Bringing the Federal Deficit Under Control: Are There Realistic Alternatives?

October 17, 2011

The Bowles-Simpson Deficit Commission suggests a better way, and solid public opinion demonstrates that there should be shared pain across the board. Economist Bill Emmons explores alternative recommendations from Fed Chairman Ben Bernanke and certain economists, including avoiding abrupt fiscal actions, cutting mandatory spending, continuing to cut discretionary spending and increasing revenues through tax reforms. There can be no sacred cows, Emmons says.

Presentation (PDF)


William Emmons: So is there any alternative to ever-rising taxes or ever-rising debt? Well, maybe. We'll get to that. But first you have to decide: Should a plan to reduce the federal budget deficit include only tax increases, only spending cuts, or some combination?

Okay. 1 percent said "only tax increases." Well, that's not exactly what the extended baseline says, but that's sort of the spirit, that mostly we're going to solve the problem with increased taxes. And yet, only 1 percent say that's the right approach. And, you know, I think the Congress people listen to this sentiment. They're not going to go for that. They're not going to allow taxes to increase as rapidly as current law suggests. 12 percent said "only spending cuts." 87 percent "some combination." That's a little bit higher, but the public opinion polls are qualitatively very similar. This is a recent public opinion poll, and so the questions are phrased very similarly to the one I just gave you. The result that I want to highlight is, again, overall 71 percent of people think that there should be a combination of tax increases and spending cuts. Independents who presumably are not listening to maybe either party, 70 percent say yes, there needs to be a combination, and even if you break down by political party, a majority. So this seems to be virtually a consensus. And yet, that's not exactly where the debate is right now.

We asked you, what about specific programs? Would you favor or oppose cutting Social Security to help reduce the federal deficit? 63 percent said they would favor that. I checked public opinion polls. They're very close to that. So that was very representative. And I think it's interesting that the received wisdom is that Social Security is the third rail of politics. Touch it and you die. And yet, I think this shows that's not true. There's a recognition by a clear majority of people that something needs to change. This would be one place that you probably should be looking for changes, and there are lots of different ways to do it in terms of age of eligibility, taxability of the benefits, et cetera, you know, tax contributions.

And, in fact, is there an alternative? Of course. People have been working on this. I wanted to point especially to the Bowles-Simpson Deficit Commission. This was the group that was created by Congress and reported last December on a number of ways to attack the budget deficit and the debt. Unfortunately, in my view it was not put to a vote in either the House or Senate because not a sufficient number of the commission members themselves voted in favor of the majority report. Nevertheless, the commission's report, of course, is an important contribution to the discussion in terms of laying out some options, some alternatives. And in particular, my summary of what that commission did is cuts in both mandatory and discretionary spending. So mandatory are sometimes called entitlements (Social Security, Medicare, Medicaid), and discretionary spending includes things like defense and all of the other programs that the federal government has. So no program should be exempt is what Bowles-Simpson is saying. No sacred cows.

The second, healthcare costs have to be dealt with. There has to be—and this is not just a federal budget issue, it's an economic issue. The private economy also, which pays about half of all healthcare spending, comes directly from private sources, primarily employer-provided health insurance. Healthcare costs are rising very rapidly for both public and private, and so that definitely needs to be part of the solution.

Tax reforms. Notice I didn't say tax increases, I said tax reforms, changes in the way we raise tax revenues that increase efficiency. And economists have been working on this for many, many years. There are better ways to raise tax revenues than taxing incomes, in particular, and I'll get to those in just a second. And also, there needs to be more tax revenue. Simply with the rising costs because of the aging population, because of healthcare costs, it's just not plausible that we can get by with the current level or even a normalized level of tax revenue right now. And what Bowles-Simpson suggested—and, of course, this is open to opinion, you may disagree—there needs to be enhanced progressivity on taxes and benefits. That is, higher income people should be expected to pay more or to receive less in benefits. Could be through changes in, say, deductions and credits, too. So that's sort of the program.

