US deficits threaten recovery, budget review warns

Unless current tax and spending policies are ''drastically altered,'' future federal budget deficits will account for an increasingly large share of the nation's output, a new review of the federal budget argues.

If Congress and the administration do not ''sharply and believably reduce future deficits,'' then fiscal and monetary policy will ''clash once again, interest rates will rise, and economic recovery will be aborted,'' according to ''Setting National Priorities,'' a budget review published annually by the Brookings Institution.

Slimming down or eliminating budget deficits will probably require new tax increases of between $55 billion and $100 billion, depending on congressional spending policies and the size of the deficit Congress decides is acceptable, the study's authors say.

Economic recovery alone will not wipe out the troubling deficits, the authors contend. To demonstrate this, they look at what happens to the so-called ''high-employment deficit'' if current spending and tax policies remain unchanged: It would grow from 2.2 percent of gross national product in budget year 1983 to 4.2 percent in 1988, a level unprecedented since World War II.

The high-employment deficit measure that Brookings economists use eliminates the effects of a recession by tracking the deficit that would occur if unemployment were at 6 percent and the nation's output were growing at 2.9 percent. So, the authors explain, even an economy running at full employment would not eliminate the deficit.

The deficits will continue to grow even as the economy recovers ''because of tax cuts enacted in 1981 and the large buildup in national defense planned for future years,'' the book's editor, Joseph Pechman, writes.

The Federal Reserve Board would face two unappealing policy options unless strong action to reduce deficits took place, the Brookings authors assert. If the Fed took the option of increasing the money supply enough to keep interest rates from rising in the face of large government borrowing, ''the deficit would generate inflation.''

A more likely scenario, the report contends, is that the Fed would refuse to accommodate that much fiscal stimulus by increasing the money supply. As a result, ''Interest rates would rise sharply and economic recovery would be retarded,'' the report contends.

A key reason interest rates would rise is that the government would be bidding for most of the dollars individuals set aside in savings accounts. Brookings calculates that a high-employment deficit of 4.2 percent of GNP would mop up almost two-thirds of net private savings. As a result it would be tough for businesses to get the funds they need to modernize plants and buy more efficient equipment.

And the economic effects of such large deficits go beyond capital spending. The high interest rates caused by prolonged deficits would also slow sales in the housing and auto industries. At the same time, high interest rates would hurt the nation's international sales by making the dollar more expensive in foreign markets. The currency would rise as investors scrambled to put their funds into dollars to take advantage of high interest rates in the United States.

As a result, Mr. Pechman says, ''Foreigners will find US goods more dear and US residents will find imports cheaper.''

Coping with the expected deficits will almost surely require tax increases, notes economist Henry J. Aaron, another of the report's authors. ''All politically plausible and fiscally responsible options imply that there is no way for Congress and the President to avoid the always painful task of increasing taxes.''

Brookings says the size of the increase in taxes hinges on how much of President Reagan's budget-cutting plans the Congress approves. For example, if the full defense buildup the President seeks were enacted, but his nondefense cuts were not, then a tax increase of $153 billion in 1988 would be needed to eliminate the structural or high-employment deficit. By contrast, if Congress elected to cut defense spending by $47 billion by budget year 1988, as Brookings recommends, and accepted the President's nondefense cuts, then no tax increase would be needed to reduce the structural deficit to 1 percent of GNP.

A more likely outcome, the authors say, is that defense spending will grow less than the President wants but will not be cut as sharply as Brookings suggests. At the same time, Congress will likely accept few of the President's proposed cuts in nondefense spending. In such a situation, it would be necessary to increase taxes about $100 billion in budget year 1988 to eliminate the structural deficit, or by about $55 billion to reduce it to 1 percent of GNP.

Low unemployment won't cure the deficit Even with 6 percent unemployment through fiscal year 1988, the federal deficit, as a percentage of gross national product, would continue to rise.

(Using budget for current programs, including proposed Reagan defense program.)

Fiscal years 'High employment' deficit 1982 0.8 '83 2.2 '84 2.6 '85 3.1 '86 3.5 '87 3.9 '88 4.2 Source:Setting National Priorities: The 1984 Budget