RevisedJune12,2011 JohnFitzgeraldjfitzger@bowdoin.edu MichaelJonesmjones@bowdoin.edu

INTHESHADOWOFDEBT

AnIntroductiontotheUSBudgetImbalance

OurFederaldeficitandnationaldebtareoneveryone’smind.Itdoesn’ttakemanysurfsthroughtheTVchannelstofinddramaticallydifferentopinionsofthecostsimposedonusbythedebt,thelikelihoodofafinancialcrisis,andtheappropriatestepstodealwiththeproblem.Economists,likepoliticiansandthegeneralpublic,coverthefullspectrumofopinionontheseissues;butthereisamiddlegroundoccupiedbymosteconomists.Speakingfromthismiddleground,wehopetoplaceinperspectivethecausesofourbudgetimbalance,itsseriousness,andtheavailableremedies.

Thisprimerwilladdressfourtopics.Inthefirstchapter,welaythegroundworkbydefiningtermsandcollectingdata:whatarethedebtandthedeficit;howaretheymeasured;andhowdoesthecurrentsituationcomparetothepastandtothatofothercountries?Asecondtopiciswhetherournationfacesbankruptcyandfinancialcrisiswithoutcorrectiveactionandwhatneedstobedone,inthenextdecadeandbeyond,tomakethebudgetsustainable.Wecanactabruptly,andsharplylimitthesizeofthedebt,orgradually,andacceptalargerobligation.Suchchoicesmotivateourthirdtopic:whatarethebenefitstousandtheburdensonfuturegenerationsofourdeficitsandthedebttheyimply?Thegreatertheburden,themorequicklyanddecisivelyweshouldact.Finally,wetakeamoredetailedlookatthecomponentsoftheUSbudgettodiscoverhowthedeficithasemerged,howitislikelytoevolvewithoutcorrectivepolicies,andsomeproposedoptionsforreachingasustainablelevelofdeficitsattheendofthedecade.Thebottomlineisthatalthoughwedonotfaceanimmediatedebtcrisis,thedebtproblemislargeandrealsolutionswillrequiresignificantchangesintaxesandspendingonpopularprograms.Wecannotgrowoutoftheproblem.Comprehensivereformsarenecessaryandshouldbegintobeimplementedinthenextfewyears.

ONE:THEMESSWE’REIN

ThedeficitofourFederalgovernmentistheexcessofitsexpendituresoverrevenuesinagivenyear.Expendituresincludethecostsofourmilitaryandgovernmentemployees;paymentstotheretired,sick,andunemployed;andinterestchargesontheaccumulatedborrowings.Revenueismainlyintheformoftaxcollections.For2010,estimatedexpenditureswereapproximately3.5trilliondollarsand

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estimatedrevenueswereapproximately2.2trilliondollars;thedifferenceistheFederaldeficitofapproximately1.3trilliondollars.For2011,thedeficitisexpectedtobeevenlarger,approximately$1.5trillion.

Thegrossnationaldebtisthetotal,accumulatedamountborrowedbytheUSTreasurysincethebirthofourcountry.Nowadays,thesefundsareobtainedprimarilythroughthesaleofgovernmentbonds.SomeofthisdebtisowedtoandownedbyUShouseholds,businesses,andgovernmentsnotapartoftheFederalsystemandbyforeignindividuals,businesses,andgovernments.Thisportionofthedebtissaidtobe“ownedbythepublic.”TherestofthegrossdebtisheldbydepartmentsoftheFederalgovernmentdifferentfromtheTreasury,notablybytheSocialSecurityAdministration.Thisportionofthedebtexistsaspaperentriesonthebooksofthegovernmentanddoesnotinvolvetheliteralpaymentofinterestto,oracquisitionoffundsfrom,apartyoutsideofthegovernment.Consequently,itisirrelevanttothewaygovernmentactionsaffecttheeconomy.Themeaningfulportionofthedebt,ownedbythepublic,isthedefinitionusedthroughoutourdiscussion.Attheendof2010,thenationaldebtheldbythepublicwasapproximately9.0trilliondollars.Incontrast,thegrossdebtwasapproximately$13.5trillion.

Thedebtanddeficitareintimatelyrelated.SincetheUSFederalgovernmentmustborroweverydollarofspendingthatisnotcoveredbyrevenues,thedeficitrepresentstheincreaseinthenationaldebtfromoneyeartothenext.(Actually,becauseourgovernmentsometimesmakesloansatthesametimeitborrows,thisassertionisnotexact;butthediscrepancyisminorandwillbeignoredhere.)Inanalogytotheuseofacreditcard:thedeficitissimilartothemonthlychargesthatarenotpaidoff,andthedebtistheoutstandingbalanceagainsttheaccount.Failingtocoveratleastthemonthlychargesisdangerous,becausetheoutstandingbalancegrows,andinterestexpensesgrow,andtheoutstandingbalancecanspiraloutofcontrol.Suchisthefearthatdeficitswillleadtomoredebt,moreexpendituresoninterest,andinturnevergrowingdeficits.

TheCongresslegislatesadebtceiling.Aspresentlyset,theceilingputsanupperlimitofroughly$14.3trilliononthedollarvalueofthegrossdebt‐‐thatis,theuninformativemeasureofthedebtthatincludesallofwhattheTreasuryhasborrowedfromthepublicandfromotherdepartmentsoftheFederalgovernment.Atthemomenttheceilingisreached,additionalborrowingbytheTreasurybecomesillegal;so,everydollarofnewexpendituremustawaitadollarofnewtaxrevenue.Thebudgetwillbeforcedintobalanceasaresult.Eliminationofa$1.3trilliondeficitinthetickofaclock,inunplannedfashion,isalmostinconceivableandnooneknowshowitcouldbedone.Certainly,theimmediateconsequencewouldbethenon‐satisfactionofmanyobligations,likefederalworkerpay,interesttocreditors,andpaymentstotheretiredandunemployedForthisreason,failuretoincreasethedebtceilingdoesnotinitselfsolveourfiscalproblemsinasatisfactoryway,wouldseverelyjoltanalreadyfragileeconomy,andmightevenbringaboutthecrisisinfinancialmarketsthatfiscalconservativesfearfromdeficits.Becausetheconsequenceswouldbedire,somebelievethatthethreatofmaintainingtheceilingcanspurotheractionstocorrectthedeficitinthelongterm.

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Forcomparisonovertimeandwithothercountries,deficitsandthedebtshouldbegaugedinrelationtotheeconomyasa“whole,”oftenmeasuredasthegrossdomesticproduct(GDP),thedollarvalueofgoodsandservicesproducedwithinacountryduringagivenyear.TheratioofthedeficitordebttoGDPcanbelegitimatelycomparedovertimebecausetheyarenotdistortedbyinflationoreconomicgrowth.Figures1(deficits)and2(debt)andTable1showtheseratiosoverthelast40years.Here,wecanseethatrelativetoGDPdeficitsandthedebtin2009and2010havereachedlevelsunprecedentedduringpeacetime.(USdebtexceededtheGDPshortlyafterWWIIbutfellquicklytolessthanhalfofGDPastheeconomygrewrapidlyafterthewar.)Duringthe38yearsbefore2009,only8timeshadthedeficitbeenlargerthan4percentoftheGDP,andonlyonceaslargeas6percent.Debthadneverreached50percentoftheGDPand,exceptforyears87‐98hadbeenlessthan40percent,andsometimeslessthan30percent,ofGDP.Duringthelasttwoyears,deficitshavebeen9‐10percentofGDPandthenationaldebthasgrowntoover60percentofGDP.Deficitsprojectedfor2011and2012,atleast,willbesimilarlylarge,andthedebtisexpectedtogrowasaproportionoftheGDP.Withoutquestion,theseareredflags.

Hasthedeficitbeencausedbyadeficiencyoftaxrevenues,oranexcessofexpenditures,relativetohistoricalstandards?Chart3,whichshowstheratioofrevenuetoGDPandexpenditurestoGDP,indicatesthatbothpartsofthedeficithavebrokennewground.Revenueshaveaveragedapproximately18.0percentofGDPoverthelastfortyyears,butin2009and2010taxcollectionswereonly14.9percentoftheGDP.Theseratiosarethelowestintheentire40yearhistory.Expendituresinthelasttwoyearswere25.0and23.8percentofGDP,incomparisontotheaverageof20.8percent,andarealsothelargestduringtheentireperiod.

Diggingdeeper,wemustaskwhatpoliciesandcircumstanceshavecausedthishemorrhageinthebudget.Thereisnosinglesource(moreonthisinchapterstofollow),butatleastsomeofthehemorrhageisnotcausedbychanginggovernmentpoliciesatall.Rather,partofthedeficitisapassiveresponsetothedepressedstateofoureconomy.Wehavenotedthatthedeficitisunprecedentedinmodernhistory,butsotooistheextentoftherecenteconomicdownturn,asmeasuredbytheunemploymentrate–thehighestithasbeeninthelastfortyyears–andasmeasuredbythepercentagegapbetweenwhatweinfactproduceandwhatwewouldproduceiftheworkforcewerefullyemployed.Thelatteriscalled“potentialGDP.”Thesizeoftheserecentoutputgaps,showninTable1,revealthatwereallyareexperiencingtheGreatRecession.Itisnoaccidentthattheothersevereeconomicdownturninmodernhistory,theeightyears1980‐1987whentheUSwassignificantlyunderemployed,werealsotheyearsofextremedeficitsinrelationtoGDP.

