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In his State of the Union address Tuesday, President Obama played on Congress’s fears that an abrupt spending sequester at a rate of about $110 billion per year ($1.1 trillion over 10 years) scheduled to begin March 1 would devastate the economy. “These sudden, harsh, arbitrary cuts,” warned Mr. Obama, would “slow our recovery and cost us hundreds of thousands of jobs.”
The sequester admittedly will produce short-term pain for those served by affected programs. But the impact will be limited. Cutting government spending by $110 billion per year would lower total federal spending, currently at about $3.6 trillion per year, by 3%. That is a modest reduction in spending, especially in view of the widely proclaimed need to cut the deficit.
Congress, especially Republicans, should embrace the sequester. While it represents only a modest, 10-year spending cut of $1.1 trillion—just 2.5% of projected total federal spending over that period—it still amounts to $2 of spending cuts for every dollar of the president’s tax increases enacted on Jan. 2. That’s not the 3:1 ratio recommended in December 2010 by the president’s Simpson-Bowles deficit commission, but it’s the best within reach now.
The sequester, along with the tax increases, would slow growth for a quarter or two, perhaps to 1%. But thereafter the slower growth in government debt levels and less uncertainty attached to fiscal policy would lead to greater private investment, increased economic growth and substantially reduced deficits.
What exactly does “substantially reduced” mean? The sequester and tax increases will reduce the primary deficit—that is, government spending minus tax revenues—by about $170 billion per year, thereby slowing the growth of the debt-to-GDP ratio by 1.4 percentage points per year. The growth in the debt-to-GDP ratio will be further slowed by the “interest gap,” or the difference between the average interest rate on outstanding U.S. government debt and the growth rate of nominal GDP.
In short, we can count on a growth rate in the debt-to-GDP ratio that is 4.6 percentage points per year slower than it would have been without the sequester and tax increases. This benign outcome requires that government interest costs remain low and that nominal growth stays at about 4% (2% real growth and 2% inflation). These conditions, in turn, are more likely given the enhanced sustainability of deficits brought about by the sequester and tax increases. Moderate deficit reductions initiate a virtuous circle that makes further deficit reduction more likely.
The deficit-reduction measures already undertaken this year, provided that Congress maintains the sequester, will be recognized as substantial progress toward achieving a sustainable path for U.S. deficits and debt. With the tax increases and sequester in place, the Congressional Budget Office projects substantially reduced deficits, falling from the $1.09 trillion deficit in fiscal year 2012 to $845 billion in 2013 and thereafter falling steadily to $535 billion in 2017.
Given this projected decline in deficits, the debt-to-GDP ratio would peak at about 77% in the 2014 fiscal year that starts this October and fall steadily to about 73% by 2017. During the five years from 2018 through fiscal year 2022, the CBO estimates that the debt-to-GDP ratio will rise modestly from 73% to 76%. The actual outcome will likely be better since the CBO assumes that interest rates on 10-year Treasury notes will rise to 5.4% from today’s 1.8%-1.95% range. But a more likely 4% yield on 10-year notes will slow growth in the debt-to-GDP ratio by 0.6 percentage points per year. The result will be a stable debt-to-GDP ratio over the next decade, even prior to entitlement reform.
In sum, by sticking to the sequester, Congress can assure some progress toward a sustainable fiscal policy. The major remaining challenges are to enact entitlement and tax reform.
There exist numerous proposals in Congress and elsewhere to moderate growth in outlays on Social Security, Medicare and Medicaid. A revenue-neutral tax reform that pays for lower marginal tax rates by closing loopholes would add half a percentage point to GDP growth over the coming five years, just when it is needed most to enhance the pace of reduction in the debt-to-GDP ratio.
Stabilizing the debt-to-GDP ratio just below current levels over the next decade and thereafter reducing it steadily back down to 60% or lower will pay substantial dividends. The uncertainty generated by unsustainable deficits will be reduced and investment in growth will accelerate.
Fear-mongering aside, the sequester is more paring knife than meat axe. Together with the tax increases enacted on Jan. 2 by the last Congress, the new Congress can use the sequester to put U.S. fiscal policy back on a sustainable path and then move on to finish the job by enacting entitlement and tax reform.
Mr. Makin is a resident scholar at the American Enterprise Institute and the author of AEI’s monthly Economic Outlook. He is a former consultant to the U.S. Treasury Department, Congressional Budget Office, and the International Monetary Fund.
Corrections & Amplifications
The percentage of federal spending that would be reduced by the budget sequester of $110 billion annually is 3%. An earlier version of this article misstated the percentage.
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