Four Observations about the Federal Budget

March 7, 2011

I spoke this morning to the Economic Policy Conference of the National Association for Business Economics. My talk was structured around four observations about the federal budget:

First, if current policies are continued, the gap between spending and revenues will remain very large even after we return to normal economic conditions.

If current laws remain unchanged, as we assume for CBO’s baseline projections, budget deficits would drop markedly over the next few years as a share of output. Still, debt held by the public would reach 77 percent of gross domestic product (GDP) in 2021. However, that projection understates the budget deficits that would occur if many policies currently in place were continued, rather than allowed to expire as scheduled under current law. Suppose instead that: the higher 2011 exemption amount for the alternative minimum tax was extended and, along with the AMT tax brackets, was indexed for inflation; the other major provisions in December’s tax legislation that affected individual income taxes and estate and gift taxes were extended, rather than allowed to expire in January 2013; and that Medicare’s payment rates for physicians’ services were held constant, rather than dropping sharply as scheduled under current law. Then, debt held by the public in 2021 would rise to almost 100 percent of GDP, the highest level since 1946.

Federal Debt Held by the Public Under CBO's Baseline or with a Continuation of Certain Policies, Compared with Past Debt

(Percetage of GDP)

Second, fiscal policy cannot be put on a sustainable path just by eliminating waste and inefficiency; the policy changes that are needed will significantly affect popular programs or people’s tax payments or both.

One way to see this point is to realize that combined outlays for just a handful of large federal programs will exceed total revenues in the second half of the coming decade, assuming the continuation of the policies mentioned above. Specifically, under that assumption, CBO projects that outlays for Social Security, Medicare, Medicaid, other health programs, defense, and net interest will pass total revenues by 2016 and not look back.

Note also that outlays for that handful of programs will exceed 18 percent of GDP by 2016 and reach 20 percent of GDP by 2021. Some proposals would cap federal spending at 18 percent or 20 percent of GDP. That is possible, but it would require cuts in at least one of these major programs even if everything else the government did was eliminated, not just cut sharply.

Outlays for Some Major Federal Programs Compared with Total Federal Revenues (Percentage of GDP)

Third, policymakers face difficult tradeoffs in deciding how quickly to implement policy changes that would reduce future budget deficits.

On the one hand, reducing deficits only gradually would lead to higher government debt, which would have several negative consequences (for more information, see CBO's analyses of the risk of a fiscal crisis and of the economic effects of waiting to resolve the fiscal imbalance). In particular, rising debt:

  • Reduces the amount of U.S. savings devoted to productive capital investment.
  • Requires greater federal spending on interest payments.
  • Gives policymakers less flexibility to respond to unexpected problems.
  • Increases the likelihood of a fiscal crisis during which investors would lose confidence in the government's ability to manage its budget and the government would lose its ability to borrow at affordable rates.

On the other hand, implementing major budgetary changes gradually would have some advantages:

    • Possibly helps older generations by deferring the increases in taxes or the cuts in benefit payments they would face.
    • Minimizes the drag of spending cuts or tax increases on the economic expansion. Cutting spending or raising taxes right now would probably lead to less output and employment now even though it would be good for the economy over time.
    • Gives families, businesses, and state and local governments time to plan and adjust. If policymakers chose to scale back benefit programs, cut government contracts, reduce grants to state and local governments, or raise taxes, those who would be affected would benefit from advance notice so they can alter their behavior.

    Although there are tradeoffs in deciding how quickly to implement policy changes that would reduce future budget deficits, there are important benefits to deciding quickly what specific combination of reductions in spending and increases in taxes will be used to put fiscal policy on a sustainable path. Most important, enacting policy changes soon would allow for gradual implementation of those changes while still limiting further increases in federal debt and the negative consequences that would flow from those increases. Moreover, enacting policy changes soon would probably provide some boost to economic activity by reducing uncertainty and holding down interest rates.

    Fourth, there is more focus in Washington on federal budget problems today than there has been since the late 1990s, and that focus has led to a range of proposals for tackling the problems.

    Members of the bipartisan National Commission on Fiscal Responsibility and Reform, created by the President, recently proposed a plan to narrow the budget gap. The plan would reduce the costs of federal health care programs by altering the degree of cost sharing required of beneficiaries, changing malpractice laws, and limiting federal costs for prescription drugs. It would also decrease mandatory spending on Social Security, agriculture programs, and military and civil service retirement; reduce defense and nondefense discretionary spending; and increase revenues, mainly by eliminating various tax preferences—such as special exclusions, exemptions, or deductions—and thus broadening the tax base.

    Other groups and individuals have also released plans focused on reducing the deficit. The plans reflect widely varying priorities, with some emphasizing spending cuts and others emphasizing tax increases. However, the plans are similar in some significant ways, because they propose policy changes that are: large in magnitude; are fairly well-specified; and would fundamentally alter the tax code and some of the activities of the government. Changes of such broad scope will be necessary to put the federal budget on a course that is sustainable for the long run.