Chart3illustrateshowthedeficitissensitivetothestateoftheeconomy.Periodsofslowdownineconomicgrowth(whichcorrespondapproximatelytoperiodsofrisingunemployment)areshadedinthechart.Duringtheseperiods,revenuessystematicallydeclineasapercentageofGDP,andexpendituressystematicallyincrease.Eveniftaxlawsandpoliciesareunchanged,revenuesfallwhengrowthslowsorisnegative,becausetaxescollectedonpersonalincomeandbusinessincomefallasincomesfall.Infact,revenuesdeclineseverelyinrelationtoGDP,becausepeoplearepushedintolowertaxbracketsandsomeofthetaxbaseunrelatedtoGDP(eg,capitalgains)evaporates.Evenifthe

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lawswhichunderlieFederalexpendituresareunchanged,expendituresrelativetoGDPincreaseduringeconomicdownturns,inpartbecausemanyexpenditures(suchasnationaldefense)arenotautomaticallyreducedinlinewithGDPandinpartbecauseotherexpenditures,suchasunemploymentcompensationandaidtothepoor,actuallyincreasewhentheeconomyworsens.

Thesepassivemovementsofthebudgetinresponsetoeconomicfluctuationsarenotofmajorconcern,becausetheyarenotapermanentfeatureofthebudget:theywillgoaway,andevenbereversed,whentheeconomyreturnstofullemploymentandtoboomperiods.(Indeed,mosteconomistsregardthispassiveresponseasagoodthing,becausetheautomatictendencyfortaxcollectionstofallandexpendituretoincreaseduringdownturnsstimulatesdemandwhentimesarebadand,hence,dampensthesizeofeconomicfluctuations.Forthisreason,thepassivebudgetresponseisknownas“automaticstabilization.”)Weseekameasureofthebudgetwhichmeasuresexpenditures,revenues,andthedeficitpurgedoftheseautomaticreactionstothestateoftheeconomy.Suchameasure(carefullyconstructedbutnecessarilyspeculative)iscompiledbytheCongressionalBudgetOffice(CBO),amongothers.Knownasthestructuralbudgetdeficit,itcomputesthedeficitthatwouldhappenunderexistingtaxlawsandexpenditurerulesIFtheeconomywereatfullemployment.

Table1andchart1showtheUSstructuralbudgetdeficitasapercentageofthepotentialGDP.Thetableandchartalsoshowperiodsofexcessiveunemployment,duringwhichactualGDPfallsbelowpotentialGDP.Asisevident,whentheGDPisbelowitsfullemploymentlevel,theactualdeficitrelativetoGDPislargerthanthestructuraldeficitrelativetofullemploymentGDP.Forexample,iftheeconomyhadbeenfullyemployedin2010,thedeficitwouldhavebeenreducedby360billion.Accordingtothislattermeasure,structuraldeficitsinmoderntimeshaverarelyexceeded4percentofGDPunderfullemployment–themid‐80scontinuetocatchoureye–butdeficitsinthelasttwoyearsremainatunprecedentedlevels,of7.3and6.1percentofpotentialGDP.Thisrefinedviewofthedeficitremindsusthatrelativetotheeconomythecoreoverspendingisnotaslargeaswefirstsupposed,butitdoesnotchangeourconclusionthatthebudgetimbalancesofrecentyearsareuniqueandominous.Fancycalculationscannothidethistruth.

Comparativeinformationfromaroundtheworldprovidesanotherusefulperspectiveonourbudgetsituation.InTable2welookatbudgetdataforthesevenlargestindustrialcountries(the“G7”)andthreesmallerEuropeaneconomiesinfinancialturmoil.Thesedata,compiledbytheInternationalMonetaryFund,averageresultsfrom2009and2010anddifferslightlyindefinitionfromthedatainTable1.AmongtheG7,asashareofGDP,USdebtisinthemiddlerangeandquitetypical.However,theUSdeficit,alongwiththoseofJapanandtheUK,arethelargestintheindustrializedworld,evenafteraccountingfortheautomaticresponsetotherecession.AnotherinterestingfeatureisthattheUShasrelativelylowtaxesamongindustrializedcountries.OnlyJapanhaslowergovernmentrevenuesasshareofGDP.

FromtheTable,wecansensewhyGreece,withatypicallylargedebtanddeficits,andIreland,withmassivedeficitsandasevererecession,havecomeunderpressure.ButPortugal,mentionedoftenas

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anotherpossibletargetforinternationalspeculators,hasdebtanddeficitsnotdissimilarfromtheUS.Areweindanger?Thatisthetopicwetakeupnext.

TWO:AREWEBROKE?

Lettherebenomisunderstanding:governments,likehouseholds,mustlivewithintheirmeans.Households(neglectinginheritedandbequeathedwealth)mustmatchspendingovertheirlifetimetoearningsovertheirlifetime.Inanyparticularyear,itoftenmakessensetolend,ortoborrow;buthouseholdscannotborrowtoomuch.Iftheirdebt(netofacquiredassets)exceedstheirlikelyfutureearnings,minusnecessaryexpenditures,theyarebroke.Similarly,ifagovernment’sdebthasgrownsolargethatitcannotberepaid(inasensetobeexploredbelow),thatgovernmentisbroke.

MostAmericanswouldbesurprisedtolearnofthefrequencyofnationalbankruptciesaroundtheworldandoverhistory.Forexample,inacomprehensivestudyoffinancialcrises,RinehartandRogoff(2009),chapter5,estimatethatafterWorldWarII,almost40percentofthecountriesoftheworldwereindefault;andduringthe1980s,almost10percent.Thetrainofeventstriggeredbyunsupportabledebthaveplayedoutmanytimes.Investorsloseconfidenceandtrytosellthedebt,loweringitsvalue,orinsistonhigherinterestincompensationfortheheightenedrisk.Thesereactions,whichdepresstheeconomyandincreasetheinterestowedbythegovernment,inflamethesituationintoacrisis,whichendsindefault–thegovernment’sadmissionthatitwon’tkeepitspromisetorepay.Theeconomyisthrownintoturmoil;andhavinglostitsreputationforsounddecisions,thegovernment’sabilitytoborrowinthefuturedeteriorates.RecentexamplesareArgentina2001/2002,andIrelandandGreecein2009/2010.(SeeCBOJuly2010foranicesummary.)

Principlesofsoundfinanceapplytogovernmentsandhouseholdsalike.Butgovernmentsdifferfromhouseholdsinseveralcrucialregards.Thesedifferencesmakeusre‐thinkwhatitmeansforagovernmenttobebrokeandhelptoputintocontextthesolvencyoftheUS.

1)Householdshavelimitedlifespansandmustsettletheirfinancialaffairsattheend.Ourgovernment,wehope,livesonindefinitely.Therenevercomesatimewhenitsdebtmustbeeliminated;instead,itcan“rollover”itsdebt,issuingnewtofundtheold,foraslongaspeoplearewillingtoloanitthemoney.Allgovernmentsusethistechnique.Thekeyistomakesurethatthegovernmentcanalwayscovertheinterestowedonthedebt.Theinterestispaidoutoftheexcessoftaxrevenuesoverexpendituresongovernmentprograms.SincetaxesarecollectedmainlyfromournationaltaxbasetheGDP,andgovernmentexpendituresotherthanoninterestgrowinroughproportionwiththesizeoftheeconomy,thisrollovertechniqueworksaslongasthedebtgrowsnofasterthandoestheGDP.Inthissituation,thebudgetissaidtobesustainable.Acountryisbrokewhenitcannot,orwillnot,achieveasustainablebudget.

2)Householdsandbusinessesarebrokewhenthesacrificeofpayingbacktheirdebtsisextremeandunreasonable.Legalstandardsgovernwhenthesacrificeisunbearableandhowmuchcreditorscanrecover.Incontrast,governmentsfacenoenforceablelegalstandardwhichdictateswhenrepaymentisunbearableandwhatcreditorsareentitledto.Agovernment’srevenues—itstaxcollections—and

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expendituresarenotsetinstone:theyaredeterminedinthepoliticalprocess.Governmentscan,anddo,defaultontheirdebt.Countrieswhichgobrokealmostalwayshavetheabilitytocollectsufficienttaxes,orreduceprograms,tosustaintheirdebts.Afterall,inprinciple,theentireGDP,minusexpendituresnecessarytomaintainlife,isavailabletofinancetheinterest.Countriesgobrokebecausetheyareunwillingtomakesuchdiresacrificesfromtheircitizens.Insteadofbearingtheburdenofhightaxesorreducedprogramstosustainthedebt,theychoosetosufferthecostsofdefault.Inconsequence,thereisnosimple,judgment‐freedeterminationofwhenacountryislikelytogobroke:sustainabilityisasubtlebalanceofpoliticalwillandthepenaltyofbreakingyourpromise.Thisbalanceisdifferentfordifferentcountriesandtimes.

Withtheseideasinmind,wecangrapplewithseveralkeyquestions.

