How Much Deficit Reduction is Appropriate?

from the Congressional Budget Office (CBO)

In coming decades, the aging of the population, rising health care costs, and the expansion of federal subsidies for health insurance will put increasing pressure on the federal budget. At the same time, by 2020, if current laws generally remained in place, federal spending apart from that for Social Security and major health care programs would drop to its smallest percentage of total output in more than 70 years, and federal revenues would be a larger percentage of output than they have been, on average, during the past 40 years.

Still, the rising cost of Social Security and the major health care programs would lead to widening deficits, CBO projects. Under those projections, federal debt held by the public would rise substantially over the long term as a share of the economy’s annual output—from 72 percent of output now to more than 100 percent of output 25 years from now—which would probably have significant negative consequences for the economy and reduce lawmakers’ ability to respond to unexpected developments.

Addressing that long-term challenge would require reducing future budget deficits. To accomplish that, lawmakers would need to increase revenues further relative to the size of the economy, decrease spending on Social Security or major health care programs from what would occur under current law, cut other federal spending to even lower levels by historical standards, or adopt some combination of those approaches. The amount of deficit reduction that would be needed would depend on lawmakers’ objectives for federal debt. For example:

• Decreasing that debt in 2038 to just below 70 percent of output—slightly less than what it is now but still quite high by historical standards—could be achieved if deficits were reduced by $2 trillion (excluding interest costs) during the next decade, and the reduction in the deficit as a percentage of output in 2023 was maintained in later years.
• Lowering the debt in 25 years to about 30 percent of output—which would be a little below the average over the past 40 years—could be achieved by reducing deficits by $4 trillion (excluding interest costs) during the next decade and maintaining that reduction in subsequent years.

Achieving savings of $2 trillion or more during the next 10 years would require significant increases in taxes, significant cuts in federal benefits or services, or both.

Making the task of deficit reduction more complicated is the economy’s slow recovery from the severe recession. By CBO’s estimate, the economy is now about 5 million jobs short of where it would be if the unemployment rate was down to its sustainable level and participation in the labor force was back up to its trend. The shortage of jobs has occurred mostly because demand for goods and services has been weak relative to the productive capacity of the economy. That shortfall in demand has stemmed largely from the lingering effects of the housing bubble and financial crisis. Also contributing, however, has been the most abrupt fiscal tightening that has occurred since the end of World War II, as the federal deficit shrank from about 10 percent of gross domestic product (GDP) in fiscal year 2009 to about 4 percent in 2013. Although that tightening has had the beneficial effect of slowing the accumulation of federal debt, it also has slowed economic growth during the past few years. Thus, lawmakers face difficult trade-offs when deciding how quickly to carry out policy changes that would make the path of federal debt more sustainable.

This report reviews the scale and sources of the federal government’s budgetary imbalance, various options for bringing spending and taxes into closer alignment, and criteria that lawmakers and the public might use to evaluate different approaches to deficit reduction. The discussion draws from CBO’s Options for Reducing the Deficit: 2014 to 2023 (November 2013) and serves as an update to the publication Choices for Deficit Reduction (November 2012).

The analysis in this report is based on CBO’s most recent 10-year budget projections, which were issued in May, and on the agency’s long-term budget projections, which were issued in September. The analysis does not include the effect of the recently passed Bipartisan Budget Act of 2013. Over the next 10 years, the agency estimates, that legislation would decrease mandatory spending by $78 billion, increase revenues by $7 billion, and increase discretionary spending by $63 billion if appropriations during the next decade equaled the limits set in current law rather than the limits set in prior law.

How Big Are Projected U.S. Deficits and Debt?

Between 2009 and 2012, the federal government recorded the largest budget deficits relative to the size of the economy since 1946, causing federal debt to soar. At 72 percent of GDP, federal debt held by the public is now higher than it has been at any point in U.S. history except for a brief period toward the end of World War II and a few years after; and it is twice the percentage recorded at the end of 2007. If current laws generally remained in place—an assumption underlying CBO’s baseline projections—federal debt held by the public would decline slightly relative to GDP over the next several years. After that, however, growing deficits would ultimately push debt back above its current high level, in CBO’s estimation. In 2038, CBO projects, federal debt held by the public would reach 100 percent of GDP—more than in any year except 1945 and 1946—even without accounting for the harmful effects that growing debt would have on the economy; taking those effects into account boosts projected debt to 108 percent of GDP.

