Economists Alan Auerbach and William Gale at the Brookings Institution this week released a significant new paper on the fiscal outlook, "The Economic Crisis and the Fiscal Crisis: 2009 and Beyond," Excerpted highlights:

• The budget outlook at every horizon is troubling: the fiscal-year 2009 budget is enormous; the ten-year projection is clearly unsustainable; and the long-term outlook is dire and increasingly urgent.


• The federal government is not alone in its fiscal troubles. The individual states face daunting fiscal prospects. Most European countries will experience significant fiscal deterioration over the next few years. Standard and Poor’s recently warned the United Kingdom that it could lose its triple-A credit rating on account of its projected debt-to-GDP ratio.


• CBO projects the 2009 deficit to be $1.7 trillion, about 12 percent of GDP. This represents the largest deficit share of the economy since World War II.


• The collapse of the budget happened both gradually and suddenly. The gradual, but sizable, decline that occurred from 2001 to 2008 was primarily the result of policy – tax cuts and spending increases. The sudden, sharp decline that occurred from 2008 to 2009 was primarily the result of the economic downturn and the financial interventions.


• Under the administration’s budget...the ten-year deficit is projected to be $9.1 trillion. The deficit declines to 4.0 percent of GDP by 2012. By 2019, although the economy is projected to have been at full employment for several years, the deficit rises to 5.5 percent of GDP (a structural deficit about equal to the 2009 figure); spending rises to 24.5 percent of GDP (the highest since World War II, except for the current downturn), the debt-to-GDP ratio rises to 82 percent (the highest since 1948), and net interest payments rise to 3.8 percent of GDP (the highest share ever and larger than defense or non-defense discretionary spending). All of these figures are poised to rise further after 2019, implying that the situation is unsustainable.


• All of these estimates are based on assumptions that may prove optimistic. These assumptions include a relatively strong economic recovery, upon which doubt is cast by the fact that recent economic activity has been tracking behind the pace assumed in the projections. The estimates also make strong political assumptions: that major components of the stimulus package will be allowed to expire as scheduled and that Congress imposes and abides by PAYGO rules for the next 10 years.


• It will prove difficult to close the gap entirely via modifications to existing taxes and spending programs. A new revenue source, such as a value added tax (VAT), may be needed.


• The long-term fiscal problem is to some extent a medical care spending growth problem, in that the projected growth in Medicare and Medicaid is perhaps the single most important cause of the growing imbalance between projected revenues and expenditures. Under the projections using the administration’s baseline, cutting the annual growth rate of health spending by 1.5 percentage points for 10 years would reduce the long-term fiscal gap by 1.5 percent of GDP.


• Over the next several years, as the recession ends and the economy recovers, policy makers will face a delicate balancing act between encouraging economic recovery and establishing fiscal sustainability. Fiscal discipline imposed too soon could weaken the recovery or push the economy back into recession. Fiscal discipline delayed too long could also harm the economy, either gradually, as higher interest rates reduce economic activity and deficits sap national saving, or suddenly, if investor fears trigger a sharp and adverse market response.

The Congressional Budget Office (CBO) released an updated Long-Term Budget Outlook. Similar to the Brookings report summarized above, the CBO projects a bleak fiscal and economic outlook unless Congress and the Administration come together to enact a robust package of spending cuts and revenue increases.

One of the more startling projections is that, without significant changes in spending and revenue policies, federal debt held by the public will surpass 100% of GDP in 2023, and 200% by 2038. (Editor's Note: By comparison, public debt reached 109% at the end of WWII, but was quickly reduced to 59% within 7 years. Moreover, the WWII debt was held domestically; nearly half of today's U.S. debt is held by foreign investors.)

*From CBO's alternative fiscal scenario which assumes extension of Bush tax cuts, inflation adjustments for the AMT, and eliminating automatic Medicare physician payment cuts

Highlights of the CBO report:

• Under current law, the federal budget is on an unsustainable path....Although great uncertainty surrounds long-term fiscal projections, rising costs for health care and the aging of the U.S. population will cause federal spending to increase rapidly under any plausible scenario. Unless tax revenues increase just as rapidly, the rise in spending will produce growing budget deficits and accumulating debt.


• Large budget deficits would reduce national saving, leading to more borrowing from abroad and less domestic investment, which in turn would depress income growth in the United States.


• Keeping deficits and debt from reaching levels that could cause substantial harm to the economy would require increasing revenues significantly as a percentage of gross domestic product (GDP), decreasing projected spending sharply, or some combination of the two. Making such changes sooner rather than later would lessen the risks that current fiscal policy poses to the economy.


• For decades, spending on the federal government’s major health care programs, Medicare and Medicaid, has been growing faster than the economy (as has health care spending in the private sector).


• CBO projects that if current laws do not change, federal spending on Medicare and Medicaid combined will grow from almost 5 percent of GDP today to almost 10 percent by calendar year 2035 and to more than 17 percent of GDP by 2080. Constraining the costs of those health care programs will be a key to developing a sustainable fiscal policy.


• Social Security has a smaller effect on the budget outlook: CBO projects that Social Security spending will increase from less than 5 percent of GDP today to about 6 percent in 2035 and then roughly stabilize at that rate through 2080.


• The current recession contributes to the long-term fiscal imbalance by raising the debt burden of the federal government and shortening the period during which policymakers can enact measures that would correct the imbalances.