AfirstsetofquestionsrelatestosustainabilityoftheUSbudget.Isitnowsustainable?Ifnot,howfardoweneedtogotomakeitsustainable?TheanswerstothesequestionsdependonthelongtermgrowthrateoftheUSeconomy:thefasterGDPgrows,themoredebtcangrowwithoutgainingasapercentageofGDP.Formanyyears,therateofgrowthofUSproductionunderconditionsoffullemploymenthasaveragedaround2.5percentperyear.OurFederalReservetargetsabout2percentinflationundernormalconditions.Thus,manyeconomistswouldballparkaverageGDPgrowthatapproximately4.5percentperyearintothefuture.Debtlevelsinrecentyearsandintheneartermforecastareontheorderof60to70percentofGDP.Underthesecircumstances,thedeficitcouldbeonaverage2.7to3.2percentoftheGDPwithoutgeneratinganincreaseindebtrelativetothesizeoftheeconomy.Consequently,manyeconomistsbelievethatastructuralbudgetdeficitrelativetofullemploymentGDPontheorderof3percentwouldbesustainablefortheUS.

RelativetofullemploymentGDP,ourstructuraldeficitin2010(andlikelyfor2011)isontheorderof6percent.Thisbudgetisnotsustainable.Toachieveasustainablebudget,weneedtoincreasetaxrevenues,orreducegovernmentprograms,ontheorderof3‐4percentoffullemploymentoutput–incurrentdollarsabout$500billionperyear.Thisgoalisnoteasy.Forexample,$500bisconsiderablylargerthantheentirenon‐militarypayrollofourFederalgovernment.Thegoalwillbecomefarmoredifficulttoachieveasourpopulationages,orifourdebt/GDPratioisallowedtoincreasesubstantially.But,aswediscussinsubsequentchapters,sustainabilityisachievable.

Asecond,relatedquestioniswhetherourdebtlevelisnow,orintheforeseeablefuture,sohighthatwearevulnerabletoalossofconfidencebyinternationalinvestors‐‐thatis,shouldthemarketplacebelieveourbudgetmaynotreachsustainability?Toanswerthisquestion,wemustaskhowlargeasacrifice,intheformofhighertaxesorsmallergovernmentprograms,theUSpublicwouldacceptinlightofthecosttoourcountryofdefault.Intruth,nooneknowstheanswertothisquestionwithprecision.Butaswelookaroundtheworld,theUS–withadebttoGDPratiotypicalofindustrializedcountries‐‐iswellpositionedtoshoulderitsdebt.Itsrateofeconomicgrowthoverthelongtermhasbeenhealthy,andsteady,bythestandardsoftheindustrializedworld,anditborrowsatfavorableinterestrates.UStaxesarelowbythestandardsoftheindustrializedworld,andoursystemsoftaxcollectionandexpenditureareefficientandfreeofcorruption.Thus,atthesameratioofdebttoGDP,

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theexcessoftaxesoverexpenditures(relativetoGDP)necessaryforsustainabilityissmallerintheUSthaninmostothercountries;andthebudgetpoliciesneededtobringthesechangesaboutinvolvelesspain.Inthebroader,globalpicture,ourgovernmentisstableandourcohesionasanationisstrong:weacceptthepromisesofourgovernmentinthepastasourownandtakesomeresponsibilityforthewelfareofourfuturecitizens.Also,thecosttotheUSofadefaultonitsdebtandconsequentlossofinternationalreputationisveryhigh.Weareoneofthefewcountriesthathasneverdefaulted;weobtainlargebenefitsofhavingourassetsheldthroughouttheworldandthedollarastheworld’scurrency;andtheconsequencesfortheworldeconomyofadebasementofUSobligationswouldbecataclysmic.Nooneknowsthe“triggerpoint”atwhichUSdebt/GDPgetssolargethatrationalinvestorsshouldpanic.Butincomparisontoalmostallcountries,includingthoseintheindustrializedworld,therelativelysmallsizeifitssacrificetostaysolvent,andtherelativelylargecostofarepudiationofitspromises,makeaUSdefaultnoworintheforeseeablefuturealmostinconceivable.

Themarketplaceagrees.TheinterestratesonlongtermUSTreasuryobligationswereathistoricallowsattheendoflastyearandremainlowbyhistoricalstandardsandincomparisontotheinterestratesoncomparableobligationsofmanyotherindustrializedcountries,includingCanada,France,andtheUK.RatesonGermanbonds,whileslightlylowerthanUSratesatthetimeofwriting,aresurprisinglysimilarinlightofthelikelyfallinthevalueofthedollarinthefuture.Whilesuggestive,thisevidenceisnotdecisive,becauseinterestratesaredrivenbymanyforcesinadditiontodefaultrisk(especially,theactionsoftheFederalReservenowandexpectedinthefuture)andinternationalcomparisonsaredistortedbyexpectedchangesincurrencyvalues.Moredirectevidenceonconfidenceisprovidedbythepriceofinsuranceongovernmentobligations(knownascreditdefaultswapsonsovereigndebt)andtheassessmentsoftheseveralagencieswhospecializeinratingnationalandcorporatedebt.InsuranceagainstdefaultonUSdebtisamongthecheapestintheworld,becausethemarketplaceviewsUSdebtasamongthesafest.Forexample,attheendof2010,outofthe56nationswhosenationaldebtcanbecoveredbyinsurance,only4‐6nations(dependingonwhethertheinsuranceisfor5yearor10yearbonds)haddebtwithcheaperinsurancethanthatonUSdebt.Notably,insuranceonFrance,Germany,andtheUKwasmorecostly.StandardandPoor’s,amongotherratingsagencies,assignstheUSdebtitshighestAAAratingforquality,aratingearnedbylessthanonesixthof126countries.Bythesemeasures,USdebtisamongthesafestintheworld.

Recenteventsdonotnegatethisconclusionbutsurelygiveuspause.ThepriceofinsuranceagainstUSdefaultroseduringthefirstquarterof2011,andattheendofthatperiodthedebtsof6‐9countriescouldbeinsuredmorecheaplythancouldUSdebt.Partly,marketsreactedtoatemporaryworryaboutdebtserviceifthedebtceilingisnotraised;butalsomarketsreactedtotheheateddebateandpossiblegridlockinWashingtononlongtermdeficitreduction.StandardandPoor’s(April18,2011)tooktheUStotaskforitslackofconsensusonadeficitreductionplanandhasindicatedthatfailuretoactcouldresultinadowngradeofUSdebtfromAAAtoAAquality.ThesedevelopmentsarehealthyearlywarningsthateventheUSisnotimmunetotheseriousconsequencesofexcessivedebt:weshouldnotdelayactionmuchlonger.Butthesedevelopmentsalsoputoursituationincontext.Tododgethedowngrade,StandardandPoor’sdoesnotlookforimmediate,sizabledeficitreductionbutrathera

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credibleandenforceableplanforthelongtermtobeagreeduponoverthenexttwoyears.DespitetherecentincreaseinthepriceofinsuranceonUSdebt,weremaininelitecompany(cheapest1/6);andUSdebtisstillcheaper,orvirtuallythesame,toinsurethanthoseofthelargeindustrialcountriesontheContinent.ComparisonstoGreece(priceofinsuranceis25timesaslarge)andIrelandandIceland(insurancepriceabout12timesaslarge),orevenItalyorJapan,areoutrageous:theyareinadifferentleague.Similarly,eveniftheUSratingweretofalltoAA,itsdebtqualitywouldberegardedasahairwidthinqualitybelowthatofAAA,stillimminentlysecure(onlyabout1/10ofcountriesachievetheAArating),andhardlyinthesameclassasPortugal,Ireland,Greece,andIceland(BBBcountries).Inthisworstcase,theUSwillfacehigherborrowingrates;andthefailuretoactwilladdimportantlytoourfutureburden,asdiscussedinournextinstallment.Butwewillstillbealongwayfromnationalbankruptcy.

Insummary:theUSisnotonthedoorstepofafinancialcrisistriggeredbyexcessivenationaldebt.Evenatthedebtlevelsprojectedfortheendofthisdecadeifnocorrectiveactionsaretaken(about90percentofGDP),itisalmostinconceivablethattheUSwouldchoosetodefault.Theimportantproblemsofthefiscalimbalancelieelsewhere.Letuslookatthem.

THREE:THEBURDENOFTHEDEBT

Aswehavediscussed,ournationaldebtisnotlikelytobankruptus.But,itcausesotherseriousproblems.Ittakesawayourflexibilitytorunlargedeficitsintheeventoffuturewarsornationalemergencies,whenotherwiseitwouldmakegoodsensetospreadthecostofsecuringourcountryoverseveralgenerations.Alargedebtlimitsourgovernment’sabilitytosoftenrecessionsthroughtemporarytaxreductionsandincreasesinexpenditures.Somebelievethatwhenweborrowfromothercountries,webecomebeholdentothemandloseadegreeofsovereignty.Thesecostsoflargedebtaredifficulttomeasurebutsurelyimportant.However,oneconsequenceoflargedebteclipsesalloftheothers:whenourgovernmentborrowstoday,itnecessarilylowersthestandardoflivingofcitizensinthefuture.Thisharmtothefutureisknownastheburdenofthedebt.Themostcompellingargumenttocorrectourfiscalimbalanceisthatourdeficitsaretakingresourcesawayfromourchildrenandgrandchildren.

