The following OECD assessment and recommendations summarise Chapter 3 of the Economic survey of the United States, published on 29 May 2007.
The Administration’s medium term fiscal target has been achieved ahead of time
The federal unified budget deficit declined further in fiscal year 2006, to just below 2% of GDP. This met the Administration’s objective of halving the deficit (relative to a 2004 baseline) three years ahead of schedule. As in the previous year, it was not the result of discretionary measures but reflected an unexpected boom in tax receipts, which expanded at almost twice the rate of GDP. The narrowing of the deficit is welcome, not least in light of the low level of national saving. But it has to be put into perspective. With the economy operating close to capacity, the deficit is largely structural, and the structural budget balance is still worse than at the beginning of the decade (to the extent of 3 percentage points of GDP, although there are significant uncertainties attached to such estimates). The Administration has set a new fiscal target, which calls for the elimination of the federal budget deficit by 2012. This would seem to be the minimum, given the demographic and other pressures that threaten both fiscal sustainability and the country’s future prosperity.
Strong revenue growth should continue to be devoted to deficit reduction, not spending growth
While accelerating budget consolidation might be desirable, even attaining it over the medium term involves considerable efforts. Indeed, with a substantial structural deficit remaining, more radical fiscal tightening than in recent years will be necessary to achieve budget balance. The temptation to spend any revenue windfalls should be resisted (the buoyancy of revenues has persisted in the first few months of fiscal year 2007). And discretionary spending, which has grown faster than GDP in the first half of this decade, will have to be tightly controlled. Changes to the budget process could be helpful in this regard. The budget enforcement rules that expired in 2002 including expenditure caps and pay as you go rules requiring new measures to be budget neutral contributed to fiscal consolidation in the 1990s, although they were undermined by loopholes (such as “emergency spending”). Statutory caps on discretionary spending and pay as you go requirements for increases in mandatory spending and tax cuts should be reinstated, and loopholes in the previous system eliminated.
Reforming entitlement programmes is essential to ensure long term sustainability
The major entitlement programmes Social Security, Medicare and Medicaid are the main reason that government finances are on an unsustainable course. Under current law, public spending on retirement and health programmes is expected to rise toward 20% of GDP by the middle of the century; resulting soaring budget deficits would entail a government debt twice the size of GDP at that time. Raising tax rates to finance such spending would be an expensive and inefficient solution. Entitlement reform is therefore essential to address this longer term fiscal challenge. The problem facing Social Security is population ageing. As the post World War II baby boomers retire while increases in life expectancy continue, the ratio of people receiving retirement benefits to the working age population will rise steadily. Relatively limited changes to programme parameters would suffice to put the scheme on a solid financial footing, but it has been difficult to reach an agreement on the appropriate measures. A compromise package for Social Security reform could include: an acceleration of the already legislated increase in the normal retirement age and indexing benefits for rising longevity; a reduction in replacement rates for higher earners; and an increase in the taxable maximum amount of earnings subject to Social Security tax. The situation is more challenging for health care programmes, where medical cost pressures compound the effect of population ageing. The growth in costs per beneficiary has exceeded that of per capita GDP by a large margin. To address this problem, ways should be sought to improve efficiency in Medicare related health delivery, so as to be able to limit payments to providers without affecting access to and quality of care. At the same time, premiums for higher income beneficiaries could be raised further. Cost conscious decisions would be encouraged by expanding individual health savings accounts and eliminating the tax bias towards high cost insurance. The Administration has proposed to achieve the latter by replacing the unlimited tax exclusion of employer furnished health insurance plan premiums by a tax deduction available to everyone. Arguably, a tax credit would have a greater effect on health insurance coverage.
Tax reform would enhance efficiency
On the revenue side, it may be difficult to sustain the recent reductions in marginal tax rates, while meeting the fiscal burden from entitlement programmes, although this would be clearly desirable. To the extent that revenues have to be raised, the tax base should be broadened, rather than reversing reductions in marginal tax rates. Since the comprehensive tax reform in 1986, which broadened tax bases and reduced marginal rates, most of the resulting gains in simplicity and efficiency have been lost through a renewed expansion in tax expenditures. To be sure, not all of them are undesirable. However, tax expenditures, which are distorting, ill targeted and ineffective, should be reduced or abolished. The President’s Advisory Panel for Federal Tax Reform has recommended, inter alia, that tax preferences for mortgage interest payments, employers’ contributions to health insurance plan premiums, and state and local tax payments should be reduced. But, in addition to the Panel’s proposals, consideration should also be given to shifting the tax burden from direct taxes to consumption based indirect taxes – such as a national sales tax or a value added tax. This would produce efficiency gains, including reducing disincentives to saving. Furthermore, higher taxation of carbon based energy consumption would help reduce greenhouse gas emissions.
The Policy Brief (pdf format) can be downloaded. It contains the OECD assessment and recommendations but not all of the charts included on the above pages.
The complete edition of the Economic survey of the United States 2007 is available from:
For further information please contact the US Desk at the OECD Economics Department at firstname.lastname@example.org. The OECD Secretariat's report was prepared by Hannes Suppanz and Peter Tulip under the supervision of Patrick Lenain.