Government Spending, Taxes, and Debt:The Choices Ahead

Lecture by Robert M. Coen

Emeritus Professor of Economics

Northwestern University

November 13, 2012

Web site: faculty.wcas.northwestern.edu/~rcoen

Email: rcoen@northwestern.edu

Outline

Federal revenue, outlays, surplus, and debt since WWIIReasons for recent surge in deficits and debtCBO medium-term projections of deficits and debt to 2022CBO long-term projections of deficits and debt to 2042Implications of the projections

Fiscal choices for the coming yearFiscal choices for the long-runHistory and prospects for tax reformSumming up

CBO Publications Utilized

The Budget and Economic Outlook: Fiscal Years 2012 to 2022, January 2012

The 2012 Long-Term Budget Outlook, June 2012

An Update to the Budget and Outlook: Fiscal Years 2012 to 2022, August 2012

Definitions

Surplus = Revenue - Outlays

Negative surplus = deficit

Debt = Accumulated deficits

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Surplus Revenue Outlays

Federal Revenue, Outlays, and Surplus, 1947-2012Percent of GDP

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Highlights of Deficit History

Deficits increase during recessions, decline during expansions

Up to 1970s, deficits in recessions offset by surpluses in expansions

In 1970s, expansions eliminated deficit but did not produce surpluses

1980s to early 1990s, persistent deficits due to increased outlays

Deficits decline in 1990s due both reduced outlays and higher revenue

In 2001-2008, persistent deficits reemerge due to lower revenues

Beginning 2008, record deficits

Why Do Deficits Increase During Recessions?

Tax revenue declines as incomes, profits, and sales fall

Outlays for unemployment benefits rise

Outlays for food stamps rise

Outlays for Medicaid rise

Outlays for aid to state and local governments rise

Why Have Deficits Been So Large Since 2008?Automatic stabilizers at work in most severe recession

Discretionary, temporary fiscal stimulus measures$150b package in early 2008, mostly one-off tax rebates, faster depreciationTax credit for first-time home buyers in 2008$787b stimulus package in early 2009

Personal tax cuts 288 Education 91 Business tax cuts 51 Aid to poor 83 Healthcare 148 Infrastructure 81 Bush tax rate cuts of 2001 and 2003, set to expire in 2010,

extended through 2012Emergency unemployment benefits enacted in for 2011-12 Payroll tax cut in 2011-12

Some non-reasonsTARP, AIG bailout, takeover of Fannie Mae-Freddie Mac, auto bailout

Depth of Postwar Recessions

Rise in Decline in unemployment rate real GDP1948-49 4.1 1.71953-54 3.3 2.61957-58 3.3 3.1

1960-61 1.7 1.61969-70 2.4 0.6

1973-75 4.2 3.21979-82 4.9 2.9

1990-91 1.7 1.4

2001 1.4 0.32007-09 5.4 4.7

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Federal Debt Held by the Public, 1946-2012Percent of GDP

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CBO Baseline Projection Assumptions

Based on current law

Lower tax rates, expanded tax credits and deductions enacted in 2001, 2003, and 2009 expire at end of 2012

Provisions limiting reach of AMT expired at end of 2011

Payroll tax cut, emergency unemployment benefits expire in Feb. 2012

Automatic spending cuts of Budget Control Act of 2011 take effect

Reductions in Medicare payment rates

CBO Baseline Projection, 2013-2022

2012 2013-17 2013-22Total deficits $1,128 $1,546 $2,258($ billions)

2012 2013 2017 2022Deficit/GDP 7.3 4.0 0.6 0.9(Percent)

Debt/GDP 72.8 76.1 67.9 58.5(Percent)

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Surplus Revenue Outlays

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CBO Baseline Projection, 2012-2022Federal Revenue, Outlays, and Surplus

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CBO Baseline Projection, 2013-2022 (shaded)Debt Held by the Public

Percent of GDP

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CBO Baseline = “Fiscal Cliff”

(Federal revenue, outlays, and surplus in billions of dollars)

2012 2013 Revenue 2,435 2,913Outlays 3,603 3,554

Surplus -1,128 -641

%Δ Real GDP +2.1 -0.3

Unemp rate (%) 8.2 9.1

CBO Alternative Scenario Assumptions

Based on current policy, not current law

Expiring tax cuts extended (except payroll tax)