Whatisthesourceofthisburden?Howlargeisit,ifwefailtogetourimbalanceundercontrol?Letusbeginwiththebasics,andthenturntosomeimportantrefinementsthatshedlightonthetimingandpoliciesneededtodealwithourcurrentproblems.

TheBasics:CrowdingOutandDistortions

Onesourceoftheburdenisthepropensityforgovernmentborrowingto“crowdout”privateinvestmentexpenditures.

Recallthatwhenourgovernmentrunsadeficititmustborrowthefundstocoverthegapbetweenexpendituresandrevenues.Wherewillthesefundscomefrom?Onepossibilityistoobtainthefundsfromothercountries.Forexample,theBankofChinamightpurchasesomeofthegovernmentbonds

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soldtofinancethedeficit.Thisborrowingfromabroadbyourgovernmentcreatesaburdenbecauseinthefuturewewillpayinteresttoourforeigncreditors,andthisinterestmusteventuallycomeoutoftaxesonusorareductioninexpendituresongovernmentprograms.Indeed,presently52percentoftheUSnationaldebtisheldbyforeigncitizensorforeigngovernments,upfrom36percentadecadeago.Theinterestwepayonthisforeigndebtispurchasingpowerthatwecouldotherwisespendongoodsandservicesbut,instead,wearesendingabroad.That’saburdenonourchildren.Here,thegovernment’sborrowingissaidtocrowdoutforeigninvestmentbecausetheseborrowedfundsareanetreductionintheamountourcountryislendingabroad.

AnotherpossibilityisthatthegovernmentobtainsfundsfromUSbusinessesorfinancialinstitutions.Atfirstglance,becauseweareinthiscaseborrowingfromourselves,thispossibilitymayappearbenign:afterall,thetaxesraisedinthefuturetocovertheinterestarejustbeingreturnedtodomesticbanksandbusinesses.Emphatically,suchlogicisflawed.Infact,thefundsborrowedbythegovernmentfromdomesticbusinessesandbankswouldotherwisehavebeenusedtopurchasenewmachines,newstructures,andotherprojectsthatmakeusmoreproductive.Economistscalltheseproductiveresourcesthecapitalstock,andtheincreaseinthecapitalstockiscalleddomesticinvestment.Inthiscase,thegovernment’sborrowingcrowdsoutfundsthatwouldotherwisebeusedfordomesticinvestment,andindoingsowillcausethefuturetohaveasmallercapitalstock.Downtheroad,wewillproducelessthanweotherwisewould.Thislostproduction,relatedtotherateofreturnontheprojectsnotundertaken,isaburden.(Belowwereturntothepossibilityofgovernmentinvestment.)

“Crowdingout”is,forthemostpart,familiartoallofus:ifwecarrydebt,eventuallywemustreduceourdesiredexpenditurestorepaythedebt,oratleastcovertheinterest.Thatreductioninfutureconsumptionisour“burden.”However,thisanalogydoesnotworkperfectly;andestimatingtheburdenofournationaldebtisconsiderablymoresubtlethansimplymeasuringtheinterestpaidonournationaldebt.Foronething,therelevantinterestrateisnottheinterestrateatwhichourgovernmentborrowsbut,instead,thatrateadjustedforinflationandeconomicgrowth.Remember:soundpublicfinanceallowsdebttogrowinagrowingeconomy(keepingtheratioofdebt/gdpconstant),anddebtislessburdensomeifitisrepaidindollarsshrunkbyinflation.Inaddition,thegovernmentdebtisnotidenticaltotheaccumulatedinvestmentthathasbeencrowdedout.Possibly,aportionofthegovernment’sdemandforfundsismetbyincreasedsavingsonthepartofhouseholds,ratherthanbyattractingfundsthatotherwisewouldhavebeenusedfordomesticorforeigninvestment.Ifdeficitsencourageprivatesaving,theburdenonthefutureislessened.Thesizeofsavingsoffsetiscontroversial,becausesomeforcesunleashedbydeficitsandtheeventualpoliciestocorrecttheimbalanceencouragesaving(eg,higherinterestratesandtheanticipationofgreatertaxesinthefuture)whileotherforcesdiscouragesaving(eg,taxesoninterest).Butalmostallbelievethataheftyshareofthegovernment’sborrowingresultsinreducedprivateinvestment.

TheCBO(Dec2010)givesoneestimateofthecostsofourfiscalimbalance.Itsmodelcontainsassumptionsthatareplausibletomanyeconomistsand,hence,providesausefulballparkestimateofourdebtburden,inthefollowingsense.IftheUSfollowsitspresentpolicies,deficitswillgrowasashareofGDPandthedebtwillgrowinrelationtoGDP.(Moreonthis“statusquo”pathinournext

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chapter.)TheUScouldachievesustainabilityin2015(ie,byadjustingtaxesandexpenditurestolimitdeficitstonomorethan3percentofGDPinthatyearandbeyond),oritcouldwaituntil2025toachievesustainability.Ofcourse,ifwewaittenyears,thedebt/GDPratiothatissustainedwillbelarger;andthetaxincreaseand/orexpenditurereductionrelativetothestatusquoneededtoachievethatsustainabilitywillbelarger.Inparticular,ifwewait,wewillhaveallowedthedebttoincreasetoabout115percentofGDPinsteadof75percentofGDP,andthetaxincreaseand/orexpenditurereductionneededtobalancetheannualbudgetisconsequentlyabout3.5percentagepointsofGDPlarger.TheCBOasks:ifwestabilizein2025ratherthanin2015,byhowmuchwillourannualconsumptioninthelongrun(ie,after2025,whentheeconomyhasre‐equilibrated)bereduced?Theansweris(dependingonthepoliciesundertakentoachievesustainability)anywherefrom1.5centsto5centsofconsumptionoutofeachdollarwemake.Thatis,becauseofcrowdingout,foreverypermanentincreaseinthedebt/GDPratioof.1,weharmourdescendentstothetuneof$.40to$1.25onevery$100theyearn,eachyear,forever.Thesearefairlytypicalestimatesoftheburdenofthedebt.

Asecondsourceofburdenistheinevitabledistortionsassociatedwithtaxesorinsufficientprovisionoflegitimatepublicgoods.Aswehavediscussed,whenthegovernmentcreatesdebtitmusteventuallyraisetaxes,orcutexpenditures,sufficientlytokeepthedebtgrowingnofasterthantheeconomyasawhole.Ifwecouldcollectthosetaxesinawaythatdoesnotdistortpeople’sincentivestosave,invest,andwork,thenthecumulativelostinvestmentwouldbetheonlysourceofaburden.However,theactofcollectingtaxes(orcuttingprograms,forreasonsthatwouldtakeusonanunproductivedetour)typicallydistortsincentivesandcreatesinefficienciesinouruseofresourcesinthefuture.Asaconsequence,theverypoliciesrequiredtocorrecttheimbalancetakeatollontheeconomy.

Likecrowdingout,attachinganumbertothedistortionscausedbycorrectivepoliciesisasubtlequestionthathasoccupiedeconomistssinceAdamSmith.Allagreethatwhenyoutaxoneperson,andtransferthatmoneytoanother,somethingislostintheprocess,duetothedistortionsinincentivescreatedbythetax.Allagreethatthisleakinthebucketbecomesmoreserious1)themoresensitiveweareinourdecisionstowork,save,andinvesttothepriceswefaceand2)thegreateristherateoftaximposedontheseactivities.However,thereisarangeofreasonableestimatesofoursensitivity,andthecomplexityofourtaxandexpendituresystemmakestracingincentiveshighlycomplex.Asaballparkestimate,manyeconomistsbelievethateverydollarofnewtaxrevenue,derivedfromanincreaseinincometaxrates,generates$.15to$.5ofhiddencoststotheeconomy.Thus,intheCBOmodelcitedabove,those3.5percentagepointsofGDPoftaxrevenuesthatneedtoberaisedasaresultofwaitinguntil2025haveahiddencostontheorderof0.5to1.75percentagepointsofGDP.Theselossesareinadditiontothe1.5to5percentagepointsofGDPoflostdirectconsumptionresultingfromthecrowdingoutdescribedabove.

Refinements

Uptothispoint,wehavetreatedallgovernmentexpendituresasequallyburdensome,andalltaxesasequallyinefficient.Infact,thereareimportantdifferences.Theproblemswithgovernmentborrowing

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arecrowdingoutandtheinefficienciescreatedbythefuturepoliciesthatclosethegap.Theobviouscorollarytothisobservationisthat,inattackingourimbalance,weshouldtargetforreductionthoseexpenditureswhichgeneratethemostcrowdingoutandfindthosetaxincreaseswhosedistortionsarethesmallest.

Consider,first,theissueofminimizingtaxdistortions.Efficienttaxsystemsexploittheentiretaxbase,havesimilartaxratesatthemarginfordifferentindividualsandactivities,andmakecomplianceeasyandinexpensive.Ourtaxsystemisflawedinmanyways.Thus,manydeficitreductionplans(seenextchapter)proposetaxreformthatwouldsimplifyourtaxsystemandreducemarginaltaxratesbyexpandingthetaxbase,reducingthelevelofemployerbenefitsthancanbeshelteredaspre‐taxdollars,andlimitingdeductionswhicharepoorlytargeted.Thesereformscanbeaccomplishedinawaythatpreservestheprogressivityofourtaxstructure.Inaddition,weoughttoidentifytaxesthatmakeoureconomyoperatemoreefficiently,becausetheycorrectproblemsthatarisewhenourmarketeconomyfailsus.Examplesareagastax(foreigndependency),acarbontax(environmentaldegradation),andataxonsweetenedbeverages(publichealth).Suchreformsarealwaysgoodbutareespeciallytimelytomoderatethedebtburden.

