Robert Kahn

Macro and Markets

Robert Kahn analyzes economic policies for an integrated world.

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U.S. Budget Policy: Problem Solved?

by Robert Kahn
April 12, 2013


Long-term budget forecasts are more art than economics.  Small changes in assumptions and initial conditions, extrapolated over 25, 50 or 75 years, produce dramatically different outcomes.  Should one assume current law remains in effect, producing structural improvement in the deficit over time, or rather that Congress acts as in the past in extending temporary cuts, adjusting tax brackets, and easing spending constraints as new needs arise? Will the recent slowdown in the rate of increase in health care costs persist? Your answer to these questions can swing the budget in the long term from unsustainable deficit to surplus.  Still, these forecasts matter, as a statement of principle, as a description of philosophy, and in framing the debate.

Thus its notable that the Administration’s long-term projection in the budget (the “Budget Policy Extended” scenario) shows government debt as a share of GDP stable till 2050 and then declining, a forecast dramatically different (and more optimistic) from that produced by the Congressional Budget Office (CBO) and the independent commissions that have addressed the need for deficit reduction.  In fact, at the end of the 75 year period, the President’s forecast has the US Federal Government in a net creditor position equal to about 60 percent of GDP.  The result is driven by three assumptions:

(1) Revenue will increase sharply over time as a share of GDP because of the tax code is not fully indexed for inflation.  Current tax law remains in effect over the whole period.  Because tax brackets are not fully indexed for inflation, over time the real burden of taxation tends to rise with rising incomes.  In OMB’s projections, Congress allows federal revenues as a share of GDP to rise to  24 percent of GDP from 19 percent currently.  In contrast the standard practice of CBO is to assume that the ratio of tax revenues to GDP tends to revert to its long-term average of about 18 percent of GDP.

(2) Obamacare will bend the cost curve, reducing entitlement spending.  The cost controls build into the Affordable Care Act (ACA, or “Obamacare”) are assumed to work.  The ACA has a mechanism built in that is required to propose changes to Medicare and Medicaid programs if cost growth exceeds caps proposed in the law, and OMB projections assume that those caps hold over the entire projection period.  In contrast CBO assumes that healthcare costs continue to grow by more than general inflation.

(3) Discretionary spending will fall as a share of GDP.  Discretionary spending growth is assumed to grow with inflation plus population growth, which is less than GDP growth due to improving productivity.  In the past, I believe that the standard assumption has been to assume that discretionary spending grows in line with GDP.

While each of these assumptions is defensible, they could also be massively wrong, and in my judgment presents a risky case for doing nothing.  Future Congress could offset the bracket creep and raise spending caps, and medical costs may not come down (though, to be fair, they have risen more slowly in recent years than forecast and, if that trend continues, would be cause for a brighter long-term outlook than CBO has).

There is no doubt that the deficit picture has improved.  The roughly $3.7 trillion in deficit reduction that we have achieved in recent years, including the sequester, is enough to reduce deficits sharply and stabilize our debt in the 70 percent range until the middle of the decade.  Near-term deficit reduction is, if anything, too rapid given the state of the recovery.  And it’s understandable that the Administration would want to argue that the additional deficit reduction proposals in the budget would be powerful.  But, in most forecasts by 2020 the longer term drivers of the debt–an aging population, and rising health care and interest costs–cause debt to rise again at an unsustainable rate.   If we are to address the long-term drivers of our deficit, it would be better to start now, so the changes could be backloaded and gradual, then to wait till the crisis hits.  Of course, our political process doesn’t work that way, and sadly the progress we have made appears to have reduced the heat on policymakers to address the long term drivers of the debt.  A grand bargain looks increasingly remote.

In sum, these exercises remind us of the simple fact that long-term projections are highly sensitive to the assumptions made, and can support very different visions.  It would be unfortunate if the Administration’s approach feeds a growing narrative that we have done enough, and further reduces the political pressure to fix our budget for the longer term.

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