The document discusses the U.S. budget situation and options for fiscal policy. It notes that while short-term deficits are not a major problem, medium-term deficits will likely require tax increases over the next decade and long-term deficits pose growing and unsustainable shortfalls. It outlines concerns about rising federal debt levels and fiscal problems in other countries as well. The document analyzes how the U.S. accumulated large budget deficits gradually and then suddenly due to economic changes, policy decisions, and the Great Recession. It projects ongoing large deficits and rising debt levels through 2020 under different policy scenarios and discusses the long-term fiscal challenges facing the country.

1. The U.S. Budget and
Options for Fiscal Policy
William G. Gale
Brookings Institution/Tax Policy Center
The Mintz Economic Policy Seminar
C.D. Howe Institute
May 12, 2010

2. The Situation
• Huge short-term deficits.
– But they aren’t the real problem
• Large and growing medium-term deficits.
– Tax increases probably needed over the next decade
– In the meantime, deficits will reduce growth
• Growing and unsustainable long-term shortfalls.
– Will require controlling spending and increasing taxes
2

3. Increasingly Urgent Concerns
about Federal Debt
• Chinese officials have publicly questioned the
security of U.S. Treasury debt.
• Credit markets see a non-zero probability of
default on senior U.S. Treasury debt in the
next five years.
• Medicare trust fund to go bankrupt by 2017.
3

4. Fiscal Problems Elsewhere, Too
• Almost all states facing significant fiscal shortfalls.
– California in particular
• Europe has its own fiscal problems.
– S&P recently warned of a possible downgrade of UK debt
– UK’s debt trajectory not significantly worse than the US
– Greece, etc.
4

5. Outline
• Why and how does fiscal policy matter?
• How did we get here?
• Where are we headed?
• What should we do?
• The President’s Fiscal Commission.
5

6. Why and How Does
Fiscal Policy Matter?
6

7. Macroeconomic Growth: Two
different concepts
• In a weak economy, “growth” means reducing the output gap,
which occurs by raising aggregate demand.
• In a strong economy, “growth” means raising the economy's
capacity, which occurs by raising aggregate supply.
• In both cases, deficits work to raise aggregate demand and
reduce national saving.
– Those effects help an economy reduce an output gap.
– But they reduce an economy’s ability to expand capacity.
7

8. Deficits and Growth
In a Weak Economy
• In an economy where unemployment of workers is high and utilization of
existing capital (machines, etc.) is low, the economy is not producing as
much as it could.
• The primary goal of policy is get people back into the labor force and
capital in use again.
• Doing so raises GDP and hence is called "growth", but it is better thought
of as reducing the gap between potential output and actual output.
• KEY POINT: A budget deficit can help an economy with an output gap.
Higher government purchases spur demand by government; tax cuts can
spur demand by households. These changes raise the demand for workers
and the use of capital.
8

9. Deficits and Growth
in a Strong Economy
• If unemployment is low and capital utilization is high, then resources are
fully employed and the economy's output is at potential output.
• The goal of policy in this case is to raise the capacity of the economy –
more workers, better workers, more capital, better-applied capital, etc.
• Raising the capacity of the economy is economic growth.
• KEY POINT: In this case, a budget deficit hinders growth. The increase
in demand caused by the deficit can't be met on a sustained basis since
resources are already fully employed. Moreover, in order to finance
investments in more and better workers and capital, the economy needs
saving, and higher budget deficits represent lower government saving.
9

10. Consequences of Sustained Deficits –
The “Crisis” Scenario
• Sharp change in investor's attitudes and willingness to hold
U.S. government debt.
• Marked by some combination of:
– Higher interest rates
– Lower value of the dollar
– Sharp outflow of capital from the U.S.
• Will it happen? When? How?
– Could be triggered by any number of events.
– May never happen
– But even if a “crisis” is not likely, there is still a big problem….
10

11. Consequences of Sustained Deficits –
The Gradual Scenario
• Lower national saving, which leads to:
– Higher interest rates
– Less national investment
– Less future economic growth
– Lower future living standards
OR
• Significant capital inflows from abroad, which leads to:
– Less of an increase in interest rates
– Less of a decline in national investment
– BUT still leads to lower future living standards, because we effectively owe more to
other countries and have to pay it back
• KEY POINT: Lower future living standards = the burden on future generations.
11

12. Magnitudes
• Considerable variation in the literature.
Reasonable rules of thumb (for the US) are:
– Each percent-of-GDP in current unified deficits
reduces national saving by 0.5 to 0.8 percent of
GDP
– Each percent-of-GDP in anticipated future unified
deficits raises forward long-term interest rates by
25 - 35 basis points, and
– Each percent-of-GDP in projected future primary
deficits raises forward rates by 40 - 70 basis points
12

13. More on Magnitudes
• Calculations using a simple neoclassical
growth model or Ball-Mankiw “debt fairy”
calculations suggest that a sustained 1%-of-
GDP deficit:
– Reduces output by 1-2%; and
– Raises interest rates by 30-80 basis points.

