The U.S. Deficit Shrank, but Will It Come Back Bigger Than Ever?

deficit

Americans aren’t used to good news about the U.S. budget deficit. So what should we make of the recent U.S. Congressional Budget Office (CBO) announcement that this year’s deficit is likely to come in lower than expected?

For the federal fiscal year ending September 30, the CBO estimates that the budget deficit will fall to $642 billion — the lowest level since 2008, when the recent recession began. That’s 4% of GDP, compared to 10.1% of GDP in 2009. And there’s even more good news in store, the agency says: The deficit is projected to shrink further to 2.1% of GDP by 2015. The main reason, according to the CBO, is an unexpected increase in revenues to the U.S. Treasury due to the improving economy and other factors.

Will this development change the budget debate? Washington is facing another showdown over next year’s budget priorities and the U.S. debt limit, which is expected to be reached by mid-October. If the White House and Congress cannot come to an agreement on a plan to lift the limit, the nation risks a government shutdown. However, Wharton finance professor Itay Goldstein is hopeful that the lower deficit “could make the tone a bit more positive.”

According to Goldstein and other Wharton faculty, this year’s deficit numbers may make the demands for budget cuts a little less urgent. “The Tea Party still wants to cut government spending significantly, but the more moderate Republicans are not so keen anymore,” notes Wharton finance professor Franklin Allen. And the easing deficit could help President Obama avoid deep cuts in government programs for the time being. “There’s less pressure to come up with something else to reduce the deficit,” says Wharton health care management professor Mark V. Pauly.

Yet, the good news won’t have too many lasting effects, Wharton experts say. “This is a thin — and transitory — silver lining on a very dark cloud,” notes Olivia S. Mitchell, Wharton business economics and public policy professor and executive director of the Pension Research Council. “Deficits are projected to ramp up again over the next decade.” Today’s $16.9 trillion federal debt amounts to $53,300 for every man, woman and child, or $135,000 per taxpayer, according to Mitchell.

Mark Duggan, Wharton business economics and public policy professor and faculty director of the Wharton Public Policy Initiative, points out that “through 2040, the number of Americans age 65 and up will grow by 90%, and those age 20 to 64 [will increase] by 10%. That’s the U.S. budget problem. If you aggregate Medicare and Social Security, [the combination] will be more than 10% of GDP and will rise like a rocket over the next 27 years, absent any policy changes.”

In other words, notes Wharton professor of business economics and public policy Kent Smetters, “the situation is slightly less horrible today, and it will return to horrible soon. A big building is on fire, [although] now one room is no longer on fire.”

“This is a thin — and transitory — silver lining on a very dark cloud.” –Olivia S. Mitchell

The CBO projects that after a brief decline, the U.S. deficit will rise again by 2023 to 3.5% of GDP. That’s above the average 3.1% of GDP during the past 40 years. And total debt held by the U.S. government, now at $16.9 trillion, is likely to stay above 70% of GDP — much higher than the 39% average of the last 40 years.

Perfect Conditions for Reform

Duggan, who worked on the Council of Economic Advisors in the Obama administration, views the upcoming budget debate in Washington as an opportunity to break new ground. The absence of a presidential election this fall and a lower than anticipated deficit are “the perfect conditions to do something about entitlements to solve the long-term deficit problem.”

Smetters, who worked at the Treasury Department during the George W. Bush administration and at the CBO prior to that, agrees: “I hope that [House Speaker John] Boehner uses [his] hammer in a big way to smash home the point that we have to start living within our means, and [I hope] that Obama will be amenable. If a second-term Democrat [president] cannot tackle this issue, that’s scary. Voters trust a Democratic president to deal with the budget deficit in the same way that they trust Republicans more on foreign policy. It’s a shame not to use the opportunity to deal with this issue.”

