Congresses will do nothing. Mechanical projection of current law.

• Assumes almost all tax provisions expire as scheduled:– 2001 and 2003 tax cuts– “Regular” expiring tax provisions– AMT patches

• Assumes discretionary spending will stay constant in real terms.

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Extended Policy • Assumes current and future Congresses will act like previous

Congresses.

• Start with the CBO baseline adjusted for health care reform.

• Extend all non-stimulus expiring tax provisions.

• Allow non-stimulus, non-defense discretionary spending to grow with inflation and population.

• Replace projected defense spending with Obama defense plan.

• Assume physician payments under Medicare will be frozen, rather than cut.

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Alternative Deficit Projections, 2010-2020

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2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

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CBO Baseline

Extended Policy

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Alternative Deficit Projections, 2010-2020

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CBO Baseline

Extended Policy

Obama Policy

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2001 2003 2005 2007 2009 2011 2013 2015 2017 2019

Percent of GDP

Net Federal Debt, 2001 and 2010 Projections

CBO, Actual and Projected, March 2010

CBO, January 2001

Obama Budget

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Obama Policy in 2020

• The (full employment) deficit = 5.5% of GDP – Highest FE deficit since WWII except for current episode

• Public debt = 90% of GDP (and rising)– Highest level since 1947 (when it was falling)

• Spending will exceed 25% of GDP– Highest level since WWII except for 2011 – Net interest will be 4.0% of GDP, highest level ever (and

larger than Defense or NDDS in 2020)

• Revenues will equal 19.5% of GDP

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Economic Assumptions

• Budget figures depend critically on the economy.

• Global, financially-induced downturns: – Tend to run a long time (slow recoveries)– Tend to leave big and long-lasting revenue declines – Tend to result in lower future output path

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Political Assumptions• The political assumptions built into the budget

forecast border on heroic. – The stimulus package expires as scheduled – NDDS falls substantially relative to GDP– Difficult cuts in health care occur – PAYGO is honored for a decade

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Where Are We Headed?The Long Term

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The Fiscal Gap

• In dollar terms, the gap is the present value of the difference between all expected future revenues and expected future non-interest spending.

• Easier to understand as a share of GDP – the gap equals the size of the immediate and permanent tax increase or spending cut (or combination) that would keep the debt/GDP ratio at the same level in the long-term at is now.

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BaselineThrough

2085Permanent Through

2085Permanent Through

2085Permanent

As a Percent of GDP 4.60 6.40 7.21 9.07 6.35 8.16

In Trillions of Present-Value Dollars 34,964 92,668 54,794 131,245 48,216 118,161

Source: Authors' calculations

CBO Baseline Obama Policy

Table 5Fiscal Gaps

Extended Policy

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What Should We Do?

• Balancing recovery and fiscal discipline

• Medium-term (10-year) budget deficits

• Long-term deficits

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What Should We Do?Balancing Recovery and Fiscal

Discipline• The dilemma:

– Recovery needs expansionary fiscal policy/bigger deficits

– Discipline requires smaller deficits• The risk:

– Impose fiscal discipline too soon and the economy could tank again (e.g. US 1930s, Japan 1990s)

– Hold off too long and markets could get jittery

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The Short-Term Solution

• Combine– Fiscal expansion now – Fiscal discipline over the next 5 years

• Would solve both problems at the same time and would be more effective than either in isolation.

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What Should We Do? The Next 10 Years

• Deficits of 5-7 percent of GDP and rising over time under either Obama policy or extended policy, even with full employment and favorable political assumptions.

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Spending Options• In a typical year, more than 70% of federal spending

is on five programs:– Defense– Social Security– Medicare – Medicaid – Net interest

• 65% in 2009 (because of TARP and stimulus)• 74% in 2014 under Obama policy • Rising to 78% by 2020 under Obama policy

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Cutting Spending

• Will be difficult to cut any of the big 5 spending items significantly in this decade.

• Under Obama policy, other federal spending will account for 6.0% of GDP in 2014 and 5.5% of GDP in 2020.– Even enormous cuts in such spending will not

reduce the deficit much.

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Health Care Reform

• CBO: Recent health care reform will reduce deficit by about $150 billion over the next 10 years. – These gains already included in the estimates

presented above.

