The latest from the Congressional Budget Office suggests the publicly held Federal debt will fall to around 20% of GDP by 2017. I have two small problems with this projection – both alluded to by Kash:
The White House and its allies are trumpeting the figures as illustrating that Bush’s policies will lead to a balanced budget by the year 2012. There are just a couple of problems with that conclusion. First, it’s worth making the oft-repeated point that the budget deficit reported in the newspaper headlines is not necessarily the number that matters. Or at least, it probably shouldn’t be. That’s because the “headline” figure (which is the one that is causing the White House to rejoice because it will move from deficit to surplus in the year 2012) includes the Social Security surplus. Since that surplus is essentially a place-holder for future liabilities that the US government is going to have to face down the road (when it has to pay SS benefits to baby-boomer retirees), a more comprehensive picture of the government’s fiscal picture should focus instead on what the budget deficit would be excluding the SS surplus – a concept called the “on-budget deficit”. As the figure below shows, if you exclude the SS surplus, the on-budget (or “general fund”) federal government balance will remain negative for the complete forecast range … But regardless, it is true that even the on-budget balance shows a marked improvement between the years 2010 and 2012. Why is that? Simple: because during those years the Bush tax cuts are currently slated to expire. The CBO forecast assumes that they will. But what would happen if Bush got his wish and those tax cuts were made permanent? The next chart tells the story. Instead of the current CBO projection of a deficit of $85 billion in 2012, the deficit would be about $460 billion – quite a difference.
This got me thinking about what the total Federal debt to GDP ratio, which is currently just over 66%, would look like as 2017 if the CBO forecasts hold. Following the monetarist arithmetic utilized by Thomas Sargent and Neil Wallace in 1981 to criticize the 1981 tax cut, let’s explore the assumptions in the CBO report starting with real GDP growth, which is assumed to be around 2.3% per year, and real interest rates, which are assumed to be around 3%. With 2006 GDP being around $13 trillion and total Federal debt being around $8.6 billion, we start with a debt to GDP ratio near 66.2%.
As I read the assumptions in the CBO report, non-interest spending including Social Security is projected to be around 17.7% of GDP, while taxes including payroll taxes to be around 19.5%. In other words, the primary surplus including the Social Security Trust Fund is projected to average 1.8% of GDP. In present value terms over the infinite horizon (Max Sawicky – please forgive), we have a surplus equal to 260% of current GDP, which exceeds the current ratio of publicly held debt to GDP. So if we let the tax cuts expire and if we focus on publicly held debt, then the debt to GDP ratio will fall.
The CBO report conveniently provides us with the projected Social Security surplus over this period, which averages 1.8% of GDP. Why anyone would question the solvency of this Trust Fund given these projections is beyond me. But we are focusing on the General Fund. Even if we let the tax cuts expire, the primary surplus in terms of total Federal debt will average only 0.4% of GDP so its present value would be less than the current debt to GDP ratio. So even if the tax cuts expire, the total debt to GDP will increase to around 67%.
But what if President Bush gets his way and we extend his tax cuts? In this case, the primary deficit will be 0.3% of GDP, which implies a faster acceleration of total Federal debt. And as our graph suggests (well, the graph will appear as soon as Blogger stops having its technical problems), the ratio of total Federal debt to GDP will rise over the next 11 years reaching almost 75% by 2017. In other words, failure to reverse Bush’s phony tax cuts will imply a greater Burden of the Debt for our children.