So, I mean, if there's anyone here who was not offended or doesn't feel like, "hey, that's not good for me," then you're the exception. Everybody should feel. And, in fact, that was another public opinion poll that I checked. Do people feel that everyone, even people in the middle class, should make sacrifices? And it was almost unanimous. People believe that it should be broad based. And so I think it's, if you will, not really representative of public opinion to believe that some people should be spared. Everybody needs to contribute in some way to this solution. I think that's what public opinion is showing, and that's what I think Simpson-Bowles is saying.

So Chairman Bernanke has spoken several times, this year especially, on fiscal policy measures. He made some comments earlier this month on sort of how should you shape this approach, what he called principles of reform. So the first thing we need to keep our eye on is making sure that that long-run scenario is taken care of. We can't just do year by year. There has to be a longer term vision, and it has to be a goal to achieve sustainability which I'll talk about what that means in particular. We need to avoid abrupt actions because it could easily damage the recovery, which as you well know is not very strong. We need to choose reforms that promote long-term growth and economic opportunity. There are better ways to raise revenues, better ways to design spending programs that have better impacts on growth, more fairness also. And fourth, we need to improve the process for making long-term budget decisions. So I'll go through them and be a little bit more specific. So in terms of that long-term sustainability goal, an appropriate goal is to stabilize the debt-to-GNP ratio. It's sort of a, if you will, a misconception. The federal government doesn't have to pay off its debt, it merely needs to stabilize it relative to the size of GNP. It would be great if we could get it down from its 66 percent level down to 50 or 40 or 30. That would be great. But at a minimum we need to stabilize it. It can't continue to rise. And we can do that by running small budget deficits. That's another kind of a misconception. We don't have to have literally a balanced budget. Because at least certainly we would anticipate in the near future, there is an increasing demand for Treasury debt. So by running a small deficit, that's satisfying that demand for debt, so that would be consistent. And the economy grows at about this rate. That's what causes this to be sustainable.

In terms of the efficiency enhancing nature, it's really what Simpson-Bowles was talking about: cutting mandatory spending, entitlement spending, discretionary spending and serious tax reform would be very, very beneficial. And in particular—and this I think is bipartisan, certainly at this level of generalities—cut tax expenditures. Those are what sometimes are called spending through the tax code. It's deductions and credits which maybe don't really provide very much benefit. And, of course, the biggest ones in dollar terms are the mortgage interest deduction and employer-provided healthcare deductions. Those alone mount up to something on the order of a half a trillion, or three to four hundred billion dollars a year. So at least scaling those back, if not eliminating those entirely, would be a way to then be able to keep lower marginal tax rates. So it reduces the negative effects that higher rates would have on economic efficiency.

Another one is to shift some of the burden away from income tax toward a sales or consumption tax. Reward saving. Don't punish earning income, but shift the burden to spending. And that, of course, generally will be progressive in the sense that higher income people tend to spend more so they will be paying more of that sales tax. And also consider imposing a carbon tax. This is a category of tax that economists have been talking about for many, many years. Why not raise revenues by taxing things we want less of like pollution? So this is a way to sort of kill two birds with one stone. Maybe change incentives to invest in more carbon neutral or low-carbon energy sources and raise revenue at the same time. So, you know, as an economist it's like a no brainer, and yet it's very controversial.

So here's current federal outlays. The big ones I've shown plus a lumped together category of other. So national defense, 19 percent of federal outlays; health spending other than Medicare, so that's Medicaid, VA, et cetera, is 10 percent; Medicare itself is 13.5 percent; income security, things like unemployment insurance and other income support programs, 16.7 percent; Social Security is the single biggest program right now, 20 percent (but remember that chart, healthcare is soon going to overtake it); and then about 20 percent is in other. All right, what is in other? That's what's in other. A whole bunch of relatively small programs, and you probably can't see all those items. But you know what they are: ag, transportation, energy, natural resources, veterans' benefits, etc., etc., etc. So the point of showing these two charts is you, I think, maybe sometimes have heard people say, well, if we could just cut this wasteful spending program and that wasteful spending program, if it's on this list, it's not going to make a difference. So if you cut all of that other spending, all of that 20 percent that I just showed you, this is how much contribution you would make versus this year's deficit.

