Budget Deficit Begs for Compromise

James Bryan, Hamilton College:

 

When Bill Clinton left office in 2001, the country was in a financially stable condition. The economy was growing, there was a substantial budget surplus – meaning the federal government’s revenue far exceeded its spending, and the national debt clocked in at a manageable six trillion dollars, 55% of GDP. Unfortunately, the following decade saw a change of direction; significant tax cuts without corresponding reductions in spending, two costly wars, and the worst financial crisis since the Great Depression created an enormous budget deficit that reached a staggering $1.4 trillion in 2009. Since then, the American economy has gone through a slow but steady recovery that has significantly raised government revenue. In addition, there were mild tax increases on top earners and an easing in military expenditures since the height of the financial crisis that have helped reduce the deficit to a more manageable $585 billion in 2016 (see figure 1), about 3% of GDP. Although the current level of deficit spending is not sustainable in the long term, it’s not an emergency either. However, the real problem is that due to demographic factors, if the United States does not have any significant changes in policy, the deficit will grow organically each year.

Figure 1

Source: Board of Governors of the Federal Reserve System/FRED

The Projections

Despite the steady decline in the deficit since the worst years of the Great Recession, the projections for the government’s budget going forward are ominous. In 2017, the deficit is expected to increase to $666 billion, an 80 billion dollar surge from the prior year, and follow a significant upward trend for the next decade. Barring no significant policy changes, the CBO currently predicts that the deficit will rise to 820 billion by 2021 and a staggering 1.3 trillion in 2026, or 4.8% of GDP. At that point, the debt-to-GDP ratio for the United States would be 87%, still not a full-blown crisis, but on trajectory for one. Further worsening the problem, the longer it takes to address the growing debt, the harder it will be to solve, as we have to pay an increasing interest payment on that debt every year. In fact, under the current projection, the interest on the national debt will grow from 475 billion per year in 2017, to 987 billion by 2026.

Aside from the growing interest payment, the factors that are driving the projections for a worsening budget situation are largely demographic. As the baby boomers begin to retire and start collecting social security and medicare benefits, the costs of those programs will grow faster than government revenue. Specifically, the CBO projects that Social Security and Medicare outlays, respectively will grow from 939 billion and 701 billion in 2017 to 1.6 trillion and 1.3 trillion, respectively in 2026. The growth in retirement benefits make up more than half of the 2.4 trillion dollar projected spending increase over the next decade. If the United States is going to get its budget under control, it will be necessary to either reign in retirement benefits or come up with new streams of revenue to fund the bursting programs.

Solutions

Before offering my opinions on a few policy changes that could help solve the long-term budget problem, it should first be stated that addressing the issue is going to require political courage, which seems to be in short supply these days. Neither tax increases nor cutting benefits plays well politically, but the United States could find itself in serious trouble if neither are accomplished. Democrats should be open to the idea of small tweaks to social programs, and Republicans are going to need to put new revenue on the table, either in the form of closing loopholes or raising tax rates. It’s hard to be optimistic about a budget compromise in today’s hyper-partisan climate, but a so called “grand bargain” was almost reached between President Obama and House Speaker John Boehner in 2012. It will be wise of the country’s current leadership to restart these talks, and there is evidence to suggest that Democrats are a more willing minority negotiator than their Republican counterparts.

Revenue

Despite what some might say, there is room for the American government to raise revenue with minimal adverse economic effect. For starters, both parties agree the tax system is filled with loopholes that benefit the ultra-wealthy and large corporations. Bringing the effective tax rate (what is actually paid after deductions and loopholes) closer to the headline rate for corporations and the highest earners would go a long way. A popular proposal along this line has been the so-called “Buffet Rule”, or a minimum effective tax rate of 30% for those making over a million dollars. On top of requiring the ultra-wealthy and corporations to pay minimum tax rates, there is also room to raise the headline rate on the most affluent. The current top marginal tax rate of 39.6% kicks in at $470,700 for married couples. Although that rate was recently raised, implementing a new bracket for those making over a million dollars, of somewhere in the 44% range, would have a minimal effect on consumer demand.

For those who argue that taxing the “job creators” in our society would have severe economic consequences, I challenge them to show me convincing evidence of their argument. In the 1950’s, when the middle class was expanding, the top effective tax rate was an unrecognizable 91%. Also, when both Bill Clinton and Barack Obama raised the top income tax rate, there was barely a noticeable economic effect, but a notable boost to government revenue. In addition, the top 1% of earners have captured an enormously disproportionate share of the income growth since the Reagan administration, a fact that should be reflected in the current tax system. Raising additional revenue from the highest earners in our society, as opposed to the middle class, not only takes from those that need it the least, but also would have the fewest economic consequences for every dollar raised in revenue.

Spending

The inconvenient truth for Democrats is that demographically-driven growth in spending is the primary cause of the current deficit trajectory. To address the issue without making any changes to the current system would require serious plans to raise government revenue in the next decade. It is against my own political instincts to want to cut spending. I firmly believe that government should play an important role in ensuring that everybody has access to economic security, but when looking at the details of social security, there are a couple of small tweaks that could pay big dividends in the future.

The first is to change the current cost of living adjustment, or COLA, to a slightly less generous method, as some economists believe the current formula overstates inflation, meaning the program is becoming more generous every year. The second adjustment would be to raise the retirement age over an extended period of time. When Social Security was created in 1935 and the retirement age was set at 65, the average life expectancy in America was 61 years old. Over the past century, the retirement age has not moved, but life expectancy is now about 79. I am not advocating for raising the age 18 years, but the system needs to be adjusted as our demographics drastically shift over time. I think a reasonable plan would be to raise the age by one month every year until it peaks at 68 in 2054. This would be a long-run shift aimed at curbing the slope of the expenditures, rather than a complete overhaul of the current Social Security system, and hopefully allow citizens to build the rising age into their retirement plan.

We Should Deal with This

Nobody wants to address this issue. I’m sure that almost everybody reading this is going to take exception to at least one of the proposed adjustments, which is exactly the problem. Pragmatic solutions to budget deficits don’t play well politically, making it easy to just continue to kick the can down the road. Unfortunately, the longer we take to deal with it, the more difficult it becomes to solve. Our leaders should be proactive, especially when the economy is healthy and can likely absorb some slowly implemented fiscal austerity. A sufficient compromise is possible if Democrats agree to moderate adjustments to social programs and their Republican counterparts stomach some new revenue from the ultra-wealthy. Hopefully if the current wave of political chaos and dysfunction passes, our nation’s leaders can go back to creating compromises that neither party is totally happy with, but both agree is superior to the ominous status-quo.

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