Tuesday, September 28, 2010

Long Term US Budget Scenarios

I'm interested in the question of what the risks are, going forward, to the federal budget deficit and US public debt levels.  In particular, I am wondering if the government is relying on much more rosy forecasts of future economic growth than I would make (given deleveraging from recent asset bubbles and peak oil).  So I'd like to investigate  how sensitive the outcome is to those kinds of assumptions.

Making any such analysis requires understanding the details of the US budget better than I do at present.  I began by working through the Congressional Budget Office report The Long Term Budget Outlook from June 2010 (with corrections in August).  In the interests of time, all I want to do today is present a couple of graphs summarizing the report.  The first is above, which shows the federal debt held by the public as a fraction of US GDP over time under two scenarios.

The first thing to note is that this is debt "held by the public" - ie it does not count debt owed by the federal government to itself (for example and especially the social security trust fund).

The second thing is to note the distinction between the two scenarios (dashed lines).  The lower one is the "baseline" scenario, which is the CBO's estimate of what will happen under current law (given their economic assumptions).  The "alternative" scenario is their attempt to recognize that it's not likely the law will stay as it is.  In particular, certain things are routinely excepted every year.  In their words:

The alternative fiscal scenario embodies several possible changes to current law that would continue certain tax and spending policies that people have grown accus- tomed to (because the policies are in place now or have been in place recently). Versions of some of the changes assumed in the scenario—such as those related to the AMT and Medicare’s payments to physicians—have regularly been enacted in the past. Those and certain other changes included in the sce- nario—such as changes related to the tax cuts enacted in 2001 and 2003—are widely expected to be made in some form over the next few years. If they are, they will receive special treatment under the Statutory Pay- As-You-Go Act of 2010 (Public Law 111-139), which excludes some of the costs of such changes from the law’s budget enforcement rules. (For details, see Box 1-1.)

After 2020, the alternative fiscal scenario also incor- porates potential modifications to several provisions of current law that might be difficult to sustain for a long period. Those provisions include certain restraints on the growth of spending for Medicare and indexing provisions that will slow the growth of subsidies for health insurance coverage. Other provisions of current law, if continued, would cause tax revenues as a per- centage of GDP to ultimately rise well above the levels that U.S. taxpayers have seen in the past. Therefore, the alternative fiscal scenario also incorporates unspec- ified changes in tax law that would keep revenues constant as a share of GDP after 2020. Together, the changes in the alternative fiscal scenario represent one interpretation of what it would mean to continue today’s underlying fiscal policy. However, different analysts might perceive the underlying intention of current policy differently.
The implications of the two scenarios are spelled out in more detail in this figure, which shows projected revenues and primary spending for both scenarios.  (Note here that primary spending excludes interest on the debt.)

In the extended baseline scenario, spending and revenues match after the next few years, while in the alternative fiscal scenario, the gap persists and grows over time (with increases in federal medical spending being the largest driver of the problem).

I note however that both spending and revenues show a very sharp trend break where they cross from "Actual" to "Projected", in the direction of better - spending stops climbing and revenues stop falling.  Having spent a lot of time staring at EIA graphs in recent years, I've grown rather distrusting of government agencies constant hope that things are just about to turn around (I'm thinking particularly of the EIA's long-standing tendency to think that US oil production is always just about to start increasing, even though it's been mostly decreasing for the last four decades).  So in future posts I want to particularly focus on what assumptions underly that turnaround.

Without getting quantitative yet, I also note that the structure of the budget clearly makes the deficit very  sensitive to assumptions about economic performance.  On the revenue side, when the economy does badly, incomes and profits will go down, and taxes on the same will also go down.  However, on the spending side, medical costs will not tend to decrease because the economy is bad, and certain kinds of spending will naturally go up - unemployment benefits, social security payments (as some people throw in the towel and retire early), etc.

Finally, it's worth noting this graph which looks at the drivers of the increase in medical and social security payments:

You can see that the bulk of the problem is the baby boom retiring.  However, "excess cost growth" is also a significant contributor (which roughly means the ability of the US medical industry to extract a larger and larger share of the economic pie over time, resulting in excessive cost inflation in that sector).

1 comment:

Burk Braun said...

Very interesting. As you say, it is rather difficult to take far-off prognostications very seriously, let alone let them outweigh the problems of the here and now.

In short, when we need to raise taxes, we will raise taxes. And when we need to cut costs, we will cut costs, based on the political landscape at that time. Right now, the government needs not to squelch economic activity by going into retrenchment, but the reverse.

A good lesson is the last time social security was "insolvent" ... was it in the late 80's? Congress twiddled with the formulas a bit, and presto- all was well for another generation.

For the future baby boom, some promises of redistribution from workers to lazy-bones will have to be revised, perhaps by raising the retirement age, perhaps by reigning in health care costs, etc. It is all a question of redistribution of real economic goods, not of "savings" built up in "Trust funds" and the like, which don't really exist.

And keeping the economic goods flowing at a high rate (including employment, education and productive capital investments) should be our prime job right now.