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The United States is on an unsustainable fiscal course. This year marks the fourth in a row that the U.S. federal deficit will exceed $1.1 trillion. Since the end of 2007, the federal debt, now $11 trillion, has doubled as a share of annual GDP-from 36% to 73%. The long-term outlook is even worse.
The deficit is likely to improve in the next few years, but it will then turn upward again due to the projected rise in federal spending on Medicare and Social Security. According to the Congressional Budget Office (CBO), spending on those two programs will rise from 8.7% to 12.2% of GDP by 2037.
The good news is that U.S. lawmakers and policy experts from across the political spectrum have begun in earnest to outline possible strategies for tackling this looming debt crisis. Unsurprisingly, many suggestions-from the Left and the Right-are misguided or not particularly constructive. For example, a number of left-leaning think tanks have recently supported a “financial transactions” tax that would cause huge distortions, raise far less revenue than projected, and push more of the industry offshore. Similarly unhelpful, some conservative groups have advocated abolishing various small spending programs on the grounds that such cuts will improve the fiscal outlook, even though their elimination would have only a trivial impact on the overall federal budget.
Given the plethora of ideas being floated, it is critical that policymakers-both liberal and conservative-zero in on a framework that effectively addresses our fiscal challenges and permits specific policies to be properly evaluated. Outlined below are three key principles that are essential to this endeavor and offer concrete policy applications based on these principles. First let’s provide some context for understanding the size of the problem.
Understanding the National Debt
The gross magnitude of the federal deficit and federal debt is incomprehensible to most citizens. One way to put the debt burden in a more digestible framework is to compare the borrowing levels appropriate for a household to those of the government.
The conventional personal finance advice is that one’s mortgage should not exceed three to four times one’s annual income. This rule of thumb can be adjusted depending on expected future income growth, interest rates, or other expected expenses, but it is a reasonable starting point. For example, a household earning $100,000 would be well advised to buy a house for no more than $375,000-$500,000, assuming a 20% down payment.
The government’s income, total taxes, are expected to be $2.4 trillion this fiscal year. Given that the federal debt is $11 trillion, the government’s debt is already more than four times greater than its income. If the debt-to-GDP ratio rises to 200%, as CBO forecasts for 2037, the situation changes dramatically, with the debt-to-income ratio rising to more than 10. This would be the equivalent of a family who earns $100,000/year buying a $1.25 million house.
Three Elements of a Successful Debt-Reduction Framework
The key metric is the ratio of debt to GDP, not the absolute debt level. This ratio rises when the federal government’s borrowing is a higher fraction of existing debt than the rate at which the economy grows-that is, when the numerator grows faster than the denominator. If the nominal level of economic growth is 4% per year, for example, then, starting from a point at which debt equals 60% of annual GDP, any deficit above 2.4% of GDP increases the debt-to-GDP ratio. Given the enormous deficits of the last few years, that goal may seem impossible. On the other hand, from 2001 to 2008, the federal deficit averaged just 1.8% of GDP. While an economic growth agenda alone will not solve our problems, the solution must include growth-oriented policy changes. Our pending debt crisis poses a threat to our country’s ability to continue to grow and prosper. High debt burdens impose high costs, as the annual obligation to service that debt (interest costs) limits our ability to fund other programs or reduce tax burdens.
Critical to any successful set of reforms to tackle the looming debt crisis is a laser focus on the economic growth consequences of policy changes to federal programs, entitlements, and the tax system. In particular, any reforms to the tax system must be structured in a manner consistent with encouraging capital formation and human capital development. The tax burden on capital income-dividend and capital gains taxes and the corporate income tax-has been shown to discourage investment in the United States and therefore is contrary to a growth agenda. High marginal tax rates on entrepreneurship can also stifle innovation. Without changes to Medicare, Medicaid, and Social Security, there is no solution. While the level of discretionary spending has spiked significantly in recent years and should be scrutinized carefully, the only real solution to our looming debt crisis comes from fundamentally slowing the growth rate of entitlement, or “mandatory,” spending, which consists primarily of Medicare, Medicaid, and Social Security.
Over the last several decades, health care costs have been consistently rising at a rate higher than inflation-about 4.9% per year in real terms between 1965 and 2005. According to CBO, spending on major federal health programs is scheduled to increase from about 5% of GDP to 10% of GDP in the next fifteen years.
Applying the Principles: Establish Policy Objectives
In applying the principles outlined above, policymakers face three questions:
What goal should be set for a debt-to-GDP ratio, and in what year should it be met?
What level of tax receipts and spending outlays should be targeted to achieve that goal?
What tax reforms will promote growth and provide sufficient levels of revenue, and what changes to federal health and retirement spending will reduce Medicare, Medicaid, and Social Security outlays to sustainable levels?
Policymakers need to be realistic in the goals they set and then pursue those goals as aggressively as they can. Reasonable people can disagree over the answers to theabove questions but for me, I would give these answers:
The task of confronting the national debt is challenging, but it is quickly becoming unavoidable. The strategy that I propose here would help policymakers face the problem head on. By bringing the real issue into focus (the debt-to-GDP ratio), policymakers can set accurate, meaningful goals. By emphasizing economic growth, they can avoid creating a growth problem as they solve a budget problem. By being honest about the primary cause of the problem-entitlement programs-they can move to address issues that will only become more painful if we delay.
Alex Brill is a research fellow at the American Enterprise Institute, served as an adviser on tax policy to the President’s Fiscal Commission, and is a former senior adviser and chief economist to the House Ways and Means Committee.
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