Testimony on Confronting the Nation's Fiscal Policy Challenges

Report
September 13, 2011

The federal government is confronting significant and fundamental budgetary challenges. If current policies are continued in coming years, the aging of the population and the rising cost of health care will boost federal spending, as a share of the economy, well above the amount of revenues that the federal government has collected in the past. As a result, putting the federal budget on a sustainable path will require significant changes in spending policies, tax policies, or both. The task of addressing those formidable challenges is complicated by the weakness of the economy and the large numbers of unemployed workers, empty houses, and underused factories and offices. Changes that might be made to federal spending or tax policies could have a substantial impact on the pace of economic recovery during the next few years as well as on the nation’s output and people’s income over the longer term.


 

The Economic Outlook

The financial crisis and recession have cast a long shadow on the U.S. economy. Although output began to expand again two years ago, the pace of the recovery has been slow, and the economy remains in a severe slump. CBO expects that the economic recovery will continue but that output will stay well below the economy’s potential output—an amount that corresponds to a high rate of use of labor and capital—for several years. CBO published its most recent economic forecast in August; that forecast was initially completed in early July and was updated in August only to reflect the policy changes enacted in the Budget Control Act. Incoming data and other developments since early July, as well as the latest Blue Chip consensus forecast, suggest that economic growth for the remainder of this year and next is likely to be weaker than the agency anticipated—with growth in the vicinity of 1½ percent this year and around 2½ percent next year.


 

With output growing at that modest rate, CBO expects employment to expand very slowly during the rest of this year and next year, leaving the unemployment rate close to 9 percent through the end of 2012. Weakness in the demand for goods and services is the principal restraint on hiring, but structural impediments in the labor market—such as a mismatch between the requirements of existing job openings and the characteristics of job seekers—appear to be hindering hiring as well.

If economic growth occurs at the slow pace that CBO anticipates, a large portion of the economic and human costs of the recession and slow recovery remains ahead. In mid-2011, according to the agency’s estimates, the economy was only about halfway through the cumulative shortfall in output relative to its potential level that will result from the recession and the weak recovery. Between late 2007 and mid-2011, the cumulative difference between gross domestic product (GDP) and estimated potential GDP amounted to roughly $2½ trillion; by the time the nation’s output rises back to its potential level, probably several years from now, the cumulative shortfall is expected to equal about $5 trillion. Not only are the costs associated with the output gap immense, but they are also borne unevenly, falling disproportionately on people who lose their jobs, who are displaced from their homes, or who own businesses that fail.

The economic outlook remains highly uncertain, however. The recent recession was unusual compared with previous ones in terms of its causes, depth, and duration. As a result, the recovery has had unusual features that have been hard to predict, and the path of the economy in coming years is also likely to be surprising in various ways. Many developments, such as changes in the degree to which households want to further reduce their debt burdens or the adoption of fiscal policies that differ from current law, could cause economic outcomes to differ substantially, in one direction or the other, from those CBO has projected.

The Budget Outlook

If the recovery continues as CBO expects, and if tax and spending policies unfold as specified in current law, deficits will drop markedly as a share of GDP over the next few years. Under CBO’s baseline projections, which generally reflect the assumption that current law will not change, deficits fall to 6.2 percent of GDP in 2012 and to 3.2 percent in 2013, and then fluctuate within a range of 1.0 percent to 1.6 percent of GDP from 2014 through 2021. In that scenario, cumulative deficits over the coming decade will total $3.5 trillion, and by 2021, debt held by the public will equal 61 percent of GDP—well above the annual average of 37 percent recorded between 1971 and 2010. (The weaker economy that CBO now anticipates for the remainder of this year and next would imply, all else being equal, a slightly larger federal deficit during that period.)

CBO’s baseline projections incorporate the assumption that current law remains in place so they can serve as a benchmark for policymakers to use in considering possible changes to the law. But those baseline projections understate the budgetary challenges facing the federal government because changes in policy that will take effect under current law will produce a federal tax system and spending for some federal programs that differ noticeably from what people have become accustomed to. Specifically, CBO’s baseline projections include the following policies specified in current law:

  • Provisions of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (Public Law 111-312, referred to in this testimony as the 2010 tax act) that reduced the payroll tax for one year and limited the reach of the alternative minimum tax (AMT) for two years are set to expire on December 31, 2011.
  • Several other key provisions of the 2010 tax act—including the extension of lower tax rates and expanded credits and deductions originally enacted in the Economic Growth and Tax Relief Reconciliation Act of 2001, the Jobs and Growth Tax Relief Reconciliation Act of 2003, and the American Recovery and Reinvestment Act (ARRA, P.L. 111-5)—are set to expire on December 31, 2012.
  • Medicare’s payments for physicians’ services are scheduled to be reduced by nearly
    30 percent after December 31, 2011.
  • Discretionary appropriations between 2012 and 2021 will be subject to statutory caps set in the Budget Control Act of 2011 (P.L. 112-25) that will reduce discretionary spending in real (inflation-adjusted) terms over time.
  • Additional budgetary savings of more than $1 trillion required by the Budget Control Act will occur as a result of legislation produced by this Committee or, if lawmakers fail to enact such legislation, by means of automatic cuts in spending that will then be triggered.