14. How Did We Get Here?
From Ernest Hemingway, The Sun Also Rises
“How did you go bankrupt?” Bill asked.
14

15. How Did We Get Here?
From Ernest Hemingway, The Sun Also Rises
“How did you go bankrupt?” Bill asked.
“Two ways,” Mike said. “Gradually and then
suddenly.”
15

16. Net Federal Debt, 2001 CBO Projections
90
80
70
P 60
D
G
f 50
o
t
n 40
e
c
r
e 30
P
20
10
0
-10
-20
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
16

17. Federal Deficit or Surplus, 2001 Projections and
Actual and Prospective Outcomes
8
6 January 2001 CBO Baseline Projections
4
P
D2
G
f
o0
t
n
e
c-2
r
e
P
-4
-6
-8
-10
Actual Projected
-12
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
17

18. Federal Deficit or Surplus, 2001 Projections and
Actual and Prospective Outcomes
8
6 January 2001 CBO Baseline Projections
4
P
D2
G
f
o0
t
n
e
c-2
r
e
P
-4 Observed Deficit or Surplus
-6
-8
-10
Actual Projected
-12
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
18

19. What Happened?
Three Factors:
1. The Economy
2. Policy
3. The Great Recession
19

20. Federal Deficit or Surplus, 2001 Projections and
Actual and Prospective Outcomes
8
6 January 2001 CBO Baseline Projections
4
P
D2 Economic and Technical Changes
G
f
o0
Policy Changes
t
n
e
c-2
r
e
P
-4 Observed Deficit or Surplus
-6
-8
-10
Actual Projected
-12
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
20

21. Federal Deficit or Surplus, 2001 Projections and
Actual and Prospective Outcomes
8
6 January 2001 CBO Baseline Projections
4
P
D2 Economic and Technical Changes
G
f
o0
Policy Changes
t
n
e
c-2
r
e
P
-4 Observed Deficit or Surplus
-6
-8
-10
Actual Projected
-12
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
21

22. Federal Deficit or Surplus, 2001 Projections and
Actual and Prospective Outcomes
8
6 January 2001 CBO Baseline Projections
4
P
D2 Economic and Technical Changes
G
f
o0
Policy Changes
t
n
e
c-2
r
e
P
-4 Observed Deficit or Surplus
-6
-8
-10
Actual Projected
-12
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
22

23. Federal Deficit or Surplus, 2001 Projections and
Actual and Prospective Outcomes
8
6 January 2001 CBO Baseline Projections
4
P
D2 Economic and Technical Changes
G
f
o0
Policy Changes
t
n
e
c-2
r
e
P
-4 Observed Deficit or Surplus
-6
-8
-10
Actual Projected
-12
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
23

24. Net Federal Debt, 2001 and 2010 Projections
90
80
70
P 60
D
G
f 50
o
t
n 40
e
c
r
e 30
P CBO, Actual and Projected, March 2010
20
10
0
CBO, January 2001
-10
-20
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
24

25. Where Are We Headed?
The Next 10 Years
25

26. Alternative Deficit Projections, 2010-2020
12
10
8
Percent of GDP
6
4
CBO Baseline
2
0
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Year
26

27. CBO Baseline
• Assumes current and future Congresses will do
nothing. Mechanical projection of current law.
• Assumes almost all tax provisions expire as
scheduled:
– 2001 and 2003 tax cuts
– “Regular” expiring tax provisions
– AMT patches
• Assumes discretionary spending will stay
constant in real terms.
27

28. Extended Policy
• Assumes current and future Congresses will act like previous
Congresses.
• Start with the CBO baseline adjusted for health care reform.
• Extend all non-stimulus expiring tax provisions.
• Allow non-stimulus, non-defense discretionary spending to
grow with inflation and population.
• Replace projected defense spending with Obama defense plan.
• Assume physician payments under Medicare will be frozen,
rather than cut.
28