In a fragile economic recovery, should deficit reduction even take priority? International Monetary Fund managing director Christine Lagarde has warned the U.S. against proceeding too fast on reducing the deficit, because such actions could send the economy back into recession. Says Goldstein: “I do tend to believe there is some room for government expenditure in stimulating the economy, and deficit reduction should not be done at all costs. If the government were to invest more in infrastructure, this could certainly provide jobs. But every [spending] decision has to be made taking into account the implications it has for the deficit. In the long run, something has to give. You can’t keep growing debt without [limits].”

According to Allen, however, last year’s tax increase and sequestration (across-the-board reductions) have not affected growth as much as expected. Therefore, “we should focus on the medium to long term and not worry too much about the short term,” he says. “The main thing [the White House and Congress] need to do is get out of the inefficiencies of sequestration and make sensible policy choices” about which government programs to fund and which to cut.

“Every [spending] decision has to be made taking into account the implications it has for the deficit. In the long run, something has to give.” –Itay Goldstein

“I’m fine with allowing a deficit in the short run [while] also having a credible plan in place to balance things in long run,” Smetters adds. “The problem is that no president wants to make the sacrifice today. They all want to leave it to the next president and propose a budget that becomes balanced within 10 years, beyond the current administration.”

Health Care Wild Card

Could factors leading to this year’s lower deficit have an impact in future years? The CBO attributes the 2012 decline to higher revenues, including payments by Fannie Mae and Freddie Mac to the Treasury. The recovering economy and last year’s budget deal imposing the across-the-board sequester on government spending along with tax increases have certainly helped also, says Duggan. So did the rush by individuals last year to take advantage of 15% long-term capital gains taxes before they rise to a 23.88% effective rate this year, Smetters points out.

Some experts say the deficit-melting factors in 2012 are one-time shots, while others argue they are more permanent. “The current reduction is because of things that won’t be repeating themselves,” according to Pauly. He notes, in particular, that health care spending came in lower because many states declined to take federal funds to expand Medicaid this year. Smetters also questions whether health care spending will continue to decline next year, when health care exchanges launch and coverage and subsidy payments increase under Obamacare.

However, Dan Polsky, executive director of the Leonard Davis Institute of Health Economics at the University of Pennsylvania, says there is evidence some declines in health care spending could be longer lasting. “The research community is trying to understand if Obama’s policies have had impact. The question is whether this decline in growth in health care spending is going to be sustained or return to a normal rate of growth.” If spending continues to fall, “on a 10-year basis, it can chop off quite a bit from the deficit,” he notes. Adds Duggan: “The health care system is so inefficient and there are so many opportunities to reduce spending — this could be just the tip of the iceberg.”

Though there’s no smoking gun yet, “we’re willing to believe it’s a permanent slowdown,” Polsky says. For instance, changes in Medicare payments to providers, which have generated some of the cuts, started during the recession but have continued even after it ended. Polsky hypothesizes three reasons for the spending dip. First, high deductible health plans, where patients pay more for health care, led to a decline in demand. Second, doctors and hospitals are becoming more efficient in the way they deliver health care, in part encouraged by health care reform. Third, prices are declining, because insurers are extracting better deals from providers. Why? “With the risk and uncertainty of the whole system evolving after health care reform, my speculation is that providers are feeling more vulnerable,” he says.

Meanwhile, the Tea Party within the GOP wants to end Obamacare in exchange for agreeing to debt talks. “A lot of conservatives view [the Affordable Care Act] as an unprecedented intrusion into the health care sector,” notes Duggan. “But it would be an odd use of political capital [for the Republicans] to defund Obamacare, as opposed to extracting real changes to entitlement programs.”

Preparing for a Rainy Day

Wharton experts agree that the long-term solution is to curtail entitlement spending. “We’ve got to put Social Security and Medicare on stronger footing and get people to work longer if we are going to avoid major economic problems,” says Mitchell.

But instead, “the approach in D.C. is to cut spending in its investment base, including research and education,” says Duggan. “It doesn’t make sense to cut investment and to leave these entitlement programs on autopilot.” Then, when crisis inevitably hits, policymakers will have to radically change programs without giving people time to prepare, he adds.

