Bringing the Federal Deficit Under Control: Is Current Law Sufficient To Solve the Budget Problems?

October 17, 2011

Can current law, including the expiration of tax laws in 2012, be sufficient to shrink long-term deficits and reduce debt levels relative to GDP after 2013? Economist Bill Emmons says that while the current law stabilizes the deficit problem, it comes at the expense of constantly rising tax burdens.

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William Emmons: So as you saw in that red portion of the diagram, maybe this problem is solved, maybe we're all here worrying about nothing. Is current law—I hear someone snicker—is current law sufficient to solve the budget problem? Well, the current laws plus the most recent, the Budget Control Act, would indeed, on reasonable projections, they would shrink the long-run deficits and reduce debt levels relative to the size of the economy fairly soon. Already by 2014 we would have the problem under control.

However—there's a but here—however, what does that mean? How would we do that? It would mean that tax revenues as a share of GNP would continue rising, not just this 20 percent jump that we would be facing plus other provisions in the very short run, but in fact, this would continue indefinitely. So this is a set of policies that would build in permanently rising tax burdens, if you will. That's due to these higher rates kicking back in along with bracket creep that would continue. The AMT would start to affect more and more people and soon half of all taxpayers would be paying the alternative tax rather than the regular tax. And so essentially all of the cost pressures that are coming in through particularly healthcare would simply be passed through to the taxpayer through higher and higher taxes. So yes, it solves the problem but in a fairly unpleasant way by pushing up your taxes fairly sharply in the short run and then permanently higher and higher and higher.

So that's what the picture would be. This is the CBO's projection out into the far distant future of what—the top line is, the outlays, the spending of the federal government, and the blue line on the bottom is the revenues. And the one I'm pointing to is the revenues. So you can see the very sharp increase in the short run, very rapid increase in tax revenues in the next couple of years. And even then, tax revenues would continue to grow faster than the economy as a whole, faster than your income, so that the burden of taxation would continue to rise as far as the scenario runs. So it's not exactly a very pleasant way to solve this problem.

The CBO I think rightly observes that certain provisions of current law—these are euphemisms. The CBO can't be maybe as blunt as they might like to be. But in their August long-term outlook, they said certain provisions of current law "are widely expected to be changed" by political analysts and others or "might be difficult to sustain for a long period." In other words, you should really question whether those long-term policies are going to be carried out exactly as written. So what the CBO does is then explore, what if we don't actually carry those out? So the things that they point out, really the most important provisions likely to change are revenues. Is it realistic that we are going to pay much, much higher taxes very, very quickly? And, of course, remember economic impacts of raising taxes very rapidly and then permanently pushing taxes higher.

Under this extended baseline scenario, federal tax revenues would increase at double-digit percentage rates for each of the next three years. So tax revenues growing at 12, 15 percent a year, a bonanza for the federal government. But that means we have to pay it and then continue growing faster than the economy forever, or at least as long as the scenario, you can imagine.

There's also some question the CBO thinks about the spending cuts. Is it realistic that we're going to cut reimbursement rates to Medicare physicians by 30 percent on Jan. 1? We weren't willing to cut it 3 percent in each of the last eight or 10 years. So that seems a little unrealistic that we're actually going to see that happen on Jan. 1. Also, non-interest, non-defense federal spending scheduled to decline at an annual rate of 1 percent for the next three years. Decline. Federal spending decline. Have you ever heard that term? Federal spending decline for each of the next three years. So point being, these are very, very ambitious targets. And the CBO and I think other analysts would agree, you shouldn't necessarily count on those happening, all of those provisions kicking in.

So as I said, I think the economic impacts are important. There's no consensus among economists about exactly how various measures would affect the economy, but I just want to point out a few things. Under this scenario, you would have over a three-year period, 2012 through '14, the change in the budget deficit essentially would be 6.3 percentage points of GNP. So going from 8.5 percent down to 2 percent in a three-year period. So I was curious and I went back and looked, when was the last time the United States had such a rapid decline in the budget deficit? And you have to go back to the late 1940s, the build-down after World War II. Between 1947 and '49, there was such a decrease in the budget deficit, and there was a recession in 1949. Now, was it due to that decline in federal spending? You can't say for sure. But at least there's circumstantial evidence that such a rapid tightening of fiscal policy may have been associated with it.

Second point. That's kind of at the macro level. At the micro level there's very good reason to believe that if we do push up marginal rates and just in general take more tax revenue out of the private economy, that well might affect incentives. It might affect incentives to work, to save, to invest, and that certainly could hurt the economy's growth potential. So this is in the category of really an unintended consequence but one we need to be aware of if we were to tighten fiscal policy so rapidly by pushing up tax rates.

Clearly, on the positive side of reducing the budget deficit quickly, lower deficits and debt and the prospect of a lower trajectory for the debt probably would reduce interest rates. But, of course, interest rates are quite low as it is—Treasury rates. But to the extent that this might have some effect, that would be a positive effect, boosting growth. So things that Congress needs to be thinking about.

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