AMT is indexed for inflation

Medicare payments not cut

Budget Control Act automatic spending cuts not applied (but caps on discretionary outlays are imposed)

CBO Alternative Scenario, 2013-2022

2012 2013-17 2013-22Total deficit $1,128 $4,437 $9,975($ billions)

2012 2013 2017 2022Deficit/GDP 7.3 6.5 4.2 4.9(Percent)

Debt/GDP 72.8 78.6 82.5 89.7(Percent)

Comparison of CBO Projections, 2012-2022Revenue, Outlays, and Surplus

Baseline projection Alternative projection

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Surplus Revenue Outlays

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Alternative Baseline

CBO Projections, Baseline and Alternative, 2013-2022 (shaded)Debt Held by the Public

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Budgetary Effects of Selected Policy Alternatives Not in CBO Baseline(Billions of dollars)

2013 2013-17 2013-22Baseline deficit 641 1,549 2,258

To reduce deficit: 45,000 troop reduction by 2015 -22 -324 -852 Freeze discretionary at 2013 level 0 -160 -904

To increase deficit: Maintain Medicare at current rates 10 85 245 Remove BCA automatic cuts 54 461 972 Extend income and estate tax cuts and index AMT for inflation 247 1,781 4,532 Same, but rates on rich expire 205 1,483 3,708

Alternative projection 1,037 4,437 9,975

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Population Age 65 and Olderas a Share of Population Ages 20-64

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CBO Long-Term ScenariosExtended baseline scenario

Again follows current lawRevenue grows steadily after 2022 because -

Bush tax cuts expireMore taxpayers subject to AMTNew taxes imposed by Affordable Care Act Interactions with demographic change and economic growth

Discretionary outlays fall to lowest levels since WWII

Extended alternative scenarioAgain incorporates current policies to 2022 (Bush cuts continue)After 2022, revenue held at 18.5% of GDPAfter 2022, Medicare and HI costs not restrainedAutomatic cuts of BCA not imposedBCA Caps on discretionary keptDiscretionary outlays fall to average level of past two decades

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SURPLUS REVENUE OUTLAYS

CBO Long-Term Baseline Projection, 2012-2042

Federal Revenue, Outlays, and SurplusP

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SURPLUS REVENUE OUTLAYS

CBO Long-Term Alternative Projection, 2012-2042

Federal Revenue, Outlays, and Surplus

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Baseline Alternative

CBO Long-Term Projections, 2012-2042

Federal Debt Held by the Public

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CBO Long-Term Projections, 2013 and 2042(Percent of GDP)

2013 2042 Base Alt Base AltSocial Security 5.1 5.1 6.1 6.1Medicare 3.7 3.8 6.5 7.3Medicaid 1.8 1.8 3.8 3.9Other 10.4 10.8 6.8 9.5Interest 1.5 1.5 2.4 11.8

Total Outlays 22.5 23.0 25.6 38.6

Revenue 18.7 16.7 24.6 18.5

Surplus -3.8 -6.3 -1.0 -20.2

Choices for Next Year - Background

How great a priority is reducing deficits and debt?

We are still in recessionUnemployment rate = 7.8%Capacity utilization = 78.3 (85 in mid-1970s)Economies of Europe and Asia forecast to slow

Are deficits and debt obstacles to recovery? Two views.

YES. They undermine confidence of business and consumersAre US deficit and debt out of line with other nations? No.Signs of faltering confidence in US bonds or dollar? No.Interest on debt growing large relative to tax revenue? No.But what about downgrade of credit rating by S&P in summer 2011? Uncertainty about future tax and spending policies

NO. They aid recovery by adding to demand for goods and services

Central Government Debt, 2010 and Change from 2006Percent of GDP

Japan 184 22 Netherlands 52 13

Greece 148 40 Spain 52 19

Italy 109 12 Germany 44 3

Belgium 97 9 Finland 42 6

Portugal 88 20 Denmark 40 7

UK 86 42 Canada 36 8

France 67 15 Sweden 34 -8

Austria 66 5 Norway 26 14

US 61 25 Switzerland 20 -5

Ireland 61 40 Australia 11 5

Source: OECD

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Yield on 10-Year Treasury Bond, 1953M4-2012M10

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Federal Interest Payments, 1947-2012

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Choices for Next Year

Go over the cliffLikely to worsen recessionFixes medium-term imbalance without severe cuts in outlays

Temporarily extend some or all tax cuts, unemployment benefitsAdds about $250b to 2013 deficitCreates more inertia to keep themAdministration: Extend all except for top income groups

Adds about $200b to deficit

Undertake tax reform, leave rates low or cut them further, but close loopholes – no time for this

Pass a new stimulus package

Whatever the choice, debt limit will have to be raised around February

Choices for the Long RunConstitutional amendment requiring balanced budget?