So the point is, you cannot make serious progress unless you cut the big ones. Which is back to this point, there have to be no sacred cows. Whether it's Social Security, Medicare, defense, those big ones have to be part of the solution. So if you strip out the interest and just look at healthcare, Social Security and what I've termed everything else, you get this picture over the long-term horizon. And, of course, that makes it even more clear it's healthcare. You've got to do something about healthcare costs and healthcare spending.

So we asked: Would you favor or oppose cutting Medicare as a means of reducing the federal deficit? 46 percent favor, 39 percent oppose. And I looked at a recent public opinion poll, and that lines up pretty closely. The public opinion poll was even closer to balanced. So there is not a consensus on cutting Medicare. And yet, this is the fastest growing, soon will be the largest component. And so this I guess, if I think of sort of my mission, is to try to get out to people the message. Those are sort of mutual incompatible ideas that we cannot touch Medicare but we must balance the budget in the long run. It can't be Medicare alone. But as I said, no sacred cows. And so I think that's sort of where we need to go is to think more about that.

So I think controlling healthcare spending will be—important is an understatement. I think it's almost essential to get the long-term budget situation stabilized. We know that healthcare costs have been rising faster than just about any other kind of cost. And it's also the case that as people age, they use more healthcare. And we also know that particularly Medicare and Medicaid and a lot of private insurance plans don't have very strong incentives to economize on the use of healthcare. So the incentives aren't lined up very well. So that's this weak cost control feature. And there is evidence that we can not only save money but also deliver healthcare more efficiently. So in other words, from an economist's perspective, huge potential to ring better efficiency and reduce spending on healthcare, both for the federal government and for the private sector.

Okay. Remember another item on Chairman Bernanke's list was to improve the policymaking process. So some of the things recommended by Bowles-Simpson and others—this is from the International Monetary Fund as sort of an outside observer—Congress should think in medium-term strategic terms. So not just year by year but should clearly have a five-year, eight-year, 10-year plan that they're trying to achieve. And not one that's really not credible, like the idea we're going to raise all these taxes next year, and then when we get to next year, of course we don't do it. There needs to be some sort of an enforcement mechanism, a failsafe mechanism, so caps probably, or remember the pay-go-type features that increases have to be offset somewhere else. And also, be conservative in terms of assuming how much growth will raise revenues. The IMF, in fact, particularly criticized the U.S. for not being conservative enough in their assumptions about how much economic growth would be generating tax revenues.

Another piece of evidence of the need for improvement, as a job review might say, Standard & Poor's downgraded the long-term debt of the United States Treasury in August. And as part of their statement they said: "This downgrade reflects our view that the effectiveness, stability and predictability of American policymaking and political institutions have weakened." In terms of should it include revenues, also here is again from the IMF: "For a country like the United States where the tax pressure is not particularly high, it is necessary that the medium-term fiscal adjustment plans also look at the revenue side, given the magnitude of the overall adjustment that's needed."

So my conclusions and then we'll open it up for questions in just one moment. Neither current law nor a continuation of current policies—that is the way policies are made, choices are made—neither one of these is palatable. The Bowles-Simpson Commission is an example of a broad-based set of reforms that include spending cuts, that include entitlement programs, that includes tax reform to try to minimize the pressure on any one of those individually. And while there needs to be attention across a broad set of programs, healthcare is absolutely essential. We have to get that under control or else all the rest will be for naught. And budget process improvements, what that means is how Congress makes budgets, how they plan for the future, how the ideas that economists and others suggest actually get into policy. That process needs to be improved.

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