Bringing the Federal Deficit Under Control: Where Are We Headed?

October 17, 2011

Knowing the past, how do we measure all of the future debt that's likely to accumulate? The "fiscal gap" between revenue and outlays will be $1.3 trillion dollars every year between now and 2085 if the nation continues on its present course, Emmons explains. Using Congressional Budget Office scenarios, Emmons demonstrates two scenarios: "extended baseline" and "alternative fiscal."

Presentation (PDF)



William Emmons: Okay, that's history. Now, where are we going? And so I'm going to be following the Congressional Budget Office in framing different measures in just a moment. But one of them—the more pessimistic of those views—is used to calculate a single measure, a flow measure to represent what we're likely to be looking forward to, and that's what that—I'm going to fill in that line in just a moment.

So the two scenarios are what's first called the extended baseline, so that's taking all of the current laws, projecting those forward, combining those with assumptions about how the economy performs, how interest rates develop, and you get something like this. Looks not too bad. And so we'll talk about how is that actually happening, what would it require for that to play out?

On the other hand, there is also a plausible scenario under which we don't get that debt ratio under control, falling back down, but in fact it continues up. This is what the CBO calls an alternative fiscal scenario. So we're going to spend some amount of time talking about these. But just to sort of visually show you how high the stakes are, depending on which direction policymakers go.

So under that more pessimistic scenario, the alternative fiscal scenario, which as I'll explain, this is really more representative of the way policymakers have been making decisions over about the last decade versus the way the law is actually written today. The CBO believes that's actually the more likely one. I throw this out here right now just to sort of motivate the idea that we really need to pay attention to this, the possibility that we might get on the wrong track and we might see a rapidly rising debt. So anyway, the measure then of how bad is that or how do you sort of bring that back to a single measure is what economists who study this call the fiscal gap. It's meant to be something like a budget deficit, so it's on that scale. It's a one-year measure. And that's to say, how much would you need to change the outlays and the revenues in order to stabilize the debt ratio? So the gap—in other words, the amount of work we have to do every year between now and in this case the scenario runs out to 2085—is that big number shown right there.

So that's how big the problem is year by year, $1.3 trillion, which coincidentally is about the size of last year's deficit. So that's saying if we get off on the wrong track and we have this alternative scenario, we have something like 8 percent of GNP's worth of corrections that need to be made. So that's one measure of how significant—remember Chairman Bernanke said significant policy changes need to be made—this is a measure of how significant. These are extremely large numbers—$1.3 trillion a year.

Okay. So as I say, we're going to look at two scenarios: what is called the extended baseline scenario, and the other one is the alternative fiscal scenario. As you may know if you follow these sorts of things, the Congressional Budget Office is a non-partisan agency created by Congress whose responsibility is to provide members of Congress with estimates of how their policies, how the laws that they pass would affect things like the budget in particular, the evolution of the debt, and to some extent also, feedback effects on the economy. So their primary job, the CBO's primary job is to take what Congress is either passing or considering to pass into legislation and then running the numbers and giving educated guesses really about how this would all work out. So you often have heard certain policies or proposals, Congress people can send a proposal to the CBO and ask them to say how would this affect revenues, how would this affect the deficit, et cetera.

So that's their first job, and so that's the extended baseline. Given the way the laws are written today, this scenario assumes everything will play out exactly as written. So in particular, all the temporary revenue reducing measures, all the temporary tax cuts will expire on schedule. It assumes that all of the temporary outlays—for example, unemployment insurance, the extended benefits—will expire as currently written. And it assumes that all of the discretionary spending caps that were put in place in August this year as well as some others that were already in law, that those in fact will be enforced. So this is a sort of no exceptions, no excuses, this is how it's going to play out. So that's what the extended baseline means.

