“Solving America’s Debt Crisis”

That’s the title of a piece my colleague Andrew Reschovsky has in the Fall La Follette Policy Report. With the admission of failure by the Supercommittee, it’s important to recall the basic choices facing the Nation.

In principle, solving the nation’s debt problems is easy. Almost all experts agree that a combination of reduced spending and increased tax revenues is needed. Cuts in spending and increases in tax revenues equal to about 5 percent of GDP are required to prevent an increase in the debt-to-GDP ratio. If a constant debt-to-GDP ratio were achieved with spending cuts alone, annual non-interest government spending would have to be reduced by about 20 percent. Alternatively, if a constant debt-to-GDP ratio were achieved by relying solely on increased tax revenues, taxes would have to be raised by about 33 percent. It is impossible to imagine that Congress would ever adopt spending cuts or tax increases of these magnitudes.

The logical conclusion is that only a balanced approach to solving our debt crisis, one that includes both spending cuts and increased taxes, is feasible. That being said, neither spending cuts nor tax increases will be politically easy to enact.

Last fiscal year, federal government spending was $3.5 trillion. Figure 2 illustrates the major spending categories. Social Security, Medicare, and Medicaid made up 41 percent of the budget. Another 15 percent was allocated to other mandated programs, and 6 percent to interest payments on the nation’s debt. The remaining 38 percent of the budget went to a wide array of discretionary programs, with nearly two-thirds going to defense and homeland security.

The current budget (fiscal year 2011 started October 1, 2010) contained tax reductions and substantial cuts in non-security discretionary programs. For the fiscal 2012 budget, the House has called for additional and controversial cuts in the same programs, but the Senate is likely to disagree. However, even if the House version were adopted, large deficits would continue and the debt-to-GDP ratio would continue to grow. The reason is the projected growth in entitlement programs, due to rising health-care costs and an aging population. As Figure 3 illustrates, after 2030 the cost of Social Security levels off at about 6 percent of GDP. The story is quite different for Medicare. Costs rise faster than GDP far into the future and are forecast to reach 10 percent of GDP in 2050. Proposals to restructure Medicare and Social Security benefits are controversial, partisan, and divisive.

The alternative route to deficit reduction is to raise government revenues. However, Congress seems to oppose tax increases even more than spending cuts. Congress has repeatedly reduced taxes by enacting rate reductions or by adding exemptions, deductions, and credits. As a result, federal tax revenues last year were 14.9 percent of GDP, their lowest level in the past 60 years. Not only have tax revenues been growing less slowly than the economy, they are substantially lower than taxes in most other developed nations. …

Here is Figure 4 from the article:

reschfig4.gifReschovsky concludes:

…Government austerity before the country is fully recovered from the recession raises the chance that the economy will be pushed into another recession. Slower economic growth lowers tax revenues and may well raise, rather than lower, the nation’s debt to GDP ratio.

While the case for delaying the implementation of debt-reduction policies until the economy gets back on track seems strong, Congress should not delay the adoption of a framework for reducing the federal government debt.

Or, as Jeffry Frieden and I conclude in our book, Lost Decades:

America’s prosperity requires fiscal responsibility. The phrase “fiscal responsibility” has been used so much that it is something between an obligatory buzzword and a code word for cutting government spending. In our view, true fiscal responsibility involves a willingness to raise sufficient tax revenue, over the longer term, to pay for the programs the government implements. Fiscal responsibility should not be equated with a small government, but rather with a commitment to pay for the government services provided. If the nation affirms that enhancing national defense and improving health care for the poor are legitimate goals, fiscal responsibility entails raising the revenue to fund these programs, rather than borrowing for them.

This post originally appeared at Econbrowser and is reproduced with permission.

4 Responses to "“Solving America’s Debt Crisis”"

  1. burkbraun   November 22, 2011 at 12:16 pm

    Do we have a debt crisis? Or do we have a debt circus?

    Our prosperity depends on having a long-term sustainable economy, based on sustainable resources and with broad-based (read middle-class) stable, aggregate demand denominated with a stable currency.

    The Federal debt has virtually nothing to do with these parameters. Other than … right now it should be increased to provide the aggregate demand and resource/infrastructure investments we do desperately need, and which the middle class needs to survive and thrive. Things like getting us off oil and coal, which are such dangers to our future prosperity.

    The drivers of the federal debt are balance of payments and internal growth. Our debt constitutes private wealth (bonds) that are valued and stable. Demand for dollars continues to be high, so our debt is not a problem. Some day, when other countries like China tire of giving us goods for piles of dollars, they may start to spend them, and we can then export more, and will indeed have to balance our federal budget, lest we resort to inflation.

    But right now, in what is obviously a deflationary environment with high net imports, debt is our friend, not our enemy.