Federal Budget Math: We Can

June 21, 2011

I was pleased to talk last Thursday at the Federal Reserve Bank of New York. I began my presentation by showing that, under current tax and spending policies, federal debt held by the public would be roughly equal to our annual economic output by the end of the decadea level that has been exceeded in the United States during only a few years in the 1940s. By current policies, I mean policies that are in effect now, even though they might be scheduled, by law, to expire or change in the next few years. Those policies include the tax cuts originally enacted in 2001 and 2003, the indexing of the parameters of the alternative minimum tax, and maintaining Medicares payment rates for physicians services. (Under current lawwhich includes the expiration in 2013 of the tax cuts originally enacted in 2001 and 2003, a sharp expansion in 2012 in the reach of the alternative minimum tax, and a nearly 30 percent cut in 2012 in Medicares payment rates for physician servicesdebt would rise only slightly relative to GDP during the rest of this decade.)

Thus, under current policies, the federal budget is quickly heading into territory that is unfamiliar to us and to most other developed countries as well. As policymakers and citizens think about this challenge, many wonder whether it is possible to return to a configuration of federal spending and revenues that, in earlier years, led to a stable trajectory of federal debt. Looking for historical reference points is natural. However, as I said in my talk, we cannot repeat the past when it comes to the federal budget: The aging of our population and the rising cost of health care have changed the backdrop for federal budget policy in a fundamental way.

To explain this point, my slides highlighted key aspects of federal budget policy during the past 40 years and of CBOs projections for 2021:

  • Revenues have averaged about 18 percent of GDP, with substantial variation around that level but no clear trend. Under current law, revenues are projected to be nearly 21 percent of GDP in 2021but if current tax policies were extended, revenues would be more than 2 percentage points lower and close to their historical average.
  • Older Americans are receiving cash payments that have risen with average wages (through Social Security); health insurance with a significant defined-benefit subsidy (through Medicare); and additional subsidies for health insurance and subsidized long-term care (through Medicaid) for many of those with very high medical costs or little income and assets. The cost of these programs is rising rapidly. Outlays for Social Security averaged 4.3 percent of GDP during the past 40 years and are projected to be 5.3 percent in 2021. The aging of the population and rising costs of health care are pushing up federal spending on the major mandatory health care programsMedicare, Medicaid, the Childrens Health Insurance Program, and insurance subsidies to be provided through exchanges in coming yearsfrom an average of 2.9 percent of GDP during the past 40 years to a projected 6.9 percent of GDP in 2021. (That figure is based on current law, including the coming drop in Medicares payment rates for physicians services; spending would be greater if current payment rates were continued.)
  • Defense spending has trended down relative to GDP, and outlays for all other federal programs have shown substantial variation relative to GDP and a slight downward trend. Given the assumptions that govern CBOs baseline projections, outlays for defense and all other federal programs together are projected to equal 8.3 percent of GDP in 2021. Such spending has averaged 11.5 percent of GDP during the past 40 years and has been as low as 8.3 percent in only two of those years.

Despite the low projected figure for defense spending and all other spending, the high costs of the major health care programs and Social Security mean that total outlays apart from interest on the debt are projected to be 20.5 percent of GDP in 2021, nearly 2 percentage points above the 40-year average. After interest payments are included, total outlays are projected to be nearly 24 percent of GDP, 6 percentage points more than the average amount of revenues during the past 40 years.

Therefore, given the aging of the population and the rising cost of health care, the United States cannot achieve all of the following objectives in the future:

  • Keep federal revenues at their average share of GDP during the past 40 years.
  • Provide the same sorts of benefits for older Americans that we have provided in the past 40 years.
  • Operate the rest of the federal government in line with its role in our economy and society during the past 40 years.

Putting fiscal policy on a sustainable path will require significant changes relative to our historical experience in popular programs, peoples tax payments, or both.