Recession averted, but rising debt still a threat, CBO warns

America won't go into recession this year, but the economy is threatened in the longer term by rising federal debt. That's what the Congressional Budget Office concludes in its latest annual forecast on the economy and the federal budget.

The CBO, the government's fiscal scorekeeper, described a rock-and-a-hard-place dilemma for policymakers Tuesday as they seek to promote growth while containing the deficit.

On the one hand, it said the "fiscal tightening" in some recently enacted tax hikes and federal spending cuts could cut economic growth in half this year. The action by Congress to avoid the so-called fiscal cliff did avert a recession. But unless lawmakers make additional changes, the CBO forecasts that gross domestic product (GDP) will grow by just 1.4 percent for the year, compared with a no-tightening scenario of 2.9 percent growth.

On the other hand, Congress still hasn't addressed a dangerous rise in the national debt. That means more fiscal tightening will be needed.

The CBO forecast finds a persistent mismatch between tax revenue and spending over the coming decade. As the economy improves, tax revenue should rise to 19 percent of GDP for the period from 2015 through 2023, up from 15.8 percent in 2012, the report said. But federal spending, after an early-decade dip, will start rising persistently faster than revenues.

"After 2017, if current laws remain in place, outlays will start growing again as a percentage of GDP," the CBO said. "The aging of the population, increasing health care costs, and a significant expansion of eligibility for federal subsidies for health insurance will substantially boost spending for Social Security and for major health care programs relative to the size of the economy."

The CBO's current-law "baseline" calls for spending to reach about 23 percent of GDP in 2023 and, more worrisome, to be "on an upward trajectory."
Congress's bean counters don't get formally involved in policy debates, but this report provides important context for both sides in a contentious debate over a "sequester" (automatic spending cuts) that is scheduled to hit much of the federal budget on March 1.

Many Democrats want to withdraw from the sequester, to avoid sharp cuts in useful discretionary programs and to avoid a needless slowdown of the economy. Many Republicans support the cuts, or some similar show of spending restraint, as a way to buoy private-sector confidence that the nation can get its fiscal house in order.

Economists differ on how the sequester would affect the economy, if it goes into effect. For its part, the nonpartisan CBO estimated that the spending cuts would have a sizable cooling effect in 2013 – about 0.6 percent of GDP – but not to the point of causing a recession. The tax hikes contained in January's fiscal-cliff deal, the CBO estimated, will further slow GDP for the year by a similar amount.

In that deal, Congress pushed taxes higher for high-income earners, while making Bush-era tax rates permanent for the vast majority of Americans. The cliff deal also allowed a temporary 2 percent payroll-tax break for US workers to expire.

The good news in the fiscal-cliff deal was that a recession may have been averted.

Back in November, the CBO warned that the expiration of the Bush tax rates, combined with other scheduled tax hikes and spending cuts, "will probably cause the economy to fall back into a recession next year." Many other economists agreed.
 
But if a near term threat was dodged, the new reality of low tax rates leaves the nation poised to dig itself deeper into debt. The new tax cuts, in fact, now account for most of the roughly $7 trillion in deficit spending that the CBO envisions for the decade from 2014 to 2023.
 
There's nothing wrong with low taxes, in general. The problem is the prospect of federal deficits that total 4 percent of GDP each year – and widening. That's a recipe for fast-rising public debt even without any recession or economic crisis.
 
Many budget experts say the solution to this problem, ultimately, must include reforms to control the costs of entitlements such as Medicare, Medicaid, and Social Security.

That's because those three programs account for nearly half of federal spending, and that share appears likely to expand. Such reforms are politically difficult, but could be phased in to avoid sharp consequences for the economy in the near term.
 
The CBO report warned of "serious negative consequences" if the debt problem goes unaddressed. The risk of failing to take action on the rising national debt is that it could slow economic growth, expose the US to a possible crisis of investor confidence, and siphon federal resources increasingly toward entitlements and away from investments that keep the nation economically competitive.