Macroeconomic effects of future fiscal policies

May 19, 2008

Under current law, rising costs for health care and the aging of the population will cause federal spending on Medicare, Medicaid, and Social Security to rise substantially as a share of the economy. At the request of the Ranking Member of the House Budget Committee, CBO released a letter examining the potential economic effects of (1) allowing federal debt to climb as projected under the alternative fiscal scenario presented in CBOs December 2007 Long-Term Budget Outlook; (2) slowing the growth of deficits and then eliminating them over the next several decades; and (3) using higher income tax rates alone to finance the increases in spending projected under that scenario.

How Would Rising Budget Deficits Affect the Economy? Sustained and rising budget deficits would affect the economy by absorbing funds from the nations pool of savings and reducing investment in the domestic capital stock and in foreign assets. As capital investment dwindled, the growth of workers productivity and of real (inflation-adjusted) wages would gradually slow and begin to stagnate. As capital became scarce relative to labor, real interest rates would rise. In the near term, foreign investors would probably increase their financing of investment in the United States, but such borrowing would involve costs over time, as foreign investors would claim larger and larger shares of the nations output and fewer resources would be available for domestic consumption.

How much would the deficits projected under the alternative fiscal scenario presented in the December 2007 Long Term Budget Outlook affect the economy? For its analysis, CBO used a textbook growth model that can assess how persistent deficits might affect the economy over the long term. According to CBOs simulations using that model, the rising federal budget deficits under this scenario would cause real gross national product (GNP) per person to stop growing and then to begin to contract in the late 2040s. By 2060, real GNP per person would be about 17 percent below its peak in the late 2040s and would be declining at a rapid pace. Beyond 2060, projected deficits would become so large and unsustainable that the model cannot calculate their effects. Despite the substantial economic costs generated by deficits under this model, such estimates greatly understate the potential loss to economic growth because the effects of rapidly growing debt would probably be much more disorderly and could occur well before the time frame indicated in the scenario.

How Would the Slowing the Growth of Deficits Affect the Economy? The minority staff of the House Budget Committee provided CBO with a target path slows the growth of budget deficits. In evaluating the economic effects of the target path, CBO did not examine how specific policies to achieve that path would affect the economy; instead, CBO limited its attention solely to examining how the deficits produced by the target would affect the economy, assuming that such effects would play out as they have in the past. (CBO has not evaluated either the political feasibility or the economic effects of reducing spending sufficiently to accomplish this path for the deficit. Furthermore, the spending and revenue targets provided by the Committee staff are not the only way to achieve a sustainable budget path. Alternative policies will have different effects on the economy, and changes in taxes and spending can exert influences on the economy other than the effects of reducing budget deficits.)

Under the target path, federal outlays excluding interest (that is, primary spending) would rise from 18 percent of GDP in 2007 to 20 percent in 2030 and then decline to 19 percent in 2050 and 13 percent in 2082. For almost all years, revenues would remain at 18.5 percent of GDP. Under those assumptions, the budget deficit would gradually increase to about 6 percent of GDP in 2040 but then would decline to almost zero in 2075. By 2082, the target path would generate a budget surplus of about 2 percent of GDP. Under this path, real GNP per person would continue to grow over the entire projection period, rising from about $45,000 in 2007 to about $165,000 in 2082 in inflation-adjusted dollars. By 2060 (the last year for which it is possible to simulate the effects of the alternative fiscal policy using the textbook growth model), real GNP per person would be about 85 percent higher under the target path than under the alternative fiscal scenario.

How Would Increasing Income Tax Rates to Finance the Projected Rise in Spending Affect the Economy? How would the economy be affected if the projected rise in primary spending under CBOs alternative fiscal scenario (from about 18 percent of GDP in 2007 to about 35 percent in 2082) was financed entirely by a proportional across-the-board increase in individual and corporate income tax rates? Answering that question is difficult because the economic models that economists have developed so far would have to be pushed well outside the range for which they were initially developed.

Nonetheless, tax rates would have to be raised by substantial amounts to finance the level of spending projected for 2082 under CBOs alternative fiscal scenario. Before any economic feedbacks are taken into account, and assuming that raising marginal tax rates was the only mechanism used to balance the budget, tax rates would have to more than double. Such tax rates would significantly reduce economic activity and would create serious problems with tax avoidance and tax evasion. The letter provides more details about possible scenarios. (Raising revenue in ways other than increasing tax rates would have a less marked effect on economic activity.)

Conclusion. The United States faces serious long-run budgetary challenges. If action is not taken to curb the projected growth of budget deficits in coming decades, the economy will eventually suffer serious damage. The issue facing policymakers is not whether to address rising deficits, but when and how to address them. At some point, policymakers will have to increase taxes, reduce spending, or both.

Much of the pressure on the budget stems from the fast growth of federal costs on health care. So constraining that growth seems a key component of reducing deficits over the next several decades. A variety of evidence suggests that opportunities exist to constrain health care costs both in the public programs and in the health care system overall without adverse health consequences, although capturing those opportunities involves many challenges.