Budget Act Required Congress to vote on it – failed

Establish safe range of debt to GDP and stay in it?

Permanently rescind tax cuts, keep Budget Control Act capsThis is the CBO baseline

Cong. Ryan: Hold revenue at “historical norm” ~ 18.5%Leaves little for nondefense discretionary outlays Cut income tax rates (10 and 25% rates), close loopholesReplace Medicare with private insurance plansShrink and restrict programs for poor, turn over to states

Simpson-Bowles: Raise some revenue, cut some entitlementsKeep income tax rates low, close loopholesRaise gasoline tax

Move away from income tax, toward consumption tax

Reflections on Income Tax Reform

Reduce rates, broaden base, keep revenue unchanged or increased

Appeals: Simplification Reduce distorting effects of tax Reduce waste of skilled labor on tax avoidance

Last major reform in 1986Reduced rates and number of brackets, top from 50 to 28Eliminated deduction for interest paid, expect on mortgagesEliminated deduction for state-local sales taxesEliminated favored rates for long-term capital gains

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Effective Personal Income Tax Rate, 1947-2012Ratio of Personal Income Tax Revenue to Personal Income (%)

Average (red line) = 9.7P

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Reflections on Income Tax Reform

Undoing of reform since 1986

1990 Top rate raised to 31%1993 Top rate raised to 39.6%

KG rate set at 28%1997 Child tax credit of $500

KG rate reduced to 20%2001 39.6% rate to fall gradually to 35% Child credit raised to $1K

Estate tax reduced, eliminated it in 2010 (temporary)2003 Accelerated reductions in top rates Dividends and KG rates reduced to 15%Numerous grants of accelerated depreciationNumerous new tax credits – biofuels, etc.

Rate increases, more rate differentials, loopholes, complexity!

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Effective Corporate Tax Rate, 1947-2012Ratio of Corporate Tax Revenue to Corporate Profits (%)

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Reflections on Income Tax Reform

How to make up for cutting rates?

Costly loopholes:Earned income tax credit (poor)Untaxed employer contributions to health insurance (middle)Mortgage interest deduction (middle)Charitable deductions (middle and rich)Favorable rates for KG and dividends (rich)Accelerated depreciation, investment credits (rich)Tax exemption of interest on municipal bonds (rich)

New proposal: Place cap on deductions/tax preferences

Closing loopholes reduces “tax expenditures”

Could hold rates constant, close loopholes, increase direct support

Taxes as Percent of GDP, 2010

Denmark 48

Sweden 46

Italy 43

Norway 43

France 43

Netherlands 39

Germany 36

UK 35

Canada 31

Switzerland 28

Japan 28

US 25 Source: OECD

Annual GDP Growth Rates, 2001-11 Taxes as Percent of GDP, 2010

Sweden 2.4 46

Canada 1.9 31

Switzerland 1.8 28

UK 1.7 35

US 1.6 25

Norway 1.5 43

Netherlands 1.3 39

France 1.2 43

Germany 1.2 36

Denmark 0.7 48

Japan 0.6 28

Italy 0.4 43 Source: OECD

Summary

Size of deficit and debt manageable in short runImmediate concern is to sustain economic recoveryRecovery will eliminate $400-500b of deficit

Debt limit must be raised in early 2013

Recent budget imbalance not sustainableSustainable budget requires both more revenue and lower outlays

In CBO baseline (sustainable path)Revenue grows to 24.6% of GDPYet drastic cuts are needed in discretionary outlays

In CBO alternative (excessive growth in deficits and debt)Revenue held at 18.5% of GDPOutlays for interest on debt swamp budget

US taxes comparatively low, room for some increaseTo promote growth, move more to consumption tax

Restraining growth of outlays impeded by philosophical differences