What needs to be done to put government finances on a sound footing?
The federal budget has moved from a surplus of nearly 1½ per cent of GDP in fiscal year 2001 to a deficit of 3½ per cent in 2003 and a projected 4¼ to 4½ per cent this year. This rapid deterioration is attributable to sharply reduced tax receipts following the recession and the demise of the stock market bubble combined with tax cuts and the rapid expansion of defence, “homeland security” and other discretionary outlays. While the cyclical drag on public finances should fade soon, recent policy changes on both the revenue and outlay sides imply that, under realistic assumptions and absent corrective action, the deficit will remain substantial over the next ten years by both US historical and international standards. At that time, the retirement of the baby boom generation will be in full swing, putting enormous pressure on entitlement programmes. Now that the recovery has taken hold, measures to reduce the deficit are urgently needed if the beneficial effects on long run national income from recent marginal tax rate cuts are not to be outweighed by the adverse consequences of the fall in public and national saving. These measures should aim both at curbing outlays and, to the extent revenues have to be raised, broadening the tax base. In its 2005 Budget the Administration proposes to halve the deficit by 2009 through unprecedented restraint on non security expenditure. However, even if that objective were achieved, it might nonetheless not be ambitious enough in view of the Administration’s intention to make the recent tax cuts permanent, its defence aspirations, the need to deal with the surging numbers of taxpayers who will be subject to the Alternative Minimum Tax and the serious demographic effects on entitlement spending that would then be just around the corner.
Baseline and adjusted federal budget surplus
Fiscal years, per cent of GDP
1. Adjusted for alternative policies; see chapter 2.
2. Adjusted surplus excluding Social Security trust fund surplus.
Source: Congressional Budget Office.
Bipartisan agreement on the need for sustained deficit reduction was a critical factor behind the improvement in public finances in the 1990s. This agreement produced and sustained the1990 Budget Enforcement Act (BEA). But its main provisions - statutory caps on discretionary spending and the pay-as-you-go requirements for mandatory spending and revenue measures - expired at the end of fiscal year 2002. Although fiscal discipline began to erode when surpluses emerged in the late 1990s, until then the BEA seemed to provide an effective restraint on both spending and revenue measures. The international evidence suggests that fiscal rules are unlikely to be effective in the absence of a strong underlying dedication to fiscal prudence. Should there be a new bipartisan commitment to deficit reduction, reinstatement of all of the BEA’s main provisions would probably facilitate the return to budget balance. In this context, it would be useful to improve the transparency of the budget outlook by accounting more clearly for the rapid accumulation of liabilities under entitlement programmes and thereby focusing stronger attention on the key choices that will have to be made to put government finances on a sustainable path. Recent Congressional and Administration proposals, if implemented, would go a long way to address these issues.
How can the long-term solvency of the entitlement programmes be assured?
While the retirement of the baby boom generation has drawn nearer and life expectancy has continued to increase, no progress has been made in recent years to put entitlement programmes on a sturdier financial footing. Under baseline assumptions, spending on Social Security, Medicare and Medicaid is projected to rise from just over 8 per cent of GDP currently to nearly 18 per cent by 2050. As time progresses, the cost of restoring the programmes to actuarial balance will rise rapidly. The Social Security programme should be safeguarded through a combination of revenue increases and benefit reductions, such as reducing replacement rates for high income earners and indexing the full benefits age to life expectancy. The financial position of Medicare and Medicaid is considerably worse, given the rapid growth of health care costs, and has deteriorated further as a result of the recent addition of a prescription drug benefit to Medicare. To keep its cost increases in check, it will be necessary to restrain the growth of costs per enrolee, particularly under the new prescription drug benefit. Controlling costs is an equally demanding and important challenge for Medicaid, where long term care expenses are projected to rise rapidly as the eligible elderly population continues to grow. Allowing greater scope for the authorities to negotiate with producers the prices paid for drugs provided under the new prescription drug benefit might lessen the impact of projected increases in drug expenditures on the financial condition of both Medicare and Medicaid. Policymakers must recognise the unpalatable arithmetic of the current entitlement programmes and take early action to rein in the inexorable rise in their costs.
Long-term projected entitlement spending
Per cent of GDP (1)
1. Intermediate spending path.
Source: Congressional Budget Office, The Long-Term Budget Outlook.
If necessary, how should revenues be raised?
Restraining both discretionary and mandatory spending, while necessary, is unlikely to be sufficient to restore the budget to balance over the longer term. To the extent that revenues have to be raised, this should be done primarily by broadening the tax base rather than by reversing recent reductions in marginal tax rates. Considering the low aggregate tax burden compared to other Member countries, statutory and marginal effective tax rates remain rather high, reflecting the heavy reliance on income taxes, in particular at the federal level. To broaden the tax base of the personal income tax, the deductibility of mortgage interest (regardless of the use of the loan) and of charitable donations should be phased out, as should the unlimited exclusion of employer health insurance plan premia. As to the corporate income tax, base broadening efforts should focus on exemptions that reduce revenues and create inefficiencies, such as sectoral tax shelters. In any case, there is significant scope to improve revenue yield by better enforcement. If the yield from broadening existing income tax bases is ultimately insufficient, a further move to a consumption-based tax system through the introduction of a nation-wide value added tax (VAT) should be considered. While introducing a VAT would be complicated in the US context, in which most states rely heavily on sales taxes for their revenues, such a step would be an efficient approach to raising revenues and might also help to boost household and national saving.
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