Fri, Aug 05, 2011 - Page 9 News List

US faces daunting fiscal challenges ahead as debt increases beyond 2020

By Martin Feldstein

The US’ enormous budget deficit is now exceeded as a share of national income only by Greece and Egypt among all of the world’s major economies. To be sure, the current deficit of 9.1 percent of GDP is due in part to the effects of the recession. However, according to the official projections of the US Congressional Budget Office (CBO), even after the economy returns to full employment, the deficit will remain so large that the US’ national debt-to-GDP ratio will continue to rise for the rest of this decade and beyond.

Understanding how to achieve US fiscal consolidation requires understanding why the budget deficit is projected to remain so high. Before looking at the projected future deficits, consider what happened in the first two years of US President Barack Obama’s administration that caused the deficit to rise from 3.2 percent of GDP in 2008 to 8.9 percent of GDP last year (which in turn pushed up the national debt-to-GDP ratio from 40 percent to 62 percent).

The 5.7 percent-of-GDP rise in the budget deficit reflected a 2.6 percent-of-GDP fall in tax revenues (from 17.5 percent to 14.9 percent of GDP) and 3.1 percent-of-GDP rise in outlays (from 20.7 percent to 23.8 percent of GDP). According to the CBO, less than half of the 5.7 percent-of-GDP increase in the budget deficit was the result of the economic downturn, as the automatic stabilizers added 2.5 percent of GDP to the rise in the deficit between 2008 and last year.

The CBO analysis calls the changes in the budget deficit induced by cyclical conditions “automatic stabilizers,” on the theory that the revenue decline and expenditure increase (mainly for unemployment benefits and other transfer payments) caused by an economic downturn contribute to aggregate demand and thus help to stabilize the economy.

In other words, even without the automatic stabilizers — that is, if the economy had been at full employment in 2008-2010 — the US budget deficit still would have increased by 3.2 percent of GDP. Lower revenue and increased outlays each account for about half of this “full-employment” rise in the deficit.

Looking ahead, the CBO projects that enacting the budget proposed by the Obama administration in February would add US$3.8 trillion to the national debt between last year and 2020, causing the debt-to-GDP ratio to soar from 62 percent to 90 percent. That US$3.8 trillion net debt increase reflects a roughly US$5 trillion increase in the deficit, owing to higher spending and weaker revenues from middle and lower-income taxpayers, offset in part by US$1.3 trillion in tax increases, primarily on high-income earners.

Even this enormous increase in the projected deficits and debt underestimates the fiscal damage that the Obama administration’s budget, if enacted, would inflict. The proposed budget assumes that non-defense “discretionary” spending (which requires congressional approval, unlike so-called “mandatory” spending like Social Security pension benefits, which continues to grow unless the US Congress changes the benefits) will rise by a total of only 5 percent in the decade from last year to 2020, implying a decline in real terms and no scope for new programs. The annual level of defense spending is projected to decline by about US$50 billion in each year after next year — a very optimistic view of US military needs in the decade ahead.

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