How Are Major Components of the Budget Changing Over Time?

If current laws remained unchanged, Social Security and the federal government’s major health care programs would absorb a much larger share of the economy’s total output in the future than they have in the past (see the figure below). Projected increases would stem from three factors: the aging of the population; rising health care spending per beneficiary; and changes related to the Affordable Care Act, specifically the introduction of exchange subsidies and the expansion of Medicaid in many states. Meanwhile, by 2020, spending for all other federal activities would account for its smallest share of GDP in more than 70 years. Taking those pieces together, total federal spending other than interest on the debt would be greater relative to the size of the economy than it has been, on average, during the past 40 years.

At the same time, under current law, revenues would represent a larger percentage of GDP in the future than they generally have in the past few decades. However, CBO projects that revenues would not keep pace with outlays, so deficits would rise and federal debt would grow at a faster pace than the overall economy.

What Are the Consequences of Large and Growing Federal Debt?

Because federal debt is already unusually high relative to GDP, further increases in that debt could be especially harmful. How long the nation could sustain the projected growth in federal debt relative to the size of the economy is impossible to predict with any confidence. At some point, investors would begin to doubt the government’s willingness or ability to pay U.S. debt obligations, making it more difficult or more expensive for the government to borrow money.

Moreover, even before that point was reached, the high and rising amount of federal debt that CBO projects would have significant negative consequences for both the economy and the federal budget. Higher debt would lead to larger interest payments; making those payments would eventually require some combination of lower noninterest spending and higher taxes. In addition, increases in debt tend to reduce national saving, leading to more borrowing from abroad and less domestic investment, which in turn reduces people’s future income relative to what it would otherwise be. Also, when debt rises, lawmakers are less able to use tax and spending policies to respond to unexpected challenges, such as economic downturns or international crises. Rising debt could itself precipitate a fiscal crisis by undermining investors’ confidence in the government’s ability to manage the budget.

What Policy Changes Could Lower the Trajectory of Federal Debt?

Lawmakers could set various goals for deficit reduction and the trajectory of debt. If current laws generally remained in place, deficits would total about $6 trillion over the next 10 years and debt would reach 108 percent of GDP by 2038, CBO projects. Alternatively, for example, with gradually increasing amounts of deficit reduction totaling $2 trillion over the next 10 years (excluding effects on interest payments and with the reduction as a percentage of GDP in 2023 maintained in later years), federal debt held by the public would drop to 61 percent of GDP in fiscal year 2023 before rising again to 67 percent in 2038. Or, as another example, with gradually increasing amounts of deficit reduction totaling $4 trillion over the next decade, debt would drop to 51 percent of GDP in fiscal year 2023 and decline even further, to 31 percent, by 2038.

To put the federal budget on either of those paths, lawmakers would need to make significant policy changes—allowing revenues to rise substantially more than would occur under current law, reducing spending for large benefit programs to amounts considerably below those currently projected, or adopting some combination of those approaches. Although changes in other activities of the federal government could affect the magnitude of the changes needed to policies that govern taxes or large benefit programs, they could not eliminate the basic trade-off that exists between those two parts of the budget.

What Criteria Might Be Used to Evaluate Policy Changes?

When considering policy changes that would reduce budget deficits, lawmakers and the public might want to consider several factors: How much deficit reduction is appropriate? What is the proper size of the federal government and the best way to allocate federal resources? What types of policy changes would most enhance prospects for near-term and long-term economic growth? What would be the distributional implications of proposed changes—that is, who would bear the burden of particular cuts in spending or increases in taxes, and who would realize long-term economic benefits? The way that people think about those criteria, and the relative importance they attach to different criteria, will vary according to their individual preferences and priorities.

source: http://www.cbo.gov/publication/44967