And in particular terms, what that means is we have quite a bit of change in our immediate future. At the end of this year, current law says that the two-year extension of provisions limiting the reach of the AMT—and I know some of you have faced, you've struggled with the AMT at tax time—this is the Alternative Minimum Tax. We have parallel tax systems. Everybody is required to prepare their taxes under these two systems and pay the higher amount. The Alternative Minimum Tax is not indexed for inflation, and so generally we've had positive inflation rates and that tends to push more and more people into the Alternative Minimum Tax regime. And so that has been year by year, on a discretionary basis has been amended—or the term that's used is patched—by Congress by extending for another year, or adding some inflation protection in the law.

So current law, though, does not foresee any further patches, any further extensions. And so at the end of this year the AMT will be locked in place exactly as it existed the previous year. There will also be the expiration of the 2-percentage-point reduction in the payroll tax, the employee portion of the payroll tax that will expire at the end of the year. At the end of next year, certain provisions of the 2010 Tax Act, which were originally enacted in 2001, 2003 and 2009, will expire at the end of next year. That includes the lower marginal tax rates that were in place will go back up essentially to 2000 levels, and a whole variety of tax credits and tax deductions that were put into the code will disappear. That's what the law says.

So just to give you some feeling, some flavor for what that might mean for you if this actually happens, this is a picture that shows the marginal tax rate schedule. In fact, it shows two. On the top, the blue line is the tax rates that applied to various levels of income back in 2000. And I've adjusted those to 2011 for inflation, so they should be comparable then to the lower line, the red line, which is the current, the 2011 marginal tax rate schedule. So the way this works is, it's as if you earned your income sequentially and every additional dollar you earn pays a particular marginal rate, a specific rate. So as you begin the first dollar under the current code, you pay 10 percent of taxable income. You pay 10 percent tax. The dollar beyond 17,000, now you pay 15 percent on that next dollar, and so on until you get to 69,000, and then the next dollar you pay 25 percent and so on. So everybody's tax is figured this way, so we have this progressive that is higher rates as the income goes higher.

So this shows that it's very clear the red line lies below the blue line. So tax rates all along this schedule are lower now than they were back in 2000. And the law says that at the end of next year we're going to jump back up to that previous 2000 level. So here's an example, a numerical example. Suppose you were a household with $100,000 of taxable income in 2011. You would pay $17,250 in taxes. And the way that's calculated is the first $17,000 pays a 10 percent rate, the next 52 to bring you up to 69,000 pays a 15 percent rate, and then the final 31,000 pays a 25 percent rate. That's the way the income tax is calculated. But on that $100,000 income, if you had to pay the rates that were in effect back in 2000 and which presumably would come back if this expires, you would end up paying 20,720, which is 20 percent higher, and that's the calculations given here. It's the same stepping through these marginal brackets.

So the current law imposes for this household a 20 percent increase in income taxes. That's what's written into the law. It also includes—this baseline includes fairly significant spending cuts. For example, for physicians who provide services to Medicare patients, there would be a 30 percent immediate decline in payments. So the rate of compensation to physicians under Medicare would fall 30 percent. That seems quite draconian and it is, but it's because the smaller adjustments that were written into law have been postponed every single year since 2003. And now they have accumulated, and if, in fact, we allow that rather than, say, pushing it one further year into the future, it would be a 30 percent decline—fairly substantial—and that turns out to be fairly big dollars also for revenue purposes.

Unemployment benefits were extended. Federal unemployment insurance was extended to 99 weeks in some states. That will expire at the end of this year, according to current law. Also, the budget agreement that was reached in August of this year, the Budget Control Act, has both discretionary spending caps. That is, there is a limit on how fast all discretionary spending can grow, and there's also the responsibility of the supercommittee, these 12 individuals who are meeting secretly and furiously hammering out an agreement to find an additional $1.2 trillion or more of cuts to be passed by the House or Senate in an up or down vote. Or, if not, there will be a sequestration of defense spending and various other spending categories to reach that dollar amount. So that's what's in the law, that's what the extended baseline assumes—that all of these things in fact will happen as currently scheduled.

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