Brad Setser

Brad Setser: Follow the Money

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Beware of a 12 division budget and a 10 division tax base …

by Brad Setser
December 27, 2004

General Sinseki famously — and it seems accurately — warned of the risks of a “12 division strategy and a 10 division army.” To paraphase the US Defense Secretary: You fight a war with the army you have, not the army you want. But if you don’t plan realistically for your future commitments, your means are likely to lag your commitments. The US would be in better shape right now if it had started training and equipping a couple new army divisions back in early 2002.

The same is true of the federal budget. Ends (spending) have to match means (tax revenue) over time — though the federal government’s ability to borrow means that “over time” can be “over a very long time.” Right now we have a 10 division revenue base — federal taxation as a percent of GDP is at its lowest level since the 1950s: 16.2% of GDP in 2004. Alas we have a 12 division spending strategy: spending was just a bit under 20% of GDP in 2004, for a deficit of between 3.6 and 3.7% of GDP.

Take out social security, which takes in more revenue than it spends, and the budget math is even worse: revenues of 11.4% v. spending of 16.3%, or a deficit of nearly 5% of GDP. Non social security revenues only cover 70% of non social security expenditures — that is the federal government’s real financial problem, not the smaller predicted gap between social security’s revenues and its expenditures that will only emerge after the trust fund is exhausted in 2055.

The Bush Administration’s public line is no longer “deficits don’t matter.” That is a bit too in your creditors’ face, even for a Texan. The new line is: “We won’t raise taxes. But we will control spending … ”

The commitment to cut the deficit in half is not a commitment to go from a $400 bilion deficit to a $200 billion deficit. Nor is it a commitment to cut the observed 3.65% of GDP FY 04 deficit in half — to around 1.8% of GDP in FY 09. Rather, it is commitment to reduce the deficit to 2.25% of GDP, or 1/2 of the peak forecast of the 04 deficit (4.5% of GDP). No doubt the Administration will exclude any borrowing for social security privatization from its accounting of how Bush is meeting his commitment to cut the deficit in half.

That is an awful lot of nuance for a plain talking Texan who says what he means and means what he says.Suppose the administration is serious about cutting the deficit to 2.25% of GDP by FY 09, and wants to hold revenue constant at 16.2% of GDP. The CBO forecasts a rise in revenue in 05, but that assumes some of the tax cuts that expire at the end of this year are not renewed … Spending as a percentage of GDP has to fall to around 18.4% of GDP, or by around 1.5%. Let’s assume that “mandatory spending” — social security, medicare, etc — stays constant at around 10.8% of GDP (the CBO baseline has mandatory spending falling a bit in 2005 as a share of GDP, rising back to 04 levels by 08 and then rising by about 1% of GDP between 09 and 14 as the baby boomers retire).

Interest spending as a percent of GDP is expected to rise by around 0.5% of GDP by FY 09. That implies meeting W’s commitment requires other spending to fall by about 2% of GDP. Suppose defense and homeland security spending stay constant as a share of GDP at FY 05 levels, or around 4.25% of GDP. Then non-defense discretionary spending needs to fall from 3.6% of GDP to about 1.6% of GDP.

The math is a bit less harsh if revenues rise to 16.5% of GDP. Then non-defense spending only has to fall by about 1.6% of GDP, from 3.6% of GDP to 2.0% of GDP — or from around $450 billion in FY 05 to around $300 billion in FY 09. Sound realistic? Or sound like trying to transform Iraq with a ten division army?

My suspicion: The Republican Congress won’t cut current spending enough to put the US on track to meet the Bush Administration’s commitment to cut the deficit in half (assuming the cost of the war don’t fall dramatically). But they will pretend that they have found ways to cut future spending — including medical spending, as the LA times notes — enough to meet the commitment. Even more nuance.