Changing provisions of current law so as to maintain major policies that are in effect now would produce markedly different budgetary outcomes. For example, if most of the provisions in the 2010 tax act were extended, if the AMT was indexed for inflation, and if Medicare’s payment rates for physicians’ services were held constant, then cumulative deficits over the coming decade would total $8.5 trillion, and debt held by the public would reach 82 percent of GDP by the end of 2021, higher than in any year since 1948.

Beyond the coming decade, the fiscal outlook worsens, as the aging of the population and the rising costs of health care exert significant and increasing pressure on the budget under current law. When CBO issued its most recent long-term projections in June 2011, debt held by the public was projected to reach 84 percent of GDP in 2035 under an extension of current law. In those projections, rising federal spending relative to GDP kept debt high even though federal revenues reached significantly larger percentages of GDP than ever seen before in the United States. The agency also examined an alternative scenario in which the tax provisions enacted since 2001 that were extended most recently in 2010 were assumed to be extended, the reach of the AMT was assumed to be restrained to stay close to its historical extent, and tax law was assumed to evolve over the long term so that revenues remained near their historical average of 18 percent of GDP. CBO projected in June that, under that alternative scenario, revenues would increase much more slowly than spending, and debt held by the public would balloon to nearly 190 percent of GDP by 2035.

Although new long-term projections reflecting the latest 10-year projections would differ, the amounts of federal borrowing that would be required under those policy assumptions clearly would be unsustainable. Interest payments on that debt would rise dramatically relative to the size of the tax base that would be available for generating revenues to cover those payments, consuming an ever-growing share of the federal budget. Even before the interest burden became unsupportable, a fiscal crisis could arise if participants in financial markets lost confidence in the government’s ability to manage its budget and became unwilling to lend to the government at affordable rates. Thus, under current policies, the federal budget is quickly heading into territory that is unfamiliar to the United States and to most other developed countries as well.

Fiscal Policy Choices

The budgetary and economic challenges facing the nation present policymakers with difficult choices about fiscal policy. As this Committee considers its charge to recommend policies that would reduce future budget deficits, its key choices fall into three broad categories:

  • How much deficit reduction should be accomplished?
  • How quickly should deficit reduction be implemented?
  • What forms should deficit reduction take?

The Magnitude of Deficit Reduction. There is no commonly agreed upon level of federal debt that is sustainable or optimal. Under CBO’s current-law baseline, which incorporates $1.2 trillion in expected deficit reduction related to this Committee’s work, as well as significant increases in tax revenues relative to GDP, debt held by the public is projected to fall from 67 percent of GDP at the end of 2011 to 61 percent by 2021. However, stabilizing the debt at that level would leave it larger than in any year between 1953 and 2009.

Lawmakers might determine that debt should be reduced to amounts lower than those shown in CBO’s baseline—in order to reduce the burden of debt on the economy, relieve some of the long-term pressures on the budget, diminish the risk of a fiscal crisis, and enhance the government’s flexibility to respond to unanticipated developments. Accomplishing that objective would require larger amounts of deficit reduction. If, for example, this Committee chose to make recommendations that would lower debt held by the public in 2021 to 50 percent of GDP, roughly the level recorded in the mid-1990s, it would need to propose changes in policies—relative to those embodied in current law, which underlie CBO’s baseline projections—that reduced deficits by a total of about $3.8 trillion over the coming decade.

Furthermore, lawmakers might decide that some of the current policies that are scheduled to expire under current law should be continued. In that case, achieving a particular level of debt could require much larger amounts of deficit reduction through other changes in policy. For example, if most of the provisions in the 2010 tax act were extended, if the AMT was indexed for inflation, and if Medicare’s payment rates for physicians’ services were held constant, then reducing debt held by the public in 2021 to the 61 percent of GDP projected under current law would require other changes in policy to reduce deficits over the next 10 years by a total of $6.2 trillion, rather than the $1.2 trillion in deficit reduction that this Committee would have to accomplish to avoid the automatic budget cuts required by the Budget Control Act.

The Timing of Deficit Reduction. Policymakers face difficult trade-offs in decisions about how quickly to implement policies to reduce budget deficits. On the one hand, cutting spending or increasing taxes slowly would lead to a greater accumulation of government debt and might raise doubts about whether the longer-term deficit reductions would ultimately take effect. On the other hand, implementing spending cuts or tax increases abruptly would give families, businesses, and state and local governments little time to plan and adjust. In addition, and particularly important given the current state of the economy, immediate spending cuts or tax increases would represent an added drag on the weak economic expansion.

