Bringing the Federal Deficit Under Control: The Alternative Fiscal Scenario

October 17, 2011

Based on recent experiences, the CBO suggests that deferring painful choices will produce a large and growing mismatch between revenues and outlays. Emmons says that the alternative scenario solves the problem of increasingly higher taxes by allowing the federal debt to explode.

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William Emmons: So that's in the realm of if we just follow this current set of policies, or current laws, that's what we would be looking at. The CBO believes—and I think it's prudent to think about—well, what if we don't actually follow that? And that's what they call the alternative fiscal scenario, what they call current policy. If you look, according to the CBO, at the way Congress has made decisions over the last decade or so, they don't always follow the law as written. And so, you know, basically the way they set this up, it's clearly an extreme set of assumptions. But just to sort of set a bound on what we might expect, suppose that the way Congress makes decisions is that any tough decision will always be postponed, that we will never, ever make any tough changes. Suppose that's the rule. If that's true, then, of course, none of these temporary revenue reducing measures will expire, none of those tax changes that I talked about, and none of the spending cuts will occur either. Whether it's unemployment insurance expiring, payments to Medicare physicians, or the discretionary spending caps, none of those will be held. So that's an extreme set of assumptions, but to really set on a stark contrast, the CBO pursued that strategy.

So what's the result? Not too surprising, it's a disaster. This set of approaches, if these decisions are made to always defer painful choices, then we will have a large and growing mismatch over the future between revenues and outlays regardless of how strong the economy grows. So we can't grow out of this problem if current policies of always deferring these tough choices are made. That's the calculation. That's the judgment of the CBO. So, because we know that outlays are going to be growing. We know that we have a rapidly aging population, the baby boomers on the edge of retirement. We know that healthcare costs are rising very rapidly, and the federal spending on healthcare is growing very rapidly interacting with that aging population. And we know that, in the picture that I showed you, the debt has increased a great deal. As we run large deficits, that increases the debt quickly which means that the interest costs on that debt will also be increasing very quickly. And I'll show you some pictures of how this all works.

On the tax side, the assumption that the CBO makes—and this is, in fact, part of the current political discussion—is that we would freeze tax revenues at their historic level over the last 50 years say, and that would not have any necessary connection to the demographic pressures, the healthcare cost pressures, budget deficits of any kind. So that's very simplistic but it does have some basis in some of the discussion that you hear today.

So that's what the picture would look like. Looking out far into the future, the outlays relative to the size of the economy are that red line, and the revenues are the lower green line. And the difference year by year is the budget deficit. So within a few decades, you would start to be seeing 30 percent of GDP budget deficits. Remember that was the size at the peak during World War II. And it would only go up from there. By the end of this horizon, you'd have 50 percent of GDP budget deficits. Well, obviously we'll never get there because the debt would be so large, it would be compounding so fast that it's just implausible that we could possibly finance that size of a government debt. But that's the track we would be on if the policies were always chosen in a way to avoid the difficult adjustments.

And so this is the picture we saw before, and that's why CBO says the red line is current law, yes, but the green is current policy. That's the way decisions appear to have been made over the last decade or so. And if that continues, that's the track we should look toward, that's what we should expect.

Okay. And this was just to show the comparison putting the two on top of each other. The two outer lines are the alternative scenario. The two closer together lines are the extended baseline. The way to think about it is under the extended baseline, it does solve this problem but at the cost of constantly rising tax burdens. And the alternative scenario solves the problem of rising tax rates by allowing the debt to explode. Neither one of those is very attractive. So to finish up this discussion, the extended baseline scenario would stabilize the debt, but it would have potentially fairly harmful effects on the economy, both in the short term and in the long term.

The alternative scenario that the CBO has outlined would result in no short-term pain but almost guaranteed disaster in the long run. Now, of course, neither of these scenarios is likely to play out exactly this way. But the CBO framed it this way to provide kind of the extremes to bracket the possibilities.

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