Out on A Limb

By Douglas Holtz-Eakin
Sunday, February 5, 2006

The federal budget does not add up.

There is universal recognition among policymakers who gaze out over the legions of baby boomers nearing retirement that the old-age programs -- Social Security and Medicare -- need a fundamental rethinking that will dictate the size of government and future levels of taxation. There is also universal political recognition that this is a job nobody wants.

For now, most Republicans and Democrats believe it's a job they can put off. Perhaps they find comfort in conventional budget forecasts, which suggest that over the next few years, the federal budget deficit can be easily managed. Business-as-usual budget projections, such as those recently released by the nonpartisan Congressional Budget Office, predict deficits in the range of 2 to 3 cents on every dollar of national economic output over the next five years. (The United States currently spends a bit more than 20 percent of its gross domestic product, raises about 17.5 percent in taxes, and borrows the difference.) The CBO shows the deficit shrinking to essentially zero over the next decade.

So what's to worry about? Plenty. Public expectations about spending and tax levels are not the same as the assumptions built into the forecasts at CBO or the Office of Management and Budget. The straight-shooting forecasters at CBO are good economists, but they can only rely on tax and spending legislation that's currently on the books. As for OMB, it presumes that the president's policies are adopted -- all of them. Neither agency's forecast is likely to match reality next year, much less five or 10 years from now. And that will become a combustible problem when the public wakes up to find that expected spending won't materialize or that tax rates taken for granted must be raised.

To appreciate the true size of the fiscal problem, dig down one layer in official budget forecasts. Government forecasts predict that budget deficits will narrow as revenues rise from the current level, which is below the post-World War II average of 18 cents on the dollar, to a level near the postwar peak of 20 cents. Is that realistic? Historically, when taxes reach that level, U.S. politics drive them back down.

Moreover, the rise in tax revenues would primarily come from the expiration of the tax cuts passed between 2001 through 2005. President Bush has asked Congress to make the current rates permanent, but if he fails it will mean a return to higher top marginal tax rates and higher tax rates on capital gains and dividends, the elimination of the 10 percent tax bracket, scaled-back child credits and an increase in the marriage penalty. Will the U.S. public tolerate that?

Most Americans also expect the administration and Congress to do something about the alternative minimum tax (AMT). As it stands, forecasts assume that as economic growth raises incomes, more and more taxpayers will move into the AMT's higher tax rates. This assumption collides with a strong sentiment in this country: that the middle class should not be expected to carry more of the nation's tax burden, especially if its members don't feel any richer than they were before. But nothing's been changed yet.

In short, it's easy to see why the current level of taxes will fail to cover the type of government Americans have grown used to. That's bad news because the government will not be getting any smaller.

If anything, current budget forecasts underestimate future spending. The forecasts assume that government will remain roughly the same size as a proportion of GDP. To do that, spending on items other than relentlessly expanding mandatory programs such as Social Security and Medicare must remain fixed in inflation-adjusted terms for a decade. Quite simply, that's never happened.

Why? Look at it this way. It means Congress and the president would have to slice discretionary spending (everything but mandatory programs like Social Security, Medicare, Medicaid or unemployment compensation) by 1.5 percent of GDP. That's a lot -- comparable to the size of the tax increase that will hit in 2011 with the scheduled sunset of the recent tax cuts. While everyone is in favor of eliminating waste, Americans want to protect defense, education, environment, transportation and a myriad of other programs. Congress expended a tremendous effort last week and just barely adopted $39 billion in cuts from projected spending -- less than 7/100ths of 1 percent of GDP.

Expect military spending to rise, too. On Monday, the revised Quadrennial Defense Review will be released alongside the president's budget. The outlines will likely be familiar. Three separate objectives -- increasing the pay of the U.S. fighting force, replacing aged equipment (a legacy of the procurement holiday of the 1990s), and "transforming" the troops and their equipment to deliver lethal force quickly and from greater distances -- imply a ramp-up in spending that outstrips current budgetary projections because they aren't set in law yet. Over the next 15 years, military spending is on track to rise by 20 percent and top its Cold War peak by 16 percent. In a world that appears unsafe, will spending rise to fund this plan or will the policy be scaled back?

Amid all this, the baby boomers come marching into retirement, and with them will come a rise in mandatory spending. By 2016, Social Security, Medicare and Medicaid alone will consume over one-half of federal spending. And later, that will be seen as the good old days; left alone, the burden of these programs just gets worse. Without some tough decisions, the federal government will look like a senior citizens' center writ (very) large.

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