Next,letusreconsidertheissueofthecrowdingoutofcapitalinvestments.Whenwe,ashouseholds,takeoutamortgagetopurchaseahome,orastudentloan,wedosotoacquireanassetthatwillbearfruitinthefuture.Suchborrowingmakesperfectsenseif,inthefuture,thebenefitofourinvestment–forexample,theincreaseinearningsattributabletooureducation–cancoverthedebtservice.Thecalculusissimilarforgovernmentexpendituresthatarethemselvesinvestments,definedasprojectsthatyieldbenefitsinthefuture.Yes,borrowingforsuchexpenditurescrowdsoutformsofprivateinvestment,butthegovernmentinvestmentinitsplaceactstoincreaseourfutureproduction.Ifthegovernmentprojectswouldnototherwisebeundertakenbyprivateinvestorsandyieldarateofreturnatleastaslargeasprivateprojects,thengovernmentborrowingtofinancethoseinvestmentexpendituresmakesperfectsense.Unfortunately,ourgovernmentdoesnotaccountsatisfactorilyfortheportionofexpendituresthatshouldcountasinvestment;so,wecannotjudgehowmuchofitsapparentcrowdingoutisactuallyhelping,ratherthanharming,thefuture.Manyexpendituresyieldfuturebenefitsthatarehardtoquantify.Forexample,howquantifythefuturebenefitstoourcountryofdefensespending,orthefuturesavingstohealthcostsofpreventativemedicinetoday?Despitetheseconceptualdifficulties,thereisevidencethatcarefulspendingoneducation(especiallypreschool),basicscienceresearch,theenvironment,andonprojectstosustainourtransportationandcommunicationsinfrastructurecanyieldatleastacompetitiverateofreturn.Wehavecost‐benefitframeworksthatcanguideus.Reducingsuchexpenditurestocureourcurrentfiscalimbalancemightbepennywisebutsurelywouldbepoundfoolish.Onemajorchallengeintrimmingexpenditureswillbetoidentifyandprotectthoseinvestmentexpenditureswhoseratesofreturncomparefavorablytoprivateopportunities.

Theotherimportantcaseofdeficitswithmodestcrowdingoutiswhendeficitspendingissuccessfulinstimulatingtheeconomyinarecession.Ifgovernmentspending,ortaxreductions,canincreaseourincome,thenthisincreasewillencouragemoreprivatesaving.Asnotedabove,thisnewsavingwillhelp

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tofundthedeficitandoffset,inpart,thereductioninfundsavailabletoprivateinvestors.Anotherroutetothissameconclusionistorecallthatinvestmentexpendituresarepurchasesofnewcapitalgoods.Assuch,theyareacomponentofourdemandforgoodsintheaggregate.Thegovernmentcanstimulatetheeconomybyincreasingthedemandforgoodsintheaggregate,directlythroughitsownpurchasesorindirectlythroughtheprivatespendinginducedbytaxreductions.Thegovernment’sstimulationispowerfulonlyifitisnotoffsetbyreductionsintheothercomponentsofaggregatedemand,suchasinvestmentexpenditures.Fromthisangle,thegreateriscrowdingout,thesmalleristhenetimpactofgovernmentactionsonaggregatedemand,andthesmalleristhenetstimulus.Insum,deficitswhichsuccessfullystimulatetheeconomyarebenign,orevenbeneficial.Thefutureburdenfromcrowdingoutislessenedbythestimulation,andtheemploymentofresourcesthatwouldotherwiselieidleisitselfabenefittosetagainstthisfuturecost.

Howpowerful,inpractice,aregovernmenttaxandspendingpoliciestoinfluenceemploymentandproduction?Economistsdivideonthisissue,butallagreethatthepreconditionsforsuccessfulstimulusare1)unemployedresourcesand2)supportivepoliciesbythecentralbanktopreventtheincreaseininterestrates(andvalueofthecurrency)thatwouldotherwiseaccompanytheactionandchokeoffinvestment.WithunemploymentintheUSnear9percentandaFederalReserveintentonkeepinginterestratesandvalueofthedollarlow,theUSisnowinpreciselythecircumstanceswhenstimulusthroughfiscalactionscanwork.Asaconsequence,manyeconomistsrecommendthatthesignificantreductionsinspendingorincreaseintaxesrequiredtoeliminateourimbalancebedelayedwhiletheeconomyisweak,i.e.untilthesepreconditionsforstimulusarenolongerwithus.Actingearlierdelaystherecoveryandhasminorimpactsonthecrowdingoutofconcern.

TogaugethestimulationandburdenofUSfiscalpolicies,weturnagaintotheanalysisoftheCBO(Nov2010).AsizeableportionofthepresentUSbudgetdeficitisattributabletothetaxcutsandexpenditureincreasesthathappenautomaticallywhenoureconomydeclinesandhappenasaresultofactivegovernmentstimulus.ThebestknownofthelatterwastheAmericanRecoveryandReinvestmentAct(ARRA)of2009,whichincreaseddeficits2009‐2011(mainly)ontheorderof$800billion(accordingtoCBOestimates).(OtheractivestimulusmeasureswereapartoftheDecember2010taxextension,whichwilladdroughly$200billionofdeficits(inadditiontothedelayoftaxincreases),andtheTroubledAssetReliefProgram(TARP)whichaddedanestimated$15billiontogovernmentexpenditures.)BecausethesemeasureswereundertakenwhentheeconomywasslackandwiththeassistanceoflowinterestratesmaintainedbytheFederalReserve,theyincreasedproductionand(throughtheadditionalprivatesavingsthatincomespawned)didnotcrowdoutinvestmentdollarfordollar.Howmuchwascrowdedoutand,theflipside,howmuchtheeconomywasstimulated,areuncertain,buttheCBOprovidesarangeofestimatesthatspantheopinionsofmosteconomistsandtheirmodels.The$800billionofARRAdeficitsaddedsomewherebetween$480to$1200billiontoGDP;$800billionisaconvenientconsensusestimate.Theseestimatesofstimulusdonot,inthemselves,indicatethedegreeofcrowdingout.Tocompletethepicture,wemustpositapropensityofUShouseholdstosaveanadditionaldollarofincome.Forthesakeofdiscussion,weselect30centsofeachdollarsaved,anumberwithinarangeplausibletomosteconomists.

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Withthesenumbersinhand,wecanestimate1(anupperbound)onthecrowdingoutassociatedwithARRA.Forthosewhobelieveinastrongstimulusof$1200b,thecrowdingoutisonly$280b:averyfavorabletradeoff.Attheotherextreme,thosewhobelieveinasmallstimulusof$480bwouldpredictacrowdingoutof(atmost)$500b.Conservativepoliticiansarepronetoassertthatrecentstimulusmeasureshavebeenineffectiveandshouldbeabandoned.Conservativeeconomists,atthelowerendofthebeliefinstimulus,wouldgiveamorenuancedassessment:fiscalpolicycanwork,buteachdollarofcurrentGDPcreatedoutofidleresourcesdrawsapproximatelyonedollarfromfutureincome.Forthoseinthemiddle,undertheconsensusestimateofastimulusof$800b,thecrowdingoutisonly$400b.Yes,thereisaburden,butforeverydollaroflossinthefuture,twodollarsaregainedinthepresent.

Thesearethedimensionsofthetrade‐offrelevantfordeficitreductionsduringperiodsofhighunemploymentandsupportivemonetarypolicies.Aswelooktothefuture,theeconomywilleventuallyrecover.Andthenwemusttacklethedifficultproblemofhowtoachieveasustainabledeficit,towhichwenowturn.

FOUR:THEHARDCHOICES

In2001,whentheUSwasalmostfullyemployed,itranabudgetsurplusof1.3percentofGDP.In2008,whentheUSeconomywasjustbeginningtoexperiencetheslumpwhichprevailstothisday,thebudgetwasindeficitequalto3.2percentofGDP.Nowmiredinthatdownturn,theUSin2011islikelytoexperienceabudgetdeficitontheorderof9.8percentofGDP.Howdidwegethere?Whatdoesthefutureholdifwefailtoact,andwhatarethedimensionsofthesacrificesrequiredtoachieveasustainablebudget?InthischapterweexplorekeycomponentsoftheUSbudgettoshowhowthedeficithasemerged,andplanstobringitbackintosustainability.

