How to fix the long-run budget deficit in six easy steps

January 24, 2013

Given that bond purchasers are literally paying the federal government for the privilege of giving us their money for the next 10 years, it's hard to justify the amount of attention that the budget deficit has received from policymakers in the short-term. But most analysts think we're probably going to need to start paring back our debt load in the next decade or so. With U.S. debt now near 70 percent of GDP (and topping 100 percent of GDP when Social Security and other trust fund obligations are taken into account*), the challenge looks, at first glance, pretty daunting.

Not so fast, says David Kamin. In a recent paper in Tax Notes, the New York University law professor and former Obama economic aide argues that it's much easier to close the long-run budget gap than most commentators assume.

But first thing first — what do we mean when we talk about the "budget gap"? That's the amount of combined spending cuts and tax increases we need over the next 75 years to keep the debt load where it is now. Kamin calculates that at 8.7 percent of GDP every year.

That's a huge contraction! But that figure is misleading. If we were to immediately enact 8.7  percent of GDP in budget cuts and tax increases, it would cause a yo-yo effect. The debt would fall at a modest pace in the short-term — tempered by the fact that a contraction that large would almost certainly cause a recession, if not a depression — and then fall extremely fast, leading to historically unprecedented surpluses, before growing again due to rising health-care costs and other budget obligations associated with population aging:


Chart by David Kamin.

A more sensical path would be to enact modest deficit reduction in the medium-term and then ratchet it up as we go along. For example, the following path, with deficit reduction over the next decade of about 2-3 percent of GDP (about the same size as President Clinton's austerity package of 1993) and growing to 14 percent of GDP by 2086, would also stabilize our debt ratio:


Chart by David Kamin.

So how do we achieve something like that? It's easier than you might think. First, Kamin considers four debt reduction proposals that both the White House budget and the Paul Ryan-authored House Republican budget include. These include slowing the pace of Medicare cost growth, continuing discretionary spending cuts and ramping down the wars in Iraq and Afghanistan, maintaining current policy on other mandatory programs like unemployment insurance and refundable tax credits, and keeping revenue at 19 percent of GDP. He aptly dubs these "consensus deficit reduction measures."

Obviously, the two parties differ on the specifics. The White House's vision of how to achieve a reduction in Medicare cost growth is rather different than Paul Ryan's, and it would prefer revenue to grow more than the 19 percent of GDP target Ryan's budget sets. But it's not unreasonable to assume that policy will follow the course set by these measures.

This is particularly true considering that Medicare cost growth is already slowing, perhaps as a result of Obamacare's cost control measures, and, Kamin argues, we're set to spend less on non-entitlement mandatory programs than the CBO estimates given laws already in place. With the tax increases passed at the beginning of this month, we already may be set for a long-run revenue average above 19 percent. And the discretionary spending cuts Kamin's talking about have, in large measure, already been passed. These changes, then, could come into effect even without further legislative action. And if they do, Kamin estimates that they cut the long-run budget gap in half:

And what about the remaining 4.5 percent gap? Well, making Social Security solvent indefinitely would lop off another percent. So we're down to 3.5 percent. Throw in another 1.6 percent of GDP in deficit reduction, and we're down to 1.9 percent. Dealing with that would require a 4 percent of GDP austerity package (again, not too different from Clinton's) in 75 years. As Kamin says, "if this alone were the remaining adjustment needed in the distant future, it would be difficult to describe it as a crisis."

But we may not even need that additional deficit reduction. Kamin estimates that health-care spending growth will cause a significant increase in revenue from the Obamacare excise tax on expensive health-insurance plans. What's more, rising incomes will naturally increase income tax revenue by pushing more people into higher bracket, and the aging of the population means money will start to come out of tax-preferred IRAs and 401(k)s and suddenly become taxable. These factors alone reduce the long-run deficit by 2.8 percent. Combine that with a permanent Social Security fix — or, if you'd prefer, a policy of tying discretionary spending growth to the rate of inflation and population growth — and you barely have any long-run deficit problem to speak of:

All of which is to say: Anyone who tells you how huge the deficit problem is is trying to sell you something. Policy changes that are already in motion will likely get rid of all but 1.7 percent of the long-run budget gap, and that's not a big hole to fill, especially if we get around to making Social Security permanently solvent.

* Of course, this depends on whether you think that the debt-to-GDP ratio even matters. Yale economist Robert Shiller makes an extremely compelling case that it's essentially a meaningless figure.

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Neil Irwin · January 24, 2013