The True Fiscal Nightmare

Bruce Bartlett’s post on his NYTimes blog last week highlighted the long-term fiscal problems faced by the US. He mentioned that his preferred solution would be to impose a national value added tax (VAT) to help close the gap between expected federal revenues and spending. His most recent NYTimes post (see Mark Thoma for excerpts, if you don’t have Times Select access) elaborates on why he thinks the VAT is a good solution to a big problem.

Several people have since noted that before any additional taxes are considered, we should first simply reverse the Bush tax cuts of 2001 and 2003. The problem, however, is this: it turns out that even reversing the Bush tax cuts will not be nearly enough to solve the US’s true fiscal problems over the coming decades.

As they do every year, in December the CBO released their analysis of the budgetary implications of several spending and revenue scenarios in the document “The Long-Term Budget Outlook”. I’ve distilled their multiple scenarios down to one picture representing what I think is a reasonably likely “intermediate” (i.e. not too sunny and not too doomsday-ish) projection.

To get this “intermediate” projection I do the following:

  • I exclude Social Security revenues and spending, since Social Security is separately funded from the rest of the budget, and because the purpose of this exercise is to focus on the future imbalances in the rest of the federal budget, which dwarf those of the Social Security trust fund. (The SS gap is only around 1-2% of GDP in the decades after 2020, compared to the much larger numbers you’ll find below.)
  • On the revenue side, I use the CBO’s estimate based on an extension of current law governing the individual income tax. In other words, the Bush tax cuts are allowed to expire (most of them in 2010). After that, real bracket creep (real income growth pushing taxpayers into higher tax brackets) and the AMT cause total revenues to gradually rise.
  • Regarding spending, I assume that the excess cost growth in Medicare and Medicaid is only 1.0 percentage point per year (compared to the average past rate of health care growth of 2.5 percentage points above overall economic growth). I also follow the CBO’s projections that assume that defense spending follows the Administration’s 2006 Future Years Defense Program (with allowances for cost risks and additional spending to support the war on terrorism) through 2024, and that other types of spending (except for interest payments on the debt) remain at their historical levels as a share of GDP.

If you put these assumptions together you get the following picture:

Obviously, even with the end of the Bush tax cuts in 2010, the picture is ugly. The general fund deficit (i.e. the deficit excluding the SS trust fund) will be close to 4% of GDP during 2010-2015, and widen to 4.6% of GDP by 2020, 6% of GDP by 2025, and 8% of GDP by 2030. After that the fiscal problem gets so bad that there’s no point in following things further.

Maybe you disagree with my assumptions. Fine – you can play this game yourself. Mix and match your own assumptions about revenues and spending with the help of the handy spreadsheet available from the CBO here. It might make for a fun party game. (I guess that depends on your definition of “fun”, though.)

But whatever specific choices you make, I think that you’ll find that under all reasonable scenarios there’s a huge fiscal problem looming for the US that is totally unrelated to Social Security.

So now for the tough part: What are some possible resolutions to this problem? There are only a few options, so it’s quite easy to enumerate them:

  1. Just live with the deficits. It is certainly possible to live with budget deficits of 3, 4, or 5% of GDP. We’ve done it in the past, and we’re doing it currently. However, by the 2020s we’ll be in a completely different situation: the deficit will be large and growing far faster than the economy. Put another way, the deficit will be growing as a fraction of the economy just to make the interest payments on the debt. Such a situation is literally unsustainable – it is the equivalent of a pyramid scheme. If the picture presented above still holds true by the 2020s, US will find itself unable to finance its deficit at any reasonable rate of interest, simply because lenders will (quite reasonably) doubt the ability of the US government to repay its debts when they come due 10 or 20 or 30 years down the road. So living with the picture above is simply not an option.
  2. Cut non-defense discretionary spending. This is many conservatives’ favorite answer, but since such spending is only 5.1% of GDP in the projection above in the year 2025, even slashing such spending in half would still leave a large deficit. But I think that such speculation is irrelevant; recent hesitation even among Republicans to cut discretionary spending from current levels seems to indicate that such spending has already been cut by as much as is politically tolerable. So this option is a non-starter, I think.
  3. Cut defense spending. The scenario graphed above assumes defense spending of only about 3% of GDP in the year 2025, however (compared to about 4% of GDP currently), so again we find that even cutting such spending in half would leave a huge problem. More relevantly, I think that it would be politically difficult to do much cutting here in the first place, so again I am comfortable ruling out this option.
  4. Totally change our health care system. The federal government could stop providing health benefits to the nation’s retirees… but again I find that politically unlikely. Alternatively, some sort of major health care system reform that generated massive cost savings and rationalization of medical care services – such as a move to a single-payer health insurance system – could do the trick. (This would be my preferred solution to the problem, incidentally.)
  5. If you rule out fundamental changes to health care, and if you agree that options #2 and #3 are not going to help you much in closing the massive general fund deficit, then you’re left with only one more option: raising taxes. Such new tax revenues would need to be on the order of 5% of GDP, at least to start with. For context, note that the federal income tax raises about 10% of GDP in taxes, so raising such new revenues through the income tax would require an approximately 50% rise in income taxes. Alternatively, you could consider adding a completely new tax, such as the VAT.

Given this list, I think that Bruce Bartlett’s logic for favoring the VAT is thus pretty good; if you rule out options #1-4 above, and you don’t think that voters will tolerate a 50% increase in income taxes, then a VAT may make the most sense. In an upcoming post I’ll discuss the pros and cons of a VAT in a bit of detail.