Tounderstandthesourcesofandpotentialsolutionstoourimbalance,letusreviewthestructureoftheFederalbudget,assummarizedinTable3.Inthistable,webreakdowntheFederalbudgetintoitsmajorrevenueandexpenditurecategories,fortheyears2001,2008,and2010.TheTableshowsthevariouscategoriesintermsofdollarsandassharesoftheGDP,anditrecordsthepercentagerateofchangeoftheseveralcomponentsbetweenthedifferentyears.Asisevident,revenuesoftheFederalgovernmentaremainlytaxes,andthebulkofthosetaxesarecollectedonhouseholdincomesinthe1Theseestimatesareillustrativeandtheauthors’calculations.TheARRAinvolvedmanykindsofexpenditureincreasesandtaxreductions,eachwithitsownmultipliedimpactontheGDP.Herewesimplifythepackageandsupposethatitinvolved$267bofanincreaseinspendingongovernmentpurchasesofgoodsandservicesand$533ofareductionintaxesand/orincreaseintransferpayments.Weassumeamultiplierof1(minimum)to2.5(maximum)fortheformerexpendituresandamultiplierof0.4to1forthelatterreductionsinnettaxes.(ThesemultipliersareinlinewiththeCBOranges.)Toobtainanupperboundonthesizeofcrowdingout,weassumethatprivatesavingisnotincreasedbytheincreaseininterestratesortheexpectationsoffuturetaxincreasesthatarelikelytoaccompanythefiscalstimulusandisaffectedonlybychangesindisposableincome.

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formofindividuals’incometaxesandthepayrolltaxforsocialinsurance.In2010,forexample,almost80percentofgovernmentrevenuecamefromthesetwosources,withtheindividuals’incometaxcomprisingthelargestshare.Federalgovernmentexpenditureisdividedintothreecategories:so‐calledmandatory,discretionary,andinterestexpenses.MandatoryexpendituresarisefromprogramswhoserulesforeligibilityandlevelofbenefitaresetbytheLegislatureandwhoseoutlayinanyparticularyearisdeterminedbythoserulesratherthananexplicitdollarallocation.Theseprograms,alsoknownasthe“entitlements,”includesocialsecuritypayments,paymentsforhealthinsurancefortheelderly(Medicare)andpoor(eg,Medicaid),andvariousincomesupportprograms,suchasunemploymentcompensationandfoodstamps.Inrecentyears,mandatoryexpenditureshavecomprisedabout60percentofallnon‐interestexpendituresandaredominatedbysocialsecurityandMedicare.DiscretionaryexpendituresareexplicitdollarallocationsvotedbytheLegislatureeachyear.Theyincludenationaldefenseandthemanycorefunctionsofgovernment(salariesofgovernmentofficialsandemployees,education,environment,transportation,andsoon).Foreignaidspendingisalsodiscretionary;atroughly0.3percentofGDP,itisatinycomponentofthebudget,toosmalltoshowonitsown.Thediscretionaryexpenditurescompriseabout40percentofnon‐interestexpenseandareaboutequallydividedbetweennationaldefenseandotheruses.TheseotheruseshavebeenthebattlegroundinCongressinrecentmonths.Asyoucanseefromthetable,theseskirmishesovernon‐defensediscretionaryexpenditureshavebeenfoughtonasmallbattlefield,comprisingonly4.5percentoftheGDPandlessthan18percentofallnon‐interestspending.Thefinalspendingcategoryisinterestonthenationaldebtheldbythepublic,whichin2010wassmallinrelationtotheGDP(1.4percent)andtotalFederalexpenditures(5.7percent).InapparentoppositiontotheincreaseovertimeinthenationaldebtinrelationtoGDP,theFederalinterestexpenseasashareofGDP(andasashareoftotalgovernmentspending)fellduringthedecade.Thisremarkabledeclineisaresultofexceptionallylowinterestrates,byhistoricalstandards,paidbytheUSTreasury;andisatrendthatsurelywillnotcontinue.

Table3showsthegrowthratesfrom2001to2008inrevenues,expenditures,andtheGDPmeasuredincurrentdollars.Weseereadilywhyadeficitemergedduringthisperiod,andthatitssourceswerebroadbased:duringthisperiod,everyimportantcomponentofexpendituregrewfasterthandidGDP,andeverykeycomponentofrevenuegrewmoreslowly.However,afewofthebudgetlinesstandout:defenseandMedicarewerethefastestgrowingexpenditurecategories,andtheindividualincometax(whichnormallywouldgrowfasterthanGDPaspeoplearepushedintohighertaxbrackets)grewlessthanhalfasrapidlyasdidGDP.Thereasonsforthesetrendsareapparent:warsinIraqandAfghanistan,anexpensivenewbenefitforprescriptiondrugsinMedicare(PartD),andsignificantreductionsintaxratesin2001and2003.Thesefactorsrevealastructuralimbalanceofroughly$400billion(ie,thedeteriorationinthefullemploymentbudgetbalance)thathappenedjustastheeconomybeganitsdownwardslidein2008.

Thechangesfrom2008to2010shownintheTable(2008comparedtotheestimated2011showsasimilarstory)revealstheimpactoftherecession:despitestagnantGDP,taxrevenuesdeclinedsharply,and(althoughallexpenditurescontinuedtogrow)incomesupportsuchasunemployment

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compensationandnon‐defensediscretionaryexpendituresbecamethefastestgrowers.ThesechangesevidencetheautomaticresponseoftaxcollectionsandincomecushionstotherecessionandtheexplicitstimulusmeasuresenactedbyCongress.Aswediscussedinourfirstchapter,theCBOestimatestheautomaticcushionatroughly$350billion,thedifferencebetweentheactualdeficitandthestructuraldeficit.Thestimulusmeasures(mainlyARRAplusthenegativeTARPadjustment)addedabout$300billiontothedeficitin2010,someindiscretionaryspendingbutalsointaxreductionsandincomesupport.

Thesethreecomponents–thestructuralimbalancethatemergedsince2001,theautomaticresponsetothedownturn,andthepoliciesenactedtodealwithit–accountformuchofthedeficitweexperiencetoday.Butthislogicalsohasaharshmessage:arollbackofthestimulusmeasuresandtheeventualre‐achievementoffullemployment(hopedforin2015)cannotalonebringusbacktosustainability.Thatstructuralimbalanceisnotgoingaway.Inaddition,powerfulforcesarebeginningtofuelgrowthinthemandatoryexpendituresinexcessofGDPgrowth.Thebabyboomersarestartingtoretireandtolivelonger,andthisagingofthepopulationcausessocialsecurityandMedicarepaymentsundercurrentbenefitrulestogrowmorerapidlythanGDP.Also,largelyasaresultofnewlyavailabletreatmentsandtechnologies,andasystemwhichoffersfewincentivesforpatientsorproviderstoeconomizeoncosts,healthcarespendingperindividualhasincreasedalmost2percentperyearfasterthanthegrowthofincomeperperson,formanyyears.Ifthistrendcontinues,thenthehealth‐relatedmandatoryexpenditureswillexplode.

InMarch2010theCBOprojectedtheFederalbudgetintothefutureunderdifferentscenarios.(Developmentssincethattimemakethesituationevenmoredaunting;seeCBOMarch2011.)Theseprojectionsarehighlyspeculative,formanyreasons,butarenon‐partisanandthebestavailable.Inonescenario,whichwewillcallthestatusquo(andtheCBOlabels“thealternativefiscalscenario”),theCBOtriedtocapturehowthebudgetwouldevolveifwecontinuewhatwe’redoing,inthefollowingsenses:i)benefitrulesformandatoryprogramsstayas‐is,andhealthcosttrendscontinuetheirhistoricalpatternofincrease;ii)ourtaxcoderesemblesthesystemthatwasextendedinDecember2010,exceptthattaxratesforthewealthy(+$250Kformarried)revertbackto2001levelsandestatetaxesrevertbackto2009features;andiii)thestimulusmeasuresarephasedoutanddiscretionaryspendingafterwardsgrowsinlockstepwithGDP.Inaddition,after2020,theprojectionsassumethatthetaxcodewillbeadjustedtokeeprevenuesaconstantshareofGDP.InTable4,weshowthestatusquoprojectedrevenuesandexpenditures,assharesofGDP,inyears2020and2035.Aswell,weincludetheactualsharesinthebenchmarkyearscoveredinTable3.

Themessageoftheprojectionissobering:

*overthenextdecade,debtwillcontinuetoriseinrelationtoGDPandreachroughly87percentin2020.Thedeficitatthattime,approximately6.6percentofGDP,willnotstabilizethedebt/GDPratiointosubsequentyears.Evenabrakeondiscretionaryspendingthatholdsexpendituresotherthanthoseoninterest,socialsecurity,andhealthto2001levelsrelativetoGDP(savingabout1.3percentofGDPofdeficit)isnotnearlyenoughtoachievesustainabilitybythatdate.

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*after2020,socialsecurityandhealthobligationsreallykickin:incomparisonto2020,underthestatusquo,in2035theseentitlementscomprise4.7percentmoreofthenationalproduct.Suchdevelopments,andinterestontheaccumulatedborrowing,generateadeficitofalmost16percentoftheGDPin2035andadebt/GDPratioof1.85.Ifweshouldreachthatstage,achievingsustainabilitywouldrequireanincreaseintaxes,orcutinnon‐interestspending,ontheorderof10percentofGDP.Thatisaverytallorder.

What’smore:theseprojectionsareanoverlyoptimisticvisionofthestatusquo,becausegovernmentborrowingofthismagnitudewouldleadtoslowerGDPgrowth,andbiggerinterestrates,thanusedintheexercise.