• The growth of debt would lead to a vicious sycle in which the government had to issue ever-larger amounts of debt in order to pay ever-higher interest charges....More government borrowing would drain the nation's pool of savings, reducing investment....In addition, a worsening fiscal situation might put pressure on monetary policy, potentially endangering the Fed's ability to keep inflation low and stable. If the budget continued along the path of rising debt, serious concerns about fiscal solvency would arise. Investors would require the government to pay an interest premium on its securities to compensate for the risk that they might not be repaid or that the value of their securities would be eroded by inflation. Such a premium would drive up the cost of borrowing. Finally, the longer the growth of debt persisted, the larger and more costly would be the policy changes needed to control debt....

Full Report

CBO Director's Blog

Following up on the President's proposal to re-enact a pay-as-you-go (PAYGO) law, the House Budget Committee on June 25th held a hearing on PAYGO and the Concord Coalition released an issue brief exploring the subject. In a nutshell, the PAYGO law would require that all new mandatory spending and tax cuts be paid for with offsetting mandatory spending cuts and/or tax increases. For example, new spending on health care reform would have to be fully paid for.

PAYGO would not reduce currently projected deficits, but would prevent the nation from going deeper into debt than is currently projected. Highlights of the Budget Committee hearing follow.

Testimony of OMB Director Peter Orszag

• PAYGO...tells Congress and the Administration that their minimum duty is not to make the existing multiyear structural deficit and worse than it already is.


• The 2001 and 2003 tax cuts, and the Medicare Rx program violated the PAYGO principle.


• Under the PAYGO Act proposed by the President, OMB would maintain a PAYGO ledger recording for each year the average 10-year budgetary effects of all mandatory spending and tax legislation enacted through 2013.


• If there is a net cost on the PAYGO ledger for the upcoming year when Congress adjourns at the end of a session, OMB would be required to offset the deficit through automatic cuts (called "sequestration") in nonexempt mandatory spending programs. (Medicare cuts would be limited to 4%, and Social Security, veterans' benefits, and low-income programs would be exempt from sequestration.)


• Sequestration is a threat--meant to deter deficit spending--not a remedy.


• There are four exceptions to the proposed PAYGO law: extension of the 2001 and 2003 tax cuts, fixing the Medicare physician payment formula, setting estate tax rates, and fixing the Alternative Minimum Tax (AMT). "In each of these areas, the policies currently in place currently in place are set to expire or substantially change in coming years in ways that unrealistically reduce costs or increase revenues." (Editor's note: It is ironic that expiration of the Bush tax cuts is viewed as "unrealistic" given previous criticism of the cuts as irresponsible.)


• The current debate over health care reform illustrates the importance of enacting the PAYGO Act.

Testimony of Alice Rivlin (OMB Director in the Clinton Administration)

• Statutory PAYGO proved a highly effective deterrent to deficit-increasing legislation in the 1990's--at least until the surplus was achieved in 1998.


• The effects of PAYGO were not visible to the public or the press because they involved spending and taxing proposals that never saw the light of day. At OMB...my uncomfortable job was to tell the President and rest of the Administration that many of their most cherished ideas could not even be proposed because we could not find a way to off-set them under the PAYGO rules.


• Detractors of PAYGO, who point out that a serious sequestration has never been enforced, miss the point that sequestration is a deterrent, not a policy.


• I believe sequestration would be even more effectiveas a deterrent if there were fewer exceptions to its automatic cuts.


• We also need firm caps on discretionary spending and long run budgets for the three biggest entitlement programs.

Testimony of Robert Greenstein

Testimony of Douglas Holtz-Eakin

The two big issues in health care reform continue to be: (1) whether a public insurance plan is needed in order to restrain health care inflation through increased competition; and (2) how to pay for health care reform.

The good news is that there is strong agreement in Congress and the Administration that the costs of health care reform should be fully offset. At his press conference last Tuesday, President Obama said health care reform "must and will be paid for." However, strong disagreements persist on which offsets are acceptable. At least one trillion in offsets are likely to be required. Following is a brief overview:

• Cap itemized deductions: In his budget, President Obama proposed to limit income tax deductions for upper income earners. Specifically, the proposal would raise $267 billion over 10 years by requiring that taxpayers in the top income brackets (33% and 35%) deduct their mortgage interest, state and local taxes, and charitable donations at the 28% income tax rate. Despite the fact that few taxpayers would be impacted by the provision, there is strong opposition from charitable and other nonprofit organizations who fear their donations would suffer.


• Tax employee health benefits: Employer-provided health care benefits are currently not taxed (that is, they are excluded from employees' income). President Obama campaigned against the McCain proposal to tax employee health benefits, however Senate Finance Chairman Max Baucus (D-MT) and other influential Senators are seriously considering this as an offset to pay for health care reform. If included in the bill, the tax would likely be limited to health benefits above a certain level, for example benefits exceeding $15,000 per year. However, unions are strongly opposed to any taxation of health benefits.


• Reduce Medicare and Medicaid spending: There are a broad range of options for reducing projected Medicare and Medicaid spending. The Administration has proposed reducing reimbursements to private Medicare plans (known as Medicare Advantage); reducing subsidies to hospitals serving large numbers of uninsured patients (since they would presumably have insurance under the new system); and reducing various payments to doctors, hospitals and other providers. The New York Times reports that the Senate Finance Committee is looking for ways to reduce Medicare and Medicaid payments to a broad range of players -- insurance companies, hospitals, doctors, pharmaceutical companies, nursing homes, home health care providers, and medical device makers.


• Increase Sin Taxes: Various reports for Congress have reported on revenues that could be raised from new or increased taxes on sugared soft drinks, tobacco products, and alcoholic beverages. In addition to raising revenues, the logic behind these offsets are that they could reduce obesity, diabetes, and cancer.

House Subcommittee (302(b) Allocations

Senate Subcommittee (302(b) Allocations