Obamacare needs careful handling

Updated: Oct 3 2013, 08:27am hrs
Between 2009 and 2012, the US federal government recorded the largest budget deficits relative to the size of the economy since 1946, causing federal debt to soar. Federal debt held by the public is now about 73% of the gross domestic product (GDP). That percentage is higher than at any point in US history except a brief period around World War II, and it is twice the percentage at the end of 2007. If current laws generally remained in place, federal debt held by the public would decline slightly relative to GDP over the next several years, CBO projects. After that, however, growing deficits would ultimately push debt back above its current high level. CBO projects that federal debt held by the public would reach 100% of GDP in 2038, 25 years from now, even without accounting for the harmful effects that growing debt would have on the economy. Moreover, debt would be on an upward path relative to the size of the economy, a trend that could not be sustained indefinitely.

Budget projections for the next 10 years

The economys gradual recovery from the 20072009 recession, the waning budgetary effects of policies enacted in response to the weak economy, and other changes to tax and spending policies have caused the deficit to shrink this year to roughly 4% of GDP. If current laws governing taxes and spending were generally unchangedan assumption that underlies CBOs 10-year baseline budget projectionsthe deficit would continue to drop over the next few years, falling to 2% of GDP by 2015. As a result, by 2018, federal debt held by the public would decline to 68% of GDP.

However, budget deficits would gradually rise again under current law, CBO projects, mainly because of increasing interest costs and growing spending for social security and the governments major health care programs (Medicare, Medicaid,the Childrens Health Insurance Program, and subsidies to be provided through health insurance exchanges). CBO expects interest rates to rebound in coming years from their current unusually low levels, sharply raising the governments cost of borrowing. In addition, the pressures of an ageing population, rising health care costs, and an expansion of federal subsidies for health insurance would cause spending for some of the largest federal programs to increase relative to GDP. By 2023, CBO projects, the budget deficit would grow to almost 3.5% of GDP under current law, and federal debt held by the public would equal 71% of GDP and would be on an upward trajectory.

Budget projections for the long term

Looking beyond the 10-year period covered by its regular baseline projections, CBO produced an extended baseline that extrapolates those projections through 2038. By 2038, CBO projects, federal spending would increase to 26% of GDP under the assumptions of the extended baseline, compared with 22% in 2012 and an average of 20.5% over the past 40 years. That increase reflects the following projected paths for various types of federal spending if current laws generally remain in place:

Federal spending for the major health care programs and social security would increase to a total of 14% of GDP by 2038, twice the 7% average of the past 40 years.

In contrast, total spending on everything other than the major health care programs, social security, and net interest payments would decline to 7% of GDP, well below the 11% average of average of the past 40 years and a smaller share of the economy than at any time since the late 1930s.

The federal governments net interest payments would grow to 5% of GDP, compared with an average of 2% over the past 40 years, mainly because federal debt would be much larger. Federal revenues would equal 19.5% of GDP by 2038 under current law, CBO projects, compared with an average of 17.5% over the past four decades. Revenues are projected to rise from 15% of GDP last year to 17.5% in 2014, spurred by the ongoing economic recovery and changes in provisions of tax law (including the expiration of lower income tax rates for high-income people, the expiration of a temporary cut in the social security payroll tax, and the imposition of new taxes). After 2014, revenues would increase gradually relative to GDP, largely because growth in income beyond that attributable to inflation would push taxpayers into higher income tax brackets over time.

The gap between federal spending and revenues would widen steadily after 2015 under the assumptions of the extended baseline. By 2038, the deficit would be 6.5% of GDP and federal debt held by the public would reach 100% of GDP. With such large deficits, federal debt would be growing faster than GDP, a path that would ultimately be unsustainable.

Incorporating the economic effects of the federal policies that underlie the extended baseline worsens the long-term budget outlook. The increase in debt relative to the size of the economy, combined with an increase in marginal tax rates, would reduce output and raise interest rates relative to the benchmark economic projections that CBO used in producing the extended baseline. Those economic differences would lead to lower federal revenues and higher interest payments. With those effects included, debt under the extended baseline would rise to 108% of GDP in 2038.

The consequences of alternative fiscal policies

Most of the projections in the 2013 Long-Term Budget Outlook are based on the assumption that federal tax and spending policies will generally follow current law. If tax and spending policies differed significantly from those specified in current law, budgetary outcomes could differ substantially as well.

To illustrate the extent of that difference, CBO analysed the effects of some additional sets of fiscal policies. Under one set of alternative policies, referred to as the extended alternative fiscal scenario, certain policies that are now in place but that are scheduled to change under current law would continue instead, and some provisions of current law that might be difficult to sustain for a long period would be modified. With those changes to current law, deficits (excluding the governments interest costs) would be a total of about $2 trillion higher over the next decade than in CBOs baseline; in subsequent years, such deficits would exceed those projected in the extended baseline by rapidly growing amounts. The harmful effects on the economy from the resulting increase in federal debt would be partly offset by lower marginal tax rates. Nevertheless, in the long run, output would be lower and interest rates would be higher in this extended alternative fiscal scenario. With those economic changes incorporated, federal debt held by the public would reach about 190% of GDP by 2038.

In a different illustrative scenario, deficit reduction would be phased in such that deficits excluding interest costs would be a total of $2 trillion lower through 2023 than in the baseline, and the reduction in the deficit as a percentage of GDP in 2023 would be continued in later years. In that case, output would be higher and interest rates would be lower over the long run than in the extended baseline. Factoring in the effects of those economic changes on the budget, CBO projects that federal debt held by the public would be 67% of GDP in 2038, close to its percentage in 2012.

Under a third scenario, with twice as much deficit reductiona $4 trillion reduction in deficits excluding interest costs through 2023CBO projects that federal debt held by the public would fall to 31% of GDP by 2038, slightly below its percentage of GDP in 2007 (35 %) and its average percentage over the past 40 years (38 %).

Choices for the future

Unless substantial changes are made to the major health care programs and social security, those programs will absorb a much larger share of the economys total output in the future than they have in the past. To put the federal budget on a sustainable path for the long term, lawmakers would have to make significant changes to tax and spending policiesletting revenues rise more than they would under current law, reducing spending for large benefit programs below the projected levels, or adopting some combination of those approaches.

The size of such changes would depend on the amount of federal debt that lawmakers considered appropriate. For example, bringing debt back down to 39% of GDP in 2038as it was at the end of 2008would require a combination of increases in revenues and cuts in non-interest spending (relative to current law) totalling 2% of GDP for the next 25 years. If those changes came entirely from revenues, they would represent an increase of 11% relative to the amount of revenues projected for the 20142038 period; if the changes came entirely from spending, they would represent a cut of 10.5% in non-interest spending from the amount projected for that period.

On the one hand, waiting to cut federal spending or raise taxes would lead to a greater accumulation of debt and would increase the size of the policy adjustments needed to put the budget on a sustainable course. On the other hand, implementing spending cuts or tax increases quickly would weaken the economys current expansion and would give people little time to plan for and adjust to the policy changes. The negative short-term effects that deficit reduction has on output and employment would be especially large now, because output is so far below its potential level that the Federal Reserve is keeping short-term interest rates near zero and could not lower those rates further to offset the impact of changes in spending and tax policies.

Douglas W Elmendorf

Excerpted from the testimony of Dr Elmendorf, director, Congressional Budget Office, before the Committee on the Budget, US House of Representatives