29. Alternative Deficit Projections, 2010-2020
12
10
8
Extended Policy
Percent of GDP
6
4
CBO Baseline
2
0
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Year
29

30. Alternative Deficit Projections, 2010-2020
12
10
8
Percent of GDP
Extended Policy
6
Obama Policy
4
CBO Baseline
2
0
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Year
30

31. Net Federal Debt, 2001 and 2010 Projections
90
80 Obama Budget
70
P60
D CBO, Actual and Projected, March 2010
G
f 50
o
t
n 40
e
c
r
e 30
P
20
10
0
CBO, January 2001
-10
-20
2001 2003 2005 2007 2009 2011 2013 2015 2017 2019
31

32. Obama Policy in 2020
• The (full employment) deficit = 5.5% of GDP
– Highest FE deficit since WWII except for current episode
• Public debt = 90% of GDP (and rising)
– Highest level since 1947 (when it was falling)
• Spending will exceed 25% of GDP
– Highest level since WWII except for 2011
– Net interest will be 4.0% of GDP, highest level ever (and
larger than Defense or NDDS in 2020)
• Revenues will equal 19.5% of GDP
32

33. Economic Assumptions
• Budget figures depend critically on the economy.
• Global, financially-induced downturns:
– Tend to run a long time (slow recoveries)
– Tend to leave big and long-lasting revenue declines
– Tend to result in lower future output path
33

34. Political Assumptions
• The political assumptions built into the budget
forecast border on heroic.
– The stimulus package expires as scheduled
– NDDS falls substantially relative to GDP
– Difficult cuts in health care occur
– PAYGO is honored for a decade
34

35. Where Are We Headed?
The Long Term
35

36. 36

37. The Fiscal Gap
• In dollar terms, the gap is the present value of the
difference between all expected future revenues and
expected future non-interest spending.
• Easier to understand as a share of GDP – the gap
equals the size of the immediate and permanent tax
increase or spending cut (or combination) that would
keep the debt/GDP ratio at the same level in the long-
term at is now.
37

38. Table 5
Fiscal Gaps
Baseline CBO Baseline Extended Policy Obama Policy
Through Through Through
Permanent Permanent Permanent
2085 2085 2085
As a Percent of GDP 4.60 6.40 7.21 9.07 6.35 8.16
In Trillions of
Present-Value
Dollars 34,964 92,668 54,794 131,245 48,216 118,161
Source: Authors' calculations
38

39. What Should We Do?
• Balancing recovery and fiscal discipline
• Medium-term (10-year) budget deficits
• Long-term deficits
39

40. What Should We Do?
Balancing Recovery and Fiscal
Discipline
• The dilemma:
– Recovery needs expansionary fiscal policy/bigger
deficits
– Discipline requires smaller deficits
• The risk:
– Impose fiscal discipline too soon and the economy
could tank again (e.g. US 1930s, Japan 1990s)
– Hold off too long and markets could get jittery
40

41. The Short-Term Solution
• Combine
– Fiscal expansion now
– Fiscal discipline over the next 5 years
• Would solve both problems at the same time
and would be more effective than either in
isolation.
41

42. What Should We Do?
The Next 10 Years
• Deficits of 5-7 percent of GDP and rising over
time under either Obama policy or extended
policy, even with full employment and
favorable political assumptions.
42

43. Spending Options
• In a typical year, more than 70% of federal spending
is on five programs:
– Defense
– Social Security
– Medicare
– Medicaid
– Net interest
• 65% in 2009 (because of TARP and stimulus)
• 74% in 2014 under Obama policy
• Rising to 78% by 2020 under Obama policy
43

44. Cutting Spending
• Will be difficult to cut any of the big 5
spending items significantly in this decade.
• Under Obama policy, other federal spending
will account for 6.0% of GDP in 2014 and
5.5% of GDP in 2020.
– Even enormous cuts in such spending will not
reduce the deficit much.
44

45. Health Care Reform
• CBO: Recent health care reform will reduce
deficit by about $150 billion over the next 10
years.
– These gains already included in the estimates
presented above.
45

46. Health Care Reform
• Legislation includes measures to slow cost
growth.
– These have to be sustained by future legislators
– Spending cuts will be harder to sustain if
underlying costs continue to grow
• Even if predictions hold, the remaining deficit
reduction task is harder, because potential
sources of revenue increases and spending cuts
have now been used to finance health.
46

