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In-Depth: Ever-Higher Taxes or Ever-Higher Debt? Exploring Scenarios and Possible Solutions to the Federal Budget Deficit

Wednesday, December 28, 2011

Since the end of World War II, the U.S. had been fairly successful at managing its debt and deficit. However, inadequate tax revenues for most of the last 30 years, the shock of the financial crisis and looming fiscal challenges related to the aging U.S. population and rising health care costs have left the U.S. with a more than $1.3 trillion fiscal gap between revenue and outlays.

While a number that size may seem insurmountable, one St. Louis Fed economist suggests that a solution is still well within our reach—but only if lawmakers and citizens make hard choices now and stick with them.

The deficit was just one of the stark figures presented during the second “Dialogue with the Fed” on Oct. 18, “Bringing the Federal Deficit under Control.” St. Louis Fed economist William Emmons led the presentation and discussion. Joining him for a question-and-answer session with the attendees were Christopher Waller, senior vice president and director of Research, and Julie Stackhouse, senior vice president and managing officer for Banking Supervision, Discount Window Lending and Community Development.

Two Scenarios for Debt Held by the Public

Figure 1

Note: The CBO’s August 2011 baseline reflects the effects of provisions related to the Congressional Joint Select Committee on Deficit Reduction.

Sources: Office of Management and Budget (OMB), Congressional Budget Office (CBO)

A $1.3 Trillion Deficit

“We have an extreme situation of very large budget deficits,” Emmons explained. According to an August 2011 Congressional Budget Office (CBO) report, the United States is facing “profound budgetary and economic challenges,” which Emmons described as “the most accurate statement of the seriousness of the budget situation.”

CBO figures anticipate that the fiscal gap between revenue and outlays will be equivalent to $1.3 trillion dollars every year between now and 2085 if the nation continues on its present course. To see what may happen, Emmons explored the CBO’s two markedly different scenarios for deficit control.1

Current-Law Scenario: Ever-Higher Taxes

The CBO’s extended-baseline, or current-law, scenario assumes that all provisions of laws currently on the books will be fulfilled on schedule in 2011 and 2012. This includes reverting tax rates to year 2000 levels, ending the one-year payroll tax reduction and ending the temporary limitations on the alternative minimum tax. Spending caps and cuts currently on the books, including those mandated by the Budget Control Act of 2011, would need to be enforced.

“Current law would reasonably shrink long-run deficits and reduce debt levels relative to the size of the economy in three to five years, with the deficit of about 2 percent of GDP,” Emmons said. “However, it would mean that revenues as a share of GNP would continue rising indefinitely.

“Tax revenues would increase at double?digit percentage rates for each of the next three years at 12 percent or more and then would continue to grow faster than the economy. It’s a windfall for the federal government,” Emmons said.

The restoration of higher marginal tax rates, “bracket creep” and the alternative minimum tax will play a large role in ever-rising taxes. “So, yes, current law solves the budget problem but in a fairly unpleasant way,” he said.

Alternative Fiscal Scenario: Exploding Debt

The CBO warned in August 2011 that certain provisions of current law are either widely expected to change or would be politically and economically difficult to sustain for a long period.

Therefore, the CBO created an alternative fiscal scenario based on current policy (not current law), assuming that many current-law provisions will not be enacted. The temporary revenue and outlay measures would not expire as planned, and most of the spending caps would not begin. Based on recent experiences and current policy, the CBO suggests that deferring painful choices would produce a large and growing mismatch between revenue and outlays, resulting in a massive increase in debt.

“At some point, investors might refuse to buy the expanding stock of Treasury debt, resulting in a debt crisis that would push interest rates sky-high,” Emmons said. “If hard choices continue to be deferred, about half of all national income would be needed simply to pay the interest on federal debt by the end of the 21st century.”

The Supercommittee and Other Ideas

If either CBO scenario is unpalatable, what can be done? Congress’ latest deficit reduction attempt, the Budget Control Act of 2011’s supercommittee, ended in deadlock on Nov. 21. According to the act, the bipartisan supercommittee’s failure to submit proposals is supposed to trigger an automatic $1.2 trillion in deficit reduction measures starting in January 2013.

Meanwhile, opinion polls consistently indicate that the majority of the public believes that the economic pain of increased taxes and spending cuts should be shared by all income levels, including spending reductions for Social Security and Medicare. Dialogue audience members generally agreed.

Also, many legislators, economists and even Fed Chairman Ben Bernanke agree that the deficit must be controlled to ensure economic stability. Alternatives include increasing tax revenue and efficiency, cutting mandatory and discretionary spending, reducing the growth of health care costs, and promoting reforms focused on growth and economic stability. “There can be no sacred cows in the budget,” Emmons said.
The supercommittee’s inability to reach a consensus illustrates that nothing will fundamentally change unless the government actually makes the hard choices and sticks with them, Emmons insisted. “The supercommittee is a new version of an old game: We’ll promise to make these changes in the future—but then we’ll see if we actually make them,” he said.

In Sum: Will We Make Hard Choices?

Neither the current-law nor the current-policy scenario that the CBO created would produce an ideal outcome because the former would mean ever-higher taxes and the latter would mean ever-rising debt.

The general public appears open to a combination of tax hikes and spending cuts. Those sentiments are echoed by advocates of broad-based spending reductions and efficiency- and revenue-enhancing tax reforms, which include controlling health care costs and reforming the budget process.

“This isn’t like a technology problem that we have to send engineers to figure out,” Waller said. “You cut spending, raise taxes or both—that’s it. But do you have the political will to do it?”


FRED Charts on the Gross Federal Debt

Questions about the Budget Deficit Have No Easy Answers


  1. Both of the CBO’s scenarios are based on a rate of inflation of about 2.5 percent CPI, with a similar economic growth rate, and interest rates of 10-year U.S. Treasuries at 5 percent. Note that the alternative/current-policy scenario does not reflect provisions related to the 2011 Budget Control Act’s bipartisan supercommittee.