February 24, 2012
I had the chance today to talk about the choices our country faces about federal spending and taxes with two economics classes at Harvard University. Martin Feldstein asked me to give a guest lecture in Ec 1420, American Economic Policy, and Greg Mankiw asked me to do the same in Ec 10, Principles of Economics. My slides can be viewed below.
On a personal note, I should take this opportunity to thank Marty and Greg for all that I’ve learned from them. When I was a graduate student at Harvard, Marty chaired my dissertation committee and Greg was a member of the committee. At the time, Marty had recently returned from serving as Chairman of the Council of Economic Advisers under President Ronald Reagan, a role that Greg later filled for President George W. Bush. After finishing my degree, I was lucky to spend a few years teaching both Ec 1420 and Ec 10 with Marty. It was fun to be back with Marty and Greg and to meet their current students.
I explained to the students that, if we maintain our current spending and tax policies, the federal budget deficit will be so large that federal debt will increase much faster than the size of the economy. That cannot go on indefinitely: We will need to change policies. Moreover, we cannot simply go back to policies we followed in the past. Given the aging of the population and rising costs for health care, the combination of budget policies that worked in the past will not work in the future. Instead, we will need to adopt a new combination of policies that will be starkly different from our past policies.
As the basis for my discussion, I used CBO’s projections under the alternative fiscal scenario, which illustrates the budgetary consequences of maintaining some tax and spending policies that have recently been in effect. (In contrast, our baseline projections are conditioned on current law, which incorporates the expiration of numerous tax provisions that have kept tax rates lower and the imposition of automatic spending reductions put in place by last year’s Budget Control Act in the event that the Joint Select Committee on Deficit Reduction did not agree on a budget plan.)
All federal spending apart from Social Security, the major federal health care programs, and interest is on track to be smaller relative to GDP by 2022 than at any point in the past 40 years—and only about two-thirds of its average share of GDP during that period. If that outcome is achieved, putting federal debt on a sustainable path still requires changes in Social Security, the major federal health care programs, and taxes that amount to about $750 billion in 2022.
To meet that target for 2022, one can think of two broad choices:
- If we extend the expiring tax provisions (other than the payroll tax reduction) and index the alternative minimum tax for inflation, as described in the alternative fiscal scenario, spending on Social Security and the major federal health care programs would need to be cut by about one-fourth. Because most of such spending goes to people over age 65, a cut of that magnitude would represent a major change to the sorts of benefits provided for Americans when they become older.
- Alternatively, if we do not change spending on Social Security and the major federal health care programs, tax revenue would need to be increased by about one-sixth. Such an increase would raise federal revenues significantly above their average share of GDP in the past several decades.
My presentation included a number of specific options for reducing spending on Social Security and the major health care programs and for increasing taxes (see slides 17 through 26). I emphasized that these were not recommendations, which CBO never makes. Instead, our role is to examine policy ideas, estimate their likely effects on the budget, and discuss their broader implications to the extent we can. We publish many reports with that sort of information, and I picked out a few examples to give the students a sense of the magnitude of the changes needed.
In sum: By the end of the coming decade, unless we cut federal spending apart from Social Security and the major health care programs below the unusually low share of GDP it is already projected to reach, stabilizing federal debt relative to GDP will require us to cut spending on Social Security and federal health care programs by about one-quarter, raise taxes by about one-sixth, or do some combination of those approaches. That’s the fundamental choice we face.