“Allowing people to prepare is really the key,” says Duggan. “Let’s make changes today that phase in gradually.” In 1983, for instance, the bipartisan Greenspan Commission on Social Security saved the Social Security trust fund from bankruptcy by pushing through a set of gradual reductions in worker benefits and increases in payroll taxes to become fully effective by 2020. Those in their 50s and 60s at the time were untouched by the plan, and those in their 20s through 40s had time to prepare.

“It doesn’t make sense to cut investment and to leave these entitlement programs on autopilot.” — Mark Duggan

Many small reforms could add up, according to Duggan. For instance, today, the government determines an individual’s social security benefit level by averaging his or her 35 best years of earnings. By changing the formula to an average of an individual’s 40 best years of earnings, “you mechanically lower benefits and improve people’s incentives to work longer,” Duggan points out. The government could also announce a reduction in Social Security and Medicare benefits for higher-income people to be phased in over time, he adds.

Smetters supports the recommendations of the bipartisan Simpson-Bowles Commission, appointed in 2010 by President Obama and chaired by retired Wyoming Republican senator Alan Simpson and former Clinton White House chief of staff Erskine Bowles. The Commission’s plan, which did not receive enough votes to be sent to Congress, proposed lowering top marginal tax rates and paying for it by eliminating credits and deductions, including those for health care premiums, home mortgage interest and retirement plans.

At the same time, says Smetters, the government must cut health care spending. “No doubt Social Security is a big question, but the big, big one is Medicare.” On that issue, Smetters supports the proposed Rivlin-Ryan Plan. Starting in 2021 and affecting those currently under age 55, the plan shifts the future costs of Medicare from taxpayers to beneficiaries. Under the proposal, the government will contribute only as much as it can afford, and beneficiaries essentially will make up the difference. The plan would give vouchers to those turning 65 in 2021 and beyond to purchase private insurance.

Pauly also supports the plan. “There are no painless solutions,” he says. “It’s going to take a blunt instrument. It will be rough for Medicare beneficiaries, no matter how you slice it, five to 10 years from now. The problem is not going to go away unless we’re willing to cut back on our aspirations of spending on health care quality, or at least the new technology we otherwise want.”

Polsky, however, does not endorse spending cuts that benefit the budget while not benefitting health care. “Either you don’t want health care and don’t pay for it, or you want it and will pay for it” he says. “You can’t have it both ways. The hidden cost of entitlements is not fully explained to the American people. We need to have a serious conversation to see if there’s a willingness to pay for it, which would involve higher taxes. Any deal would have to be a balance between taxes and spending cuts.” Though they may not yield large cost reductions, Polsky endorses measures to make health care more efficient — his area of research. “We need to extract more value from the system. The first step is to pay providers for delivering health, instead of delivering health care.”

Dire Consequences

If Washington continues to dither on solutions, the U.S. and world economy eventually could face “catastrophic results,” says Goldstein. “The basic perception is that the U.S. has a strong economy, and its debt is more or less under control. But if you keep growing your debt, market participants might lose confidence. If they think the chance that their debt will get paid back is low, interest rates will be higher, and then it’s difficult to pay back the debt. It becomes self-fulfilling.” So far, most countries that have faced such crises are relatively small economies, he notes. Today, the world is watching the shaky sovereign debt conditions of European countries, including Greece, Spain and Portugal.

Says Smetters: “You could easily have a crisis scenario of the types we’ve seen in Latin American or Asia, where the horrible thing that happens is considerable inflation” as governments resort to printing money to pay back their debt. Allen agrees: “That’s effectively what happened in Germany in 1923, and the political effects of that can be quite devastating.” He adds that Japan — with its aging population and long-time fiscal imbalance — is now facing similar challenges and risks.

Realistically, prospects for an imminent solution to the U.S. deficit are dim, says Goldstein. “Democrats and Republicans still see things very differently — debating whether to increase expenditures and taxes, or to do the opposite [respectively]. I don’t think there will be a very quick resolution with the current political map.”

However, Duggan points out, politics in the mid-1990s were toxic, too, and Washington was able to reduce the deficit then. “We should be able to do something bipartisan now,” he says.

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