Theseprojectionsarearealitycheck.Wecan’tgrowoutofourdebtproblem:theprojectionsalreadyaccountfortheeffectoftheeconomy’sgrowthontaxcollectionsandtheeliminationoftemporarystimuluswhenfullemploymentisachieved.Highertaxesontherichwillnotinthemselvessolvetheproblem:these,too,arealreadyinthemodel.Abrakeonnon‐defensediscretionaryspending(ofwhichthemuchdiscussed“earmarks”andforeignaidareatinyfraction)isnotenough:atlevelsofnon‐defensediscretionaryspendingtypicaloffullemployment(forexamplethe3.6percentofGDPin2008),eliminationofeverydollaroftheseprogramswouldnotbeenoughin2020tobringaboutasustainabledeficitoflessthan3percentofGDP.Rather,theprojectionsmakeevidentthattheactionsnecessaryforasustainablebudgetpatharepreciselytheoptionsthatnoonewantstotalkabout:weMUSTeitheri)reducediscretionaryspending,includingdefense,asashareofGDP;and/orii)collectmoretaxes,asashareofGDP,thanwehaveinrecenthistory;and/oriii)reformentitlements,especiallythenationalhealthinsuranceprograms.

Indeed,anysensibleandsuccessfuldeficitreductionplanthatwecanimaginewillinvolveadoseofallthreeoftheseoptions.Ideally,wewouldcutspendingonprogramswiththelowestfuturepayoffsandraisetaxesinawaythatinducestheleastharm.Benefitcostanalysiscanhelpguideushere,butpeoplewilllikelydisagreeontherelativevalueofprogramsandrelativeharmcausedbyvarioustaxes.Thepoliticalcompromisesneededtobringaboutanagreementrequirethatallsidesgiveupsomething.Aplancannotbesuccessfulunlessitisregardedasfair.Thissimplyreflectspoliticalreality:amajorityofAmericanswillsupportnecessarilypainfuldeficitreductiononlyifitbelievesthesacrificeisshared.Butalso,mosteconomistswouldviewabroad‐basedapproachassensible.Ineverydaylife,whenwereduceourspending,wetypicallycutbackonallexpenditures.Ifwe,asindividuals,werefacedwiththechoiceofreducingsomegovernmentprograms(likenationaldefenseoraidtofarmersoraccesstoournationalparksoraidtotheunemployedorhungry)orreducingourownconsumptionbyhighertaxes,likelywewouldchooseabitofboth.Ifwe,asindividuals,werefacedwiththechoiceofgivingupspendingwhenweareyoung(socialsecuritytaxes)and/orwhenweareold(socialsecuritybenefits,Medicare),likelywewoulddoabitofboth.Writlargeinthebudget,thesearethewaysdeficitreductionaffectsus,asindividuals.Mostofus,uponreflection,wouldoptforthesamebroad‐basedreductioninallformsofourconsumptionaswedoineverydaylife.

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Theneedforsharedsacrificeisevidentintherecommendationsoftwoprestigiousandmuch‐publicizedbipartisanbudgetplans,oneproposedbytheNationalCommitteeonFiscalResponsibilityandReform,chairedbyErskineBowlesandSenatorAlanSimpson(B&S,Dec2010),andtheotherproposedbytheDebtReductionTaskForce,chairedbySenatorPeteDominiciandDr.AliceRivlin(D&R,Nov2010).Thesegroupshadtomakedecisionsonmanydimensions,includingwhen,andatwhatlevelofindebtedness,theUSshouldreachsustainability;whatareasofthebudgetshouldbeartheburdenofgettingthere;andhowthenecessarypoliciesshouldbephasedinovertime.Itisthereforestrikingthat,inbroadoutline,therecommendationshavemuchincommon.Inparticular:

*eachrecommendsatargetdebt/GDPratioofapproximately60percent,andadeficit(ofroughly3‐2percentofGDP)thatatleastsustainsthatratio,by2020;

*tosupportthefragilerecovery,eachrecommendsnosignificantdeficitreduction(indeed,noreductionsindollardiscretionaryexpenditures)until2013.Underbothplans,debtrelativetoGDPwouldpeakatapproximately70percentinthatyear,andinthatyeardeficitsforthefirsttimewouldbesmallenoughtoeatawayatthatratio;

*bothplanswouldemploythefullrangeofbudgetaryremedies.Bothwouldrollbackdiscretionaryspending,onbothdefenseanddomesticprograms,asashareofGDP,toatmost2001standards.BothwouldincreasetotaltaxcollectionsasashareofGDPrelativetothestatusquowhilesimultaneouslyreducingmarginaltaxratesandsimplifyingthetaxcodebyeliminating,orbytargetingbetter,manyofthedeductionsandcreditscurrentlyallowed.Eachwouldfindsavingsinsocialsecuritybenefitsbyincreasedmeans‐testing,bycalibratingpaymentsandretirementagetoincreasedlifeexpectancy,andbyindexingtoacostoflivingmeasurethatismoreaccuratethatusedcurrently.Eachwouldattempttocontrolthegrowthofhealthcarecostsbyintroducingincentivesforprovidersanduserstoeconomizeandbyloweringexpenses,suchasthoseofprescriptiondrugsandmalpractice.Bothplansacknowledgethatexpenditure/gdpmustriseoverhistoricalaveragesinresponsetoouragingpopulation,risinghealthcosts,increasedhomelandsecurityneeds,andhigherinterestexpenses;

*bothplansenvisionmodestdeficitreductionfromentitlementreform2012‐2020(becauseofthecomplexityofreformandtheneedtofulfillcommitmentstotoday’sretired)butregardpromptreformsasessentialtolongrunsustainability.

Tobesure:theplansdifferinthedetailsoftheirhundredsofrecommendedpolicychanges.Thetaxandentitlementreformsarecontroversialandcomplexandwillbedebatedatlength.Butthecommonmessageofthesetwoeminentandbi‐partisangroupscapturesamiddlegroundaboutthesizeofnecessaryadjustmentsthatmanyeconomistswouldendorse.

Theseplansalsoillustrateakeydifferenceinperspectives:theextenttowhichsustainabilityshouldbeachievedthroughtaxincreasesorexpenditurereductions.TheB&Sproposalwouldachieveroughly2/3ofitsdeficitreductionthroughreductionsingovernmentprogramsand1/3throughincreasesintaxrevenues(relativetothestatusquo).TheR&Dproposalwouldachieveasimilardeficitreductionwithalesserrelianceonprogramcuts:expenditurereductionsandtaxrevenueincreaseswouldeach

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contributetoroughlyhalfofthegoal.Inbothplans,taxesandspendingwouldreachhistoricallyhighproportionsofGDPin2020(andbeyond).B&Srecommendataxshareof20.6percentin2020,wouldreducediscretionaryexpendituressharply(to5.3percentofGDPin2020,andashareof“other”of7.3percent),andwouldholdoverallspendingto21.6percentofGDPattheendofthedecade.Incontrast,D&Rrecommendthelargertaxrevenues(21.3percentofGDPin2020,inpartachievedthroughanationalsalestax)and,correspondingly,asmallerreductionindiscretionaryexpendituresrelativetothestatusquo,andalargeroverallspendingshareof23percentin2020.

Doesthebalanceofspendingandtaxesmatter?TheR&Dplanwouldprovidemorestimulustoaneconomywhichisexpectedtohaveexcessiveunemploymentuntil2015,becauseexpenditurereductionsdiminishaggregatedemandmorethandotaxincreases.TheB&Splancutsdomesticdiscretionaryexpendituressodeeplythatgovernmentinvestmentsarelikelytobereduced.However,theB&Stemplatewillbefavoredbythosewhoemphasizetheinefficienciescreatedbytaxesandwhojudgesomegovernmentprogramsaslessessentialthantheprivateconsumptiontheyreplace.

Theseissues,andthegiantcomplexitiesofreformingourtaxcodeandmodeofhealthcareprovision,arethelegitimatefocusofthedebateoverourdeficitthatmusttakeplaceoverthenexttwoyears.Thesoonerdebatecanoccupythismiddleground(ratherthantheextremesofnochangeinentitlementsortotaxrevenues)thebetter.