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Health Care Reform

• Legislation includes measures to slow cost growth.– These have to be sustained by future legislators– Spending cuts will be harder to sustain if

underlying costs continue to grow• Even if predictions hold, the remaining deficit

reduction task is harder, because potential sources of revenue increases and spending cuts have now been used to finance health.

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Tax Increases• It is difficult to see how the budget deficit can be

reduced to the 3 percent range or lower in the next decade without significant tax increases.

• We need both better taxes and more taxes. – Opportunity for reform

• Two strategies – not mutually exclusive – Reform existing taxes – Create new taxes

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Change Existing Taxes

• Increase rates

• Broaden the tax base – More conducive to economic growth than rate hikes– Reduces distortions and special treatment – Simpler – Fairer – Lots of revenue

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Broadening the Base – Options

• Limiting itemized deductions – Mortgage interest– State and local taxes– Charitable contributions

• Limit employer deductions for health insurance

• Limit corporate tax loopholes and deductions

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Energy Taxes?

• Cap & trade (with permits auctioned) or a carbon tax would likely raise at most about 1% of GDP in revenues if well designed.– Most extant proposals imply smaller revenue yields.

• A European-style gas tax ($4-$5 per gallon) could raise significant revenue.– Roughly, each dollar of gas tax would raise 1% of GDP in

revenues

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All Roads Point to a VAT

• It’s where the money is:– Used in more than 100 countries, including all other

OECD countries – Significant revenue source, much larger than could

be attained from income tax reform– Exempts exports and capital income – Is regressive

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How a Typical VAT Works

• All sales by all businesses are taxable.– Businesses pass on tax invoices to purchasers

• Registered VAT taxpayers claim credits for taxes paid on their purchases.

• Exports are “zero-rated.”– Exporters claim credits on purchases

• Imports are taxable.– No credits on purchases from overseas

• Tax base equals domestic consumption.

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Revenue Yield of a VAT

• Almost all OECD countries have rates between 15% and 22%.– Scandinavian countries around 25%– British Empire countries 6-13%, Japan 5%

• Rough rule of thumb in OECD countries: Each percentage point on the VAT rate “yields”between 0.3% and 0.4% of GDP in revenue.

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A VAT in the U.S.

• In the US, a 10% VAT – …with a fairly broad base and – …with a “demogrant” that compensates everyone on

consumption expenditures equal to the poverty level – could raise 4.0 – 4.5 percent of GDP in revenues.

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What Should We Do?The Long-Term

• Containing health care spending growth is essential to long-term fiscal balance, in addition to the changes discussed above.

• What is your number?

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Revenues and Expenditures as a Percent of GDP

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2009 2013 2017 2021 2025 2029 2033 2037 2041 2045 2049 2053 2057 2061 2065 2069 2073 2077 2081 2085

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CBO Baseline Revenues

CBO Baseline Expenditures

Obama Policy Expenditures

Obama Policy Revenues

Extended Policy Revenues

Extended Policy Expenditures

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The Long-Term Gap is Huge Relative to Typical Policy Changes

• The long-term gap = 6.3-8.2% of GDP.• In 2009,

– Income tax revenues = 7.2% of GDP– Corporate tax revenues = 1.2% of GDP– Payroll tax revenues = 6.3% of GDP– Defense spending = 5% of GDP– NDDS = 4.7% of GDP– Mandatory spending = 11% of GDP (in 2008)

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The President’s Fiscal Commission

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The Commission• Final report due in December 2010

• 18 members – 6 Obama appointees, politically diverse– 6 Democratic Congressional appointees– 6 Republican Congressional appointees

• Charged with eliminating the deficit other than interest payments in/by 2015– Would require a reduction in spending and/or increase in taxes of 2.2%

of GDP relative to the extended policy scenario and 1.4% of GDP relative to the Obama policy scenario.

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The Commission• The likelihood that:

– The Commission agrees on a plan that meets the deficit target, AND

– Congress votes on the plan, AND– Congress enacts the plan…– …is small.

• Two key problems: – No New Taxes coalition – 6 members have signed the

pledge, but the Commission needs 14 out of 18 votes– The public is not ready to have this discussion and hence

not ready to support politicians who support deficit reduction

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The Commission

• Still the Commission can do a lot of good

• Describe the problem clearly and show the options – “Show me the money”

• Begin the process of educating the public – “You think we’re fighting. I think we’re finally

talking.”