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CBO: Tax Hikes, Defense Cuts, and Slow Growth -- One Vision for the Future

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The recently released Congressional Budget Office report on the budget for the next ten years has what might at first seem like good news for the US fiscal order.  It estimates that, by 2015, the national deficit would fall to under 2% of the GDP, often hovering around 1% until 2022 (when the CBO projections stop).  If one subtracts net interest payments on the national debt (which the CBO estimates would increase considerably after 2014), the US federal government would often be running surpluses that would, by 2018, reach around 1% of the federal budget.

The current federal deficit runs at around 8.7% of GDP, so a decline to 1% of GDP would be a big improvement.  Moreover, the size of the federal debt relative to the national economy would begin to decline around 2013, so the United States would, in many respects, be on a firmer fiscal footing.  By 2022, the debt held by the public would be only 62% of the national GDP (compared to the projected 75.1% of GDP in 2013).  That 62% figure would be higher than that of any year during the 1952-2009 period, but the trend is heading in a good direction.

However, there's some bad news: that CBO projection depends upon a number of assumptions, including improved economic growth, no "doc fixes" for Medicare, a decrease in defense spending, and the expiration of the Bush tax-cuts.

On growth, the CBO has little hope for the next few years: it projects that real GDP will grow 2% in 2012 and a mere 1.1% in 2013.  It does hope for a considerable increase in growth in the years after 2013, however.  It assumes that real GDP will grow an annual average of 4.1% in the 2014-2017 period, settling down to a 2.5% average rate of increase between 2018 and 2022.  Those growth numbers are possible, but they assume a much stronger economy than the US has had since 2000.  If the economy does not reach this rate, the deficits would likely be even worse.  And if the economy turns around faster and maintains a stronger rate of growth after 2017, we could see the deficit shrink even more due to increased tax revenue and less spending on various income-stabilization measures.

The CBO baseline projection assumes that defense spending will fall from 4.7% of US GDP in 2012 to 3% of the GDP in 2022.  Since World War II, defense spending has never been less than 3% of the GDP.  It also assumes that nondefense discretionary spending will fall from 4.3% of GDP to 2.6% of GDP.  Under this standard, discretionary spending would fall to the smallest proportion of the national economy seen in decades.  Will that happen?  If not, add some more to the deficit.

If payment rates for Medicare do not fall at the rate they are currently scheduled, the CBO estimates that over $300 billion would be added to the federal debt over the next ten years.

The CBO baseline assumes that revenues will climb considerably after 2012; they would jump from 16.3% of GDP in 2012 to 18.4% of GDP in 2013 to 20% of GDP in 2014.  They would stay above 20% of GDP until 2022.  Part of this increased revenue would come from an improved economy, but part of it would also come from higher taxes.  The CBO projection assumes that the Bush/Obama tax-cuts will expire at the end of 2012 and that the Alternative Minimum Tax will not be indexed to inflation after 2011.  Under this scenario, personal income taxes would climb from 7.4% of GDP in 2012 to 11.5% of GDP in 2022, a historic high.

Based on these projections, extending the Bush tax-cuts would add $2.8 trillion to the national debt over the next decade.  Keeping those tax-cuts and indexing the AMT to inflation would add $4.5 trillion to the debt over the next decade.  Those numbers do not include the increased interest payments such an increased debt would also cause.

If CBO assumptions about increased revenue due to tax increases and certain spending cuts are not met, the seemingly rosy scenario of a declining debt burden relative to GDP does not take place.  Under an alternative scenario in which these non-economic assumptions are not realized, deficit spending remains an average of over 5% of the national GDP and the debt burden would increase; publicly held debt would rise to over 90% of GDP by 2022.  The CBO suggests that decreased tax revenues due to tax-cuts would be primarily responsible for this increase: the deficit caused by extending current tax policy alone would equal almost 3% of US GDP during many years.

It's possible that extending current tax policies could lead to new growth unanticipated by the CBO, though it should be noted that Bush's and Obama's tax policies have led to slower growth that the CBO projects during the 2014-2017 period and slower growth than was seen during the Clinton and Reagan presidencies.

The CBO has some interesting information about entitlement spending.  Social Security spending is currently 4.8% of the GDP, and it is estimated to climb to 5.5% of GDP by 2022; it will stay around 5% of GDP until 2019.  Medicare is estimated to climb from 3.7% of GDP to 4.2% of GDP over the next decade, while Medicaid will climb from 1.8% to 2.5% of GDP.  So Medicaid is estimated to be the fastest growing entitlement over the next ten years.

The assumptions made here by the CBO suggest a radically different federal government than we're used to, one that taxes more and one that spends more on various mandatory domestic programs and less on defense and discretionary programs.

Increased growth with an improved employment picture may be one way of keeping some discretionary and military spending while also not having a much heavier tax burden.  Growth seen during the Reagan or Clinton (or Carter or Nixon or Johnson) years could spur enough increased revenue (combined with some tax reform) to allow the government to continue to meet its obligations and not indulge in radical deficit spending.  Some entitlement reform (especially regarding medical spending) might help bend the curve of government expenditures down.  The CBO assumes that domestic discretionary spending will decrease as a percentage of GDP, and a rigorous approach to cutting waste and appropriately focusing federal energies would help ensure that necessary and advantageous discretionary spending will be kept.

This CBO report suggests that the US fiscal situation is not necessarily at DEFCON 1, but it also implies that the stagnation of the past few years is untenable for the nation's long-term fiscal future.  Growth and reform will be necessary components of fiscal sanity.  As they gear up for the 2012 campaign, Republicans would be wise to attend to these crucial details.