Forgotten but not gone: The long-term fiscal Imbalance

Over the past few years, the long-term fiscal situation has improved. With the passage of the American Taxpayer Relief Act of 2012 (in early January, 2013), the Budget Control Act of 2011, the subsequent imposition of sequestration, and slowdowns in projections of health care expenditures, there have been a variety of sources of improvement. In addition, the slow but steady economic recovery has helped reduce the short-term deficit. Policy makers are clearly fatigued from dealing with the issue.

Yet, the fiscal problem is not gone. First, ignoring projections for the future, the current debt-GDP ratio is far higher than at any time in U.S. history except for a brief period around World War II. While there is little mystery why the debt-GDP ratio grew substantially over the last six years – largely the recession and, to a smaller extent, countercyclical measures – today’s higher debt-GDP ratio leaves less “fiscal space” for future policy.

Second, while we clearly face no imminent budget crisis, our new projections suggest the 10-year budget outlook remains tenuous and is worse than it was last year, primarily due to changes in economic projections.

There is no “smoking gun” in the 10-year projections, “just” a continuing imbalance between spending and taxes. All federal spending other than net interest is projected to fall as a share of GDP over the next decade. Net interest is projected to rise by 2.0 percent of GDP to its highest share of GDP in history.

Notably, there is no suggestion in the projections that the debt-GDP ratio will fall. In the past, when the U.S. has run up big debts, typically in wartime, the debt-GDP ratio has subsequently been cut in half over a period of about 10-15 years. Under current projections, the debt-GDP ratio will rise, not fall; the only question is how fast. Moreover, even if seemingly everything goes right – with respect to the economy and keeping the fiscal house in order – deficits and debt will rise, not fall, and we still face the prospect of a high and rising debt-GDP ratio by the end of the next decade.

And, of course, fiscal problems worsen after the next 10 years. Results over the longer term depend very much on one’s choice of forecasts, in particular regarding the growth in health care spending. Nevertheless, under the most optimistic of the health care spending scenarios we employ, the debt-GDP ratio will rise to 100 percent in 2032 and 200 percent by 2054 and then continue to increase after that. All told, to keep the 2040 debt-GDP ratio at its current level, 72 percent, in 2040, would require immediate and permanent policy adjustments – reductions in spending or increases in taxes – of 1.9 percent of GDP relative to current policy. The achievement of more ambitious future debt-GDP targets, a delay in the initiation of adjustment, or the realization of more pessimistic fiscal outcomes will necessitate even larger policy responses.