Presentation at the Macroeconomic Advisers’ Washington Policy Conference

September 15, 2011

Yesterday I spoke at the Macroeconomic Advisers’ Washington Policy Conference. My presentation focused on the significant and fundamental budgetary challenges facing our nation. I thought I’d spend the majority of this blog post discussing the latter part of my presentation—some alternative broad changes in federal spending and tax policies that might result in a budget that is sustainable over the long term. You can refer to my blog post and testimony from Tuesday for a detailed discussion of the budget and economic outlook.

The key point is that the nation cannot continue to maintain the spending programs and policies of the past with the tax revenues it has been accustomed to paying. The aging of our population and the rising cost of health care have changed, and will continue to change, the backdrop for budget policy in a fundamental way. We will either have to pay more for our government, accept less in government services and benefits, or both.

The left pair of bars, shown below, displays averages over the past 40 years: revenues at 18 percent of GDP, spending for Social Security and the federal government’s major health care programs at about 7 percent of GDP, and all other noninterest spending at 11½ percent of GDP. The right pair of bars shows an extrapolation to 2021 assuming that Social Security and the major health care programs are continued in their current form (equal to more than 12 percent of GDP in 2021) and all other programs are operated in line with their average relationship to the size of the economy during the past 40 years (11 ½ percent of GDP). Under that scenario, total noninterest spending would cost nearly 24 percent of GDP by 2021. That amount exceeds the historical average for revenues as a share of GDP by nearly 6 percentage points—and interest payments on the debt haven’t even been included yet.

This shows why the past combination of policies cannot be repeated when it comes to the federal budget. The pieces that used to add up don’t when there are substantially more older Americans and health care is substantially more expensive. That very large gap of 6 percentage points of GDP—equal to about $1.4 trillion in 2021 alone—is a measure of the mismatch between what it would cost for the government to provide services and benefits at historical levels and the revenues that it has historically collected.   

What choices might policymakers and citizens make for the future?

One might choose to keep revenues at their average share of GDP. That would require reducing the benefits provided through Social Security and the major health care programs, having the rest of the government play a smaller role in the economy, or both.

An example of that approach, shown below, is the long-term budget proposal put forward by Congressman Paul Ryan, the Chairman of the House Budget Committee.

Congressman Ryan's Proposal in 2022

This slide shifts the extrapolation of policies to 2021 to the left side, and shows Congressman Ryan’s proposal on the right. His proposal would hold revenues at 18½ percent of GDP in 2022 (which is the first year for which we estimated the proposal). That is roughly what would happen if current tax policies were extended, and it’s close to the 40-year average. In that year, the proposal would reduce spending on the major health care programs by about one-quarter relative to current law, and it would set spending apart from Social Security, the major health care programs, and interest payments at 6 percent of GDP—about half its historical average. Although the budget would not be balanced under this proposal in that year, the deficit would be small enough that debt held by the public would be declining slowly relative to GDP.

Alternatively, one might choose to provide the same sorts of benefits through Social Security and the major health care programs that have been provided during the past 40 years. That would require raising revenues above their average share of GDP, having the rest of the government play a smaller role in the economy, or both.

For example, consider again CBO’s current-law baseline projections, shown below on the right side of the slide with the extrapolation again on the left.

Current Law in 2021

Under current law, expected improvement in the economy, underlying features of the tax code, and the expiration of key tax provisions would result in revenues in 2021 reaching nearly 21 percent of GDP—about one-sixth above the historical average. In addition, with expected improvement in the economy and the new caps on discretionary spending, all noninterest spending apart from Social Security and the major health care programs would total less than 8 percent of GDP—about one-third below its historical average. As under Congressman Ryan’s proposal, debt would be declining slowly relative to GDP—but the role of the government in our economy and society would be very different under current law than under Congressman Ryan’s proposal.

As another alternative, one might choose instead to have the government programs and activities apart from Social Security and the major health care programs operate in line with their average relationship to the size of the economy during the past 40 years. That would require reducing the benefits provided through Social Security and the major health care programs, raising revenues above their average share of GDP, or both.

For example, suppose that all spending in 2021 apart from Social Security, the major health care programs, and interest equaled 11½ percent of GDP, its historical average. Suppose also that current law for revenues was unchanged, pushing revenues in 2021 close to 21 percent of GDP, one-sixth above their historical average. And suppose that spending for Social Security and the major health care programs was cut by about one-third from its projected amount under current law, to a bit more than 8 percent of GDP. Then, total noninterest outlays would roughly equal the amount in CBO’s baseline, which, together with the revenue projected under the baseline, leaves debt falling slowly relative to GDP. However, the role of the government in our economy and society would be very different than under current law or under Congressman Ryan’s proposal.

Cut Spending for Social Security and Major Health Care Programs by One Third 
All in all, the budgetary arithmetic makes clear that, given the aging of the population and rising costs for health care, significant changes in policy—on either the spending side or the revenue side of the budget, or both—relative to what we’ve been accustomed to, will be necessary to bring the federal budget into a sustainable posture in the coming years.