Congress has until early June to raise the debt limit and prevent the nation’s debt default, according to new estimates from the Congressional Budget Office (CBO) and the Treasury Department. But Washington currently remains at an impasse, with sharp disagreements over whether a debt limit correction should be “clean” (ie, no strings attached) or whether it should include measures to reduce projected federal budget deficits. Acting quickly to address the debt limit is imperative to avoid an actual or perceived default. But so is finding a fiscal solution to the nation’s growing debt. This blog post is the first in a series exploring the problems and possible solutions to the growing deficits and debt.
The debt limit and projected federal budget deficits are separate but related issues. The nation’s debt reflects the accumulation of past Budget deficits: Spending promises that have already done and must be paid. Congress limits the amount of debt the Treasury can issue to service those obligations, and the Treasury hit that limit at nearly $31.4 trillion in January. Since then, it has relied on cash balances and extraordinary measures to manage debt in the interim, but that is about to run out.
In addition to raising the debt limit to allow the Treasury to service past obligations, the CBO projects that federal budget deficits will grow substantially over the next decade. Over the next decade (2024 to 2033), deficits will total more than $20 trillion, reaching an annual budget deficit of almost $2.9 trillion by 2033, as spending growth outpaces revenue growth. The biggest drivers of the rising deficits are Social Security and Medicare. As a result, debt held by the public will grow each year, reaching 118 percent of GDP by 2033, larger than the size of the entire US economy and the highest level ever recorded.
The longer Congress takes to find a fiscal solution to stabilize the debt, the more painful and comprehensive that solution will be. like the CBO Explain“Regardless of the policy option used to stabilize the debt, the debt as a percentage of GDP (and thus the level at which the debt would ultimately be stabilized) would increase the longer the process was delayed…” In other words, the tax increases will be bigger and the benefit cuts more severe.
The most recent measures to modify the indebtedness limit have been accompanied by other budgetary measures. As Brian Riedl of the Manhattan Institute has notedthe eight main deficit reduction laws since 1985 adhered to debt limit legislation.
As policymakers consider options to address the underlying spending-revenue gap in the future, they should draw on international experiences with fiscal consolidation.
In a recent studies survey Drawing on the experience of countries around the world facing fiscal deficits and debt, the International Monetary Fund finds that successful fiscal consolidations (i.e., sustained improvements in deficit and debt/GDP levels) often involve tax measures. and expense. Reductions in social spending, unlike public investment, tend to produce more lasting fiscal improvements, as do less distortionary tax increases, including higher excise, property, excise, and environmental taxes, and reductions in tax expenses.
Other important factors for success include the public’s perception that the government will actually honor its commitments and that the adjustment will be gradual, not “pre-loaded” with big structural policy changes. In general, successful consolidations often led to an annual improvement in the cyclically adjusted primary balance (deficit without interest) of 1 to 2 percent of GDP.
Although the authors did not reach a conclusion on whether tax or spending reforms (or both) are the best methods of reducing debt, they still review some of the older literature that finds that spending reductions are more effective in many cases than would be applicable to the United States: “[M]More recent work still finds that spending-based bindings could be expansionary in certain circumstances, such as in economies that are highly open to trade or those beginning consolidation with high levels of debt (above 60 percent of GDP). ) and higher interest rate risk premiums. .”
In addition, other economists have found that fiscal consolidations based on spending cuts have had fewer negative effects on GDP than tax increases.
Looking at 16 OECD countries over a 30-year period, Alberto Alesina and his co-authors found that, on average, spending cuts were associated with mild recessions and, in some cases, no recessions at all, while almost all tax reforms based on tax increases were followed by “long and deep recessions.” Fiscal adjustments based on tax increases reduced investment and business confidence. By contrast, business confidence picked up almost immediately after a fiscal adjustment based on spending reforms.
Examining the fiscal adjustments of a sample of 26 countries from 1995 to 2018, a Market Center Analysis found that successful consolidations, defined as those in which the debt-to-GDP ratio declines by at least 5 percentage points in the three years after the plan’s implementation, focused more on spending than on taxes. More than half (53 percent) of expense-based tax consolidations were successful, compared to just 38 percent of tax-based ones. However, balanced tax consolidations had the highest success rate at 55 percent.
TO European Central Bank analysis reached a similar conclusion: EU countries that sought spending-based bindings had higher growth rates five years after a fiscal consolidation announcement than those that sought tax-based bindings. While some of the difference in economic performance can be explained by better tracking of income-based plans, most of the difference was due to the composition of the consolidations, where income had large negative effects compared to almost zero for expenses.
The types of spending cuts and tax reforms that are part of a fiscal consolidation are also important.
in a follow-up documentAlesina and her coauthors showed that cuts in transfers had smaller negative effects on economic growth, close to zero, compared to cuts in consumption and government investment, although both have a relatively small impact on growth in compared to tax increases.
In a study of 17 OECD countries over a 30-year period, Norman Gemmell and other academics It showed that reducing deficits by raising distortionary taxes, such as income taxes, consistently reduced economic growth, while raising less distortionary taxes, such as excise taxes, further enhanced growth. They found small positive effects on the growth of deficit-financed “productive” spending, such as infrastructure, implying that cutting such spending could hurt growth. However, the negative effects on growth derived from the reduction in productive spending would take longer to materialize, while the negative effects of tax increases would be more immediate. Deficit-financed “nonproductive” spending, such as transfers, was shown to have a negative effect on economic growth in the long run, suggesting that cutting it would boost growth.
Altogether, experience with successful fiscal consolidations suggests that they should be gradual and focused on spending, with careful consideration of the growth effects of selected policies. If tax increases are included in a package, it is more efficient to focus on less distortionary taxes, such as excise taxes, or on streamlining tax expenditures and broadening the tax base.
Lawmakers must act quickly to lift the debt limit and meet our obligations. Whether attached to the debt limit, they should adopt the same sense of urgency in the effort to control our deficits and debts, taking into account international experiences on successful fiscal consolidations.