Reducing the Budget Deficit

January 9, 2011

I participated this morning in a panel discussion about budget deficits at the annual meeting of the American Economic Association. The panelists were asked to talk about what should, or will, or might, happen regarding the fiscal imbalance and the likely economic impact. Of course, CBO doesn’t make policy recommendations, so I couldn’t talk about what should happen. We also don’t make political forecasts—finding economic and budget projections quite difficult enough—so I couldn’t talk about what will happen. What CBO does is to examine for the Congress the effect of alternative policies, so it’s natural for me to talk about what might happen, and that’s what I did.

I noted that implementing the laws currently in place that govern tax and spending policy would reduce deficits over the next few years but would leave federal debt at a historically high level relative to the size of the economy over the next decade. Under current law, the tax cuts enacted early in the last decade will expire at the end of 2012, the alternative minimum tax (AMT) will affect significantly more taxpayers beginning in 2012, and Medicare’s payments to doctors will drop in 2012. With those assumptions, which correspond to CBO’s baseline projections, by 2020 federal revenues would rise to about 21 percent of GDP and the budget deficit would be about 3 percent of GDP.

Another possibility is to maintain the tax and spending policies that are currently in effect. Because that would mean lower taxes and higher spending than would occur under current laws, the government’s debt would grow much faster. For example, if the 2001 and 2003 tax cuts were permanently extended, the scope of the AMT was kept limited, cuts in Medicare payments to physicians did not occur, and the rest of the budget followed current law, then the budget deficit in 2020 would be about 6 percent of GDP.

A third possibility I highlighted is that the Congress makes changes to current policy that bring debt down toward the share of GDP that it has been for most of the past half-century, which is between about 25 percent and about 50 percent of GDP. That could be accomplished, for example, by balancing the budget for a number of years so that debt would be unchanged in dollar terms and would decline relative to a growing GDP (which is essentially the approach the country took following the Second World War).

In order to balance the budget, changes in policy would need to have three characteristics:

  • First, the policy changes would need to be large. Relative to what would happen if current policies were extended (as described above), balancing the budget in 2020 would require a cut in spending of about one-quarter, an increase in tax revenue of about one-third, or some combination of those approaches.
  • Second, the policy changes would need to affect popular programs or people’s tax payments. What would it mean to cut spending by one-quarter in 2020? That’s a bit more than total projected spending on Social Security; almost as much as combined spending on Medicare, Medicaid, and other health programs; much more than spending on defense; and a bit more than all federal spending apart from net interest and the programs just mentioned. On the other side, what would it mean to raise tax revenue by one-third in 2020? That would be more than a tripling of revenue from the corporate income tax or a substantial increase in individual income tax revenue.
  • Third, the policy changes would need to be enacted fairly soon. That is partly because federal debt has surged in the past few years, and will continue to rise sharply over the next decade under current policies, so bringing that debt back under control would require large changes in spending and revenues within this decade, not just in the long run. And the longer we delay, the greater would be the harmful effects of the federal debt: a larger reduction in future incomes relative to what would otherwise occur, a larger share of the federal budget devoted to interest payments than otherwise, tighter constraints on the government’s ability to deal with unexpected domestic or international problems, and a larger risk of a fiscal crisis. Also, the later that policy changes were made, the more drastic they would have to be.
    • At the same time, changes of this magnitude would be disruptive, so they would need to be implemented gradually, to give families, businesses, and other levels of government time to plan and adjust, and to reduce any near-term negative effects on the economy as it recovers from the severe recession. For example, proposals to make significant changes to Social Security and Medicare often exempt from the changes people over the age of 55 or 60, on the grounds that responding to large changes would be more difficult for them. However, many of those people will live for 20 years or more, so that spending under those programs would change course only slowly even if the changes being applied to younger people were fairly dramatic.