However, credible steps to narrow budget deficits over the longer term would tend to boost output and employment in the next few years by holding down interest rates and by reducing uncertainty and enhancing business and consumer confidence. Therefore, the near-term economic effects of deficit reduction would depend on the balance between changes in spending and taxes that take effect quickly and those that take effect gradually. According to CBO’s analysis, credible policy changes that would substantially reduce deficits later in the coming decade and over the long term—without immediate cuts in spending or increases in taxes—would both support the economic expansion in the next few years and strengthen the economy over the longer term.

There is no inherent contradiction between using fiscal policy to support the economy today, while the unemployment rate is high and many factories and offices are underused, and imposing fiscal restraint several years from now, when output and employment will probably be close to their potential. If policymakers wanted to achieve both a short-term economic boost and medium-term and long-term fiscal sustainability, a combination of policies would be required: changes in taxes and spending that would widen the deficit now but reduce it later in the decade. Such an approach would work best if the future policy changes were sufficiently specific and widely supported so that households, businesses, state and local governments, and participants in the financial markets believed that the future fiscal restraint would truly take effect.

The Composition of Deficit Reduction. As policymakers consider the composition of policy changes to be used to reduce budget deficits, many factors may play a role. The amount and composition of federal spending and revenues affect the total amount and types of output that are produced and consumed in the country, the distribution of those material resources among various segments of society, and people’s well-being in a variety of ways.

In considering the challenge of putting fiscal policy on a sustainable path, many observers have wondered whether it is possible to return to policies regarding federal spending and revenues that, in earlier years, usually generated deficits that were small relative to GDP and kept the amount of debt held by the public to between about one-quarter and one-half of GDP. Unfortunately, however, the past combination of policies cannot be repeated when it comes to the federal budget: The aging of the population and rising costs for health care have changed the backdrop for federal budget policy in a fundamental way.

Under current law, spending on Social Security and the major health care programs—Medicare, Medicaid, the Children’s Health Insurance Program, and insurance subsidies to be provided through exchanges in coming years—is projected to be much higher than has historically been the case, reaching 12.2 percent of GDP in 2021, compared with 10.4 percent of GDP in 2011 and an average of 7.2 percent of GDP during the past 40 years. Most of that spending goes to benefits for people over age 65, with smaller shares for blind and disabled people and for nonelderly able-bodied people.

In contrast, under current law, all spending apart from that for Social Security, the major health care programs, and interest payments on the debt is projected to decline noticeably as a share of the economy. That broad collection of programs includes defense (the largest single piece), the Supplemental Nutrition Assistance Program (formerly known as Food Stamps), unemployment compensation, other income-security programs, veterans’ benefits, federal civilian and military retirement benefits, transportation, health research, education and training, and other programs. Such spending has averaged 11.5 percent of GDP during the past 40 years and totals 12.0 percent in 2011. Expected improvement in the economy and the caps on discretionary spending instituted in the Budget Control Act are projected to reduce such spending to 7.7 percent of GDP in 2021, the lowest level as a share of GDP in the past 40 years.

Thus, according to CBO’s projections under current law, even with the new constraints on discretionary spending, federal spending excluding net interest will grow to 19.9 percent of GDP in 2021—compared with the 40-year average of 18.6 percent. And the composition of that spending will be noticeably different from what the nation has experienced in recent decades: Spending for Social Security and the major health care programs will be much higher, and spending for all other federal programs and activities, except for net interest payments, will be much lower. Alternatively, if the laws governing Social Security and the major health care programs were unchanged, and all other programs were operated in line with their average relationship to the size of the economy during the past 40 years, total federal spending excluding net interest would be much higher in 2021—nearly 24 percent of GDP. That amount exceeds the 40-year average for revenues as a share of GDP by nearly 6 percentage points—even before interest payments on the debt have been included.

At the same time, the sharp increase in federal debt and a return to more-normal interest rates will boost the government’s net interest costs. They are projected to reach 2.8 percent of GDP in 2021, compared with only 1.5 percent of GDP in 2011 and an average of 2.2 percent of GDP during the past 40 years.

What do those numbers imply about the choices that policymakers—and citizens—confront about future policies? Given the aging of the population and the rising costs for health care, attaining a sustainable budget for the federal government will require the United States to deviate from the policies of the past 40 years in at least one of the following ways:

  • Raise federal revenues significantly above their average share of GDP;
  • Make major changes to the sorts of benefits provided for Americans when they become older; or
  • Substantially reduce the role of the rest of the federal government relative to the size of the economy.

The nation cannot continue to sustain the spending programs and policies of the past with the tax revenues it has been accustomed to paying. Citizens will either have to pay more for their government, accept less in government services and benefits, or both.