47. Tax Increases
• It is difficult to see how the budget deficit can be
reduced to the 3 percent range or lower in the next
decade without significant tax increases.
• We need both better taxes and more taxes.
– Opportunity for reform
• Two strategies – not mutually exclusive
– Reform existing taxes
– Create new taxes
47

48. Change Existing Taxes
• Increase rates
• Broaden the tax base
– More conducive to economic growth than rate hikes
– Reduces distortions and special treatment
– Simpler
– Fairer
– Lots of revenue
48

49. Broadening the Base – Options
• Limiting itemized deductions
– Mortgage interest
– State and local taxes
– Charitable contributions
• Limit employer deductions for health
insurance
• Limit corporate tax loopholes and deductions
49

50. Energy Taxes?
• Cap & trade (with permits auctioned) or a carbon tax
would likely raise at most about 1% of GDP in
revenues if well designed.
– Most extant proposals imply smaller revenue yields.
• A European-style gas tax ($4-$5 per gallon) could
raise significant revenue.
– Roughly, each dollar of gas tax would raise 1% of GDP in
revenues
50

51. All Roads Point to a VAT
• It’s where the money is:
– Used in more than 100 countries, including all other
OECD countries
– Significant revenue source, much larger than could
be attained from income tax reform
– Exempts exports and capital income
– Is regressive
51

52. How a Typical VAT Works
• All sales by all businesses are taxable.
– Businesses pass on tax invoices to purchasers
• Registered VAT taxpayers claim credits for taxes
paid on their purchases.
• Exports are “zero-rated.”
– Exporters claim credits on purchases
• Imports are taxable.
– No credits on purchases from overseas
• Tax base equals domestic consumption.
52

53. Revenue Yield of a VAT
• Almost all OECD countries have rates between
15% and 22%.
– Scandinavian countries around 25%
– British Empire countries 6-13%, Japan 5%
• Rough rule of thumb in OECD countries: Each
percentage point on the VAT rate “yields”
between 0.3% and 0.4% of GDP in revenue.
53

54. A VAT in the U.S.
• In the US, a 10% VAT
– …with a fairly broad base and
– …with a “demogrant” that compensates everyone on
consumption expenditures equal to the poverty level
– could raise 4.0 – 4.5 percent of GDP in revenues.
54

55. What Should We Do?
The Long-Term
• Containing health care spending growth is
essential to long-term fiscal balance, in
addition to the changes discussed above.
• What is your number?
55

56. Revenues and Expenditures as a Percent of GDP
30
Obama Policy Expenditures
Extended Policy Expenditures
28
CBO Baseline Expenditures
26
24
Percent of GDP
22
CBO Baseline Revenues
20
Obama Policy Revenues
18
Extended Policy Revenues
16
14
2009 2013 2017 2021 2025 2029 2033 2037 2041 2045 2049 2053 2057 2061 2065 2069 2073 2077 2081 2085
Year
56

57. The Long-Term Gap is Huge Relative
to Typical Policy Changes
• The long-term gap = 6.3-8.2% of GDP.
• In 2009,
– Income tax revenues = 7.2% of GDP
– Corporate tax revenues = 1.2% of GDP
– Payroll tax revenues = 6.3% of GDP
– Defense spending = 5% of GDP
– NDDS = 4.7% of GDP
– Mandatory spending = 11% of GDP (in 2008)
57

58. The President’s Fiscal
Commission
58

59. The Commission
• Final report due in December 2010
• 18 members
– 6 Obama appointees, politically diverse
– 6 Democratic Congressional appointees
– 6 Republican Congressional appointees
• Charged with eliminating the deficit other than interest
payments in/by 2015
– Would require a reduction in spending and/or increase in taxes of 2.2%
of GDP relative to the extended policy scenario and 1.4% of GDP
relative to the Obama policy scenario.
59

60. The Commission
• The likelihood that:
– The Commission agrees on a plan that meets the deficit
target, AND
– Congress votes on the plan, AND
– Congress enacts the plan…
– …is small.
• Two key problems:
– No New Taxes coalition – 6 members have signed the
pledge, but the Commission needs 14 out of 18 votes
– The public is not ready to have this discussion and hence
not ready to support politicians who support deficit
reduction
60

61. The Commission
• Still the Commission can do a lot of good
• Describe the problem clearly and show the
options
– “Show me the money”
• Begin the process of educating the public
– “You think we’re fighting. I think we’re finally
talking.”
61