A Rock and a Hard Place

Jul 1, 2012

A recent study by the Congressional Budget Office (CBO) looked at the impending fiscal cliff and the dire consequences if Congress and the administration fail to address the expiring tax cuts and proceed with the across-the-board spending cuts to defense and other discretionary programs. The result could be a return to recession. In contrast, extending the tax cuts and ignoring the sequestration would continue the string of unprecedented huge budget deficits and rising debt levels. The ultimate result of such profligacy can be seen in modern day Greece.

So it seems that Congress and the administration are trapped between a rock and a hard place. Because we covered the fiscal cliff last month, we thought that it would be good to take a closer look this month at the long-run fiscal problems.

The current predicament was exacerbated by the severe recession, but decades of excessive spending, especially on entitlement programs, virtually assured that we would be facing long-run fiscal problems at some point.

Debt and Deficits

In 2007, the deficit was about $161 billion or 1.2% of GDP. This was after the 2001 and 2003 tax cuts, the recession of 2001, and the weak recovery that followed. As the recession intensified in 2008, the deficit rose to over $458 billion or about 3.2% of GDP and continued to grow to about $1.4 trillion or 10.1% of GDP as the economy bottomed out in early 2009.

Even with the economy recovering over the last three years, the deficit still averaged over $1.3 trillion a year or almost 9½% of GDP. These deficits pushed the debt held by the public from about $5 trillion or 36% of GDP in 2007 to over $10 trillion and almost 68% of GDP by the end of fiscal year (FY) 2011, the latest data available.

Forecasts of deficits and debt levels over the next few years call for more of the same. The CBO recently forecast that under current service (i.e., if Congress and the administration do not allow the tax cuts to expire or the spending cuts to take place) we will run deficits that average $975 billion or 3.2% of GDP over the next five years and push the debt-to-GDP ratio to over 82%. Such huge deficits, high debt levels, and an accelerating debt-to-GDP ratio are simply not sustainable.

The solution to this problem is as obvious to state as it is hard to implement— cut spending, increase revenue, or pursue some combination of both. But a solution ought to bear some relationship to the cause of the problem. So I thought it might be enlightening to take a closer look at revenues and expenditures.

Revenues and Outlays

Revenues are driven by the tax code as well as by economic conditions. The combination of tax cuts and the 2001 recession caused revenues to fall until 2004, reaching a low point of 16.1%. As growth once again rose above its long-run potential, revenue grew to about 18.5% of GDP in 2007, in line with historical norms—revenues averaged 18.3% between 1980 and 2007.

As the economy slid into one of the steepest and most prolonged recessions since the Great Depression, and Congress and the administration agreed to a series of temporary tax breaks to stimulate the economy, tax revenues plummeted to only 15.1% of GDP, near historical lows.

With growth returning in 2009, but at a paltry rate that barely matched its long-run potential, revenue has been slow to grow and reached only 15.4% of GDP in 2011. Under CBO’s baseline projections, revenues return to trend as the economy recovers. In fact, revenues rise to over 20% of GDP, well above historical norms.

CBO also prepares an alternative forecast, which assumes that we do not allow the tax cuts to expire or the spending cuts to take effect. Under the alternative forecast, revenues rebound more gradually over the next few years but reach 18.0% by 2017 and hit 18.3% by the end of the forecast. What this shows is that the revenue stream is projected to get back to its historical norm without significant increases to tax rates.

Revenues by Source

Recently, much has been said about who does or does not pay taxes. But data on the composition of tax revenue suggest a different conclusion. Despite considerable anti-corporate rhetoric, the composition of revenues is more a reflection of the underlying economic conditions. The components have been relatively stable and consistent over time, with fluctuations mostly driven by the state of the economy.

Individual and corporate tax revenues continued to rise through 2007 but then declined as the economy deteriorated. As corporations reemerge from the recession, their contribution to total revenues is again rising. Similarly, the share of revenues from individual income taxes is rising again. And under CBO’s baseline, both corporate and individual income taxes are expected to be a larger share of total revenues by 2022 than they were in FY 2011.

Revenues from social insurance and retirement taxes and other sources, such as excise taxes, are rising in dollar terms but are expected to contribute less to the total share of revenues by 2022.

With corporate and individual income taxes expected to return to historical norms, the revenue shortfall that contributed to rising budget deficits is likely to fix itself over time as the economy recovers. Our longer term fiscal problems are driven by government outlays.

On the spending side, outlays rose over the past decade from 18.2% of GDP in 2000 to over 24% in 2011. Government spending peaked in 2009 at 25.2% of GDP. This growth is the result of the weak economy, which automatically triggers higher transfer payments—such as unemployment insurance and other social programs—as well as direct stimulus spending to try and jump-start economic growth.

It would be wrong to conclude that these increases are purely temporary. CBO expects outlays to remain above 22% for the entire forecast horizon and to be just under 24.5% by 2022. To put this in perspective, between 1980 and 2007 outlays averaged 20.8% of GDP.

The composition of outlays will never return to what we experienced prior to the recession. Mandatory spending, driven by the aging population, will crowd out discretionary spending over the next 10 years. The forecast beyond 10 years is even bleaker.

Discretionary spending accounted for about a third of spending in 2000. That share increased by a few percentage points by 2011 but is expected to decline to only 25% by 2022.

Net interest costs declined from 12.5% of total outlays in 2000 to only 6.3% in 2011. With the recent increases in our national debt, however, net interest payments will rise over the forecast horizon to 11.3% of outlays by 2022.

Finally, mandatory spending is expected to increase to nearly 65% of total spending by the end of the forecast horizon, from 53.2% in 2000 and 56.3% in 2011. As a result, expenditures remain high, and the debt to GDP ratio remains problematic.

The conclusion for our deficit and debt problem is clear. We must get spending under control and get the economy growing strongly again. Increased spending, especially entitlement spending, is the primary culprit in our fiscal mess and should bear the brunt of the solution. Now, we are not naïve, and we know that there will be a push for more revenue. But we must resist the temptation to simply increase taxes. We must comprehensively reform the tax code and enact fundamental entitlement reform. And we must do more to ensure future strong economic growth. Growth alone will not fix the problem, but it is a necessary condition to make entitlement and tax reform work.

Brian Higginbotham, an economist at the U.S. Chamber of Commerce, contributed to this article.

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