BOOKS,ARTICLES,ANDDATABASESCITED

ErskineBowlesandSenatorAlanSimpson,co‐chairsoftheNationalCommissiononFiscalResponsibilityandReform,TheMomentofTruth,December,2010

CongressionalBudgetOffice(CBO),“LongTermBudgetProjections,”June,2010

CBO,“FederalDebtandtheRiskofaFiscalCrisis,”July,2010

CBO,“EstimatedImpactoftheAmericanRecoveryandReinvestmentActonEmploymentandEconomicOutputfromJuly2010throughSeptember2010,”November,2010

CBO,“EconomicImpactsofWaitingtoResolvetheLong‐TermBudgetImbalance,”December,2010

CBO,“TheBudgetandEconomicOutlook:FiscalYears2011to2021,”January,2011

CBO,“ReducingtheDeficit:SpendingandRevenueOptions,”March,2011

SenatorPeteDominiciandDr.AliceRivlin,co‐chairsoftheDebtReductionTaskForce,RestoringAmerica’sFuture:RevivingtheEconomy,CuttingSpendingandDebt,andCreatingaSimple,Pro‐GrowthTaxSystem,”November,2010

InternationalMonetaryFund,WorldEconomicOutlookDatabase,October,2010

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CarmenM.ReinhartandKennethS.Rogoff,ThisTimeisDifferent:EightCenturiesofFinancialFolly,PrincetonUniversityPress,Princeton,NJ,2009

Table1FederalRevenue,Expenditure,andDeficitsasPercentofGDP

GDP

PotentialGDP GDPgap

Revenue/GDP

Expenditure/GDP

Deficit/GDP

StructuralDeficit/potentialGDP

PubicDebt/GDP

1971 1,080 1,094 ‐1.32 17.3 19.5 ‐2.13 ‐1.7 28.1 1972 1,177 1,181 ‐0.39 17.6 19.6 ‐1.99 ‐1.9 27.4 1973 1,311 1,272 3.04 17.6 18.7 ‐1.14 ‐2.2 26.0 1974 1,438 1,411 1.92 18.3 18.7 ‐1.49 ‐1.2 23.9 1975 1,560 1,617 ‐3.50 17.9 21.3 ‐3.41 ‐2.2 25.3 1976 1,738 1,791 ‐2.93 17.1 21.4 ‐4.24 ‐2.9 27.5 1977 1,974 2,000 ‐1.35 18.0 20.7 ‐2.72 ‐2.1 27.8 1978 2,217 2,209 0.39 18.0 20.7 ‐2.67 ‐2.8 27.4 1979 2,501 2,473 1.14 18.5 20.2 ‐1.63 ‐2.1 25.6 1980 2,724 2,771 ‐1.69 19.0 21.7 ‐2.71 ‐2.1 26.1 1981 3,057 3,113 ‐1.81 19.6 22.2 ‐2.58 ‐1.7 25.8 1982 3,224 3,419 ‐5.71 19.2 23.1 ‐3.97 ‐1.8 28.7 1983 3,441 3,677 ‐6.43 17.5 23.5 ‐6.04 ‐3.3 33.1 1984 3,844 3,926 ‐2.09 17.3 22.2 ‐4.82 ‐3.9 34.0 1985 4,146 4,187 ‐0.97 17.7 22.8 ‐5.12 ‐4.7 36.4 1986 4,404 4,428 ‐0.54 17.5 22.5 ‐5.02 ‐4.7 39.5 1987 4,651 4,690 ‐0.83 18.4 21.6 ‐3.22 ‐2.9 40.6 1988 5,008 4,990 0.37 18.2 21.3 ‐3.10 ‐3.2 41.0 1989 5,399 5,342 1.07 18.4 21.2 ‐2.83 ‐3.3 40.6 1990 5,734 5,706 0.49 18.0 21.9 ‐3.85 ‐4.1 42.1 1991 5,930 6,091 ‐2.64 17.8 22.3 ‐4.54 ‐3.5 45.3 1992 6,242 6,414 ‐2.68 17.5 22.1 ‐4.65 ‐3.4 48.1 1993 6,587 6,729 ‐2.10 17.5 21.4 ‐3.87 ‐2.9 49.3 1994 6,977 7,062 ‐1.21 18.0 21.0 ‐2.91 ‐2.3 49.2 1995 7,341 7,423 ‐1.10 18.4 20.6 ‐2.23 ‐1.8 49.1 1996 7,718 7,796 ‐1.00 18.8 20.2 ‐1.39 ‐0.9 48.4 1997 8,212 8,192 0.24 19.2 19.5 ‐0.27 ‐0.3 45.9 1998 8,663 8,575 1.03 19.9 19.1 0.80 0.4 43.0 1999 9,208 8,994 2.39 19.8 18.5 1.36 0.4 39.4 2000 9,821 9,503 3.35 20.6 18.2 2.41 1.0 34.7 2001 10,225 10,086 1.39 19.5 18.2 1.25 0.5 32.5 2002 10,544 10,602 ‐0.55 17.6 19.1 ‐1.50 ‐1.3 33.6 2003 10,980 11,149 ‐1.52 16.2 19.7 ‐3.44 ‐2.8 35.6 2004 11,686 11,733 ‐0.40 16.1 19.6 ‐3.53 ‐3.3 36.8 2005 12,446 12,398 0.39 17.3 19.9 ‐2.56 ‐2.7 36.9 2006 13,225 13,123 0.78 18.2 20.1 ‐1.88 ‐2.2 36.5 2007 13,892 13,851 0.29 18.5 19.6 ‐1.16 ‐1.3 36.2 2008 14,394 14,513 ‐0.82 17.5 20.7 ‐3.19 ‐2.9 40.3 2009 14,098 15,020 ‐6.14 14.9 25.0 ‐10.02 ‐7.3 53.5 2010 14,513 15,397 ‐5.74 14.9 23.8 ‐8.92 ‐6.1 62.1

Source: "Budget and Economic Outlook: Fiscal Years 2011‐2021," CBO, January 2011. GDP and Potential GDP in current dollars; the GDP gap is the percentage difference between actual output and potential output; and the other columns are percentages of GDP.

Table2:InternationalComparisons

Debt/GDP

Deficit/GDP

StructuralDeficit/potentialGDP GDPgap

Revenues/GDP

Canada 30.6 ‐5.2 ‐3.3 ‐3.1 38.0France 71.4 ‐7.8 ‐5.0 ‐3.7 48.4Germany 57.3 ‐3.8 ‐2.0 ‐3.3 43.2Greece 103.2 ‐10.7 ‐11.5 1.5 38.2Italy 97.9 ‐5.2 ‐3.7 ‐3.3 46.3Ireland 45.8 ‐16.1 ‐9.0 ‐6.4 34.9Japan 116.2 ‐9.9 ‐7.4 ‐6.0 29.8Portugal 75.5 ‐8.3 ‐7.1 ‐1.5 39.6UK 64.9 ‐10.2 ‐8.1 ‐3.4 36.7US 62.3 ‐12.0 ‐7.6 ‐5.5 30.3Source: IMF "World Economic Outlook Database," October, 2010; all numbers are percentages of GDP; the GDP gap is the percentage difference between actual output and potential output; revenues are government tax revenues. Government refers to all levels of government, not just Federal.

Table3:ComponentsofSpendingandRevenues

2001 2008 2010

Percentchange01‐08

Percentchange08‐10 2001/GDP 2008/GDP 2010/GDP

Revenues IndividualIncomeTax 994.3 1145.7 898.5 13.2 ‐27.5 9.7 8.0 6.2

SocialSecurity+MedicareTaxes 694 890.9 864.8 22.1 ‐3.0 6.8 6.2 6.0

Total 1991.1 2524 2161.7 21.1 ‐16.8 19.4 17.5 14.9 MandatorySpending

SocialSecurity 429.4 612.1 700.7 29.8 12.6 4.2 4.3 4.8Medicare 237.9 456 520.4 47.8 12.4 2.3 3.2 3.6Medicaid 129.4 201.4 272.8 35.7 26.2 1.3 1.4 1.9

UnemploymentInsurance 143.1 260.7 437.7 45.1 40.4 1.4 1.8 3.0

Total 1007.6 1594.8 1909.6 36.8 16.5 9.8 11.1 13.2 Non‐Mandatory

Defense 306.1 612.4 689.1 50.0 11.1 3.0 4.3 4.7Non‐defense 342.9 522.5 660.1 34.4 20.8 3.3 3.6 4.5

Total 649 1134.9 1349.2 42.8 15.9 6.3 7.9 9.3 Interest 206.2 252.8 196.9 18.4 ‐28.4 2.0 1.8 1.4 Deficit 128.2 ‐458.6 ‐1294.1 1.3 ‐3.2 ‐8.9StructuralDeficit 49 ‐425 ‐935 0.5 ‐3.0 ‐6.4GDP 10255 14394 14513 28.8 0.8 Inflation 22.0 1.0 Source: historical data in CBO "The Budget and Economic Outlook: Fiscal Years 2011 to 2021," January, 2011. The first three columns are in current dollars; the last three are percentages of GDP.

TABLE4:ActualandProjectedSpending,RevenuesandDeficitsasPercentofGDP 2001 2008 2010 2020 2035FederalRevenues 19.4 17.5 14.9 19.3 19.3 TotalNon‐InterestSpending 16.1 18.9 22.4 22.1 26.5SocialSecurity 4.2 4.3 4.8 5.2 6.2Medicare 2.3 3.2 3.6 4.3 7Medicaid/otherhealth 1.3 1.4 1.9 2.9 3.9Other 8.4 10.1 12.1 9.7 9.3 InterestSpending 2 1.8 1.4 3.8 8.7 Deficit(positiveissurplus) 1.3 ‐3.2 ‐8.9 ‐6.6 ‐15.9 Debt 32.5 40.3 62.1 87 185Source:CBO, "The Long Term Budget Outlook," June, 2010;andCBO "The Budget and Economic Outlook: Fiscal Years 2011 to 2021," January, 2011. Figures for 2001, 2008, and 2010 are actuals but 2020 and 2035 are the CBO's "Alternative Fiscal Scenario" -- our version of an expected status quo path.

Figure1

Figure2

Source:authorsgraphfromCBOdatain"BudgetandEconomicOutlook:FiscalYears2011‐2021,"CBO,January2011.

Figure3 FederalRevenuesandSpendingasProportionofGDP

Note:bluelineisfederalexpenditureasproportionofGDP;redlineisfederalrevenuesasproportionofGDP.Source:FederalReserveofStLouisFREDdata.http://research.stlouisfed.org/fred2/