Sunday, February 26, 2006

Bleak Budget Outlook

The Brookings Institution/Urban Institute has just published a paper, New Estimates of the Budget Outlook: Plus Ça Change, Plus C’est la Même Chose, by Alan J. Auerbach, William G. Gale, and Peter R. Orszag. The conclusions are scary (comments in bold italics are mine):
• CBO now projects a 10-year baseline deficit of $831 billion in the unified budget for fiscal years 2007 to 2016. The budget outside of Social Security faces a baseline deficit of $3.4 trillion.

• Over the first five years of the Bush Administration, the 10-year fiscal outlook deteriorated by $8.3 trillion. In January 2001, the unified baseline for 2002 to 2011 projected a surplus of $5.6 trillion. The baseline for the same period now projects a deficit of $2.7 trillion. (Emphasis in the original. So much for Republican fiscal responsibility.)

• The budget projections have deteriorated since the beginning of 2005. On a comparable basis, the baseline 10-year unified deficit for 2006 to 2015 has risen by almost $400 billion since January 2005.

• About 58 percent of the deterioration in the official baseline figures since 2001 is due to lower revenues, and 42 percent is due to higher spending. Specifically, the decline can be attributed to legislated tax cuts (29 percent), other declines in revenue (28 percent), legislated spending increases (36 percent) and other changes in spending (6 percent). Declines in revenue have also accounted for most of the deterioration in actual budget outcomes (as opposed to 10-year projections) between 2000 and 2006. Tax revenues as a share of GDP have fallen dramatically since 2000, and are low relative to their average value between 1960 and 2000. (So much for claims that tax cuts will add revenue.) Spending as a share of GDP has risen somewhat since 2000, but nonetheless remains at or below its average level between 1960 and 2000.

• As is now widely recognized, the baseline projections use mechanical assumptions that may not reflect the best representation of current policy. Among other things, the baseline assumes that (1) almost all expiring tax provisions will be allowed to expire, (2) the alternative minimum tax (AMT) will be allowed to grow explosively, (3) no additional funding requests will be necessary to conduct the wars in Iraq and Afghanistan and (4) real discretionary spending (including defense) will be held constant in real terms. (In other words, Bush's SOU message concerning the deficit was a lie.)

• If almost all of the expiring tax provisions are extended, the AMT is held in check (as described below), and real discretionary spending keeps pace with population growth, the 10-year unified budget deficit will be $4.8 trillion (2.8 percent of GDP), with deficits of 2.4 percent of GDP or more in every year. The differences between the CBO baseline and this adjusted unified budget projection grow over time. By 2016, the annual difference is $784 billion (3.8 percent of GDP).

• The unified budget figures include large cash-flow surpluses accruing in trust funds for Social Security, Medicare, and government pensions over the next 10 years. In the longer term, Social Security and Medicare face significant deficits. Outside of the retirement trust funds, the adjusted 10-year budget faces a deficit of $7.8 trillion over the next decade (4.6 percent of GDP). Thus, a simple way to summarize the fiscal status of the government is to note that the retirement trust funds face substantial long-term deficits, and under realistic assumptions about current policy, the rest of government faces deficits in excess of 4 percent of GDP over the next decade. (In other words, the cash surplus in Social Security and Medicare has been hiding the true extent of the deficit run by the rest of the government.)

• We estimate that over a permanent horizon, the long-term fiscal gap for the federal government as a whole is now 8.0 percent of GDP under the CBO baseline and 10.8 percent of GDP under an adjusted baseline.

• While the primary driving force behind the deficits over the next 10 years is reduced revenue, the primary driving force behind the deficit over the long term is increased spending due to demographics – in particular the retirement of the baby boom generation, a smaller number of new entrants into the labor force, and lengthening life spans – coupled with increasing per-capita health care expenditures.

Despite heated political debate about deficits, there is broad consensus, extending even to the Administration’s top economists, that sustained budget deficits have adverse macroeconomic consequences, reducing the capital stock and future national income and raising interest rates. Moreover, even without any immediate macroeconomic consequences, these deficits will eventually require substantial and deleterious tax increases and spending cuts to deal with the debt that accumulates. It is inconceivable that the economy will be able to grow its way out of the deficits, and delaying steps to deal with the problem simply makes it worse. In addition, simply paying for the tax cuts embodied in the adjusted baseline would require massive cuts in other spending that are far beyond anything likely to be considered in the political arena. In such an environment, policy-makers, especially those who support making the tax cuts permanent, will be sorely tempted to turn to budget gimmicks. (My emphasis in both places.)

• The only real solution to the nation’s fiscal imbalance is some combination of reduced spending and increased revenue. Restoring fiscal discipline will require painful adjustments, and it is unrealistic to think that the required adjustments can be undertaken entirely on one side of the budget or the other. The painful decisions necessary to restore fiscal balance might be easier to enact and to enforce if policy-makers reinstated credible budget rules governing both spending and taxes, either of the form used in the past or perhaps a new variant.
The bottom line is that we will be paying for the folly of George Bush for a long time to come.

Hat Tip: TaxProf.

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