Defining the problem: the difference between current deficit and long-term deficits

KEY POINTS FOR FEDERAL DEFICIT DISCUSSIONS Overview: Unless our budget policies are changed, the imbalance between spending and revenues will eventually become unsustainable rapidly rising debt will threaten the ability of the government to meet crucial needs and will pose a threat to the health of the economy. Specifically, if deficits grow as projected over the long run and the debt continues to mount as a result, we will see huge increases in interest payments on the debt that likely will crowd out various other important parts of the budget, as well as a substantial increase in the risk of a severe financial crisis and a decline in the standard of living. Individuals and organizations that work to create and sustain effective government policies and investments should be concerned about this problem. Continued growth in long-term deficits will reduce available resources available to sustain key programs or invest in areas that serve real needs in this country like education, health care, retirement and disability benefits, assistance to those in need, basic research, infrastructure and other important government functions. Some advocates of limited government, however, are taking advantage of concerns over deficits to push their long-standing proposals to shrink government and fundamentally undercut social insurance and other programs that are designed to provide a safety net for vulnerable Americans or to help ensure quality education, social services and health care in this country. Their efforts to do this should be resisted. At the same time, these attempts to hijack legitimate concerns about long-term deficits should not blind thoughtful people to the need to deal with the long-term deficit problem and to do so in a fair and equitable way that includes increases in revenues, as well as changes in programs. Cutting the current deficit now would be counter-productive. Taking steps now to cut the current deficit could undercut the economic recovery which is just starting to get a toehold. The recovery is still fragile. Unemployment levels remain very high. Additional steps are needed to ensure the recovery is sustained, such as extending unemployment benefits and providing additional temporary fiscal relief to states that are struggling to balance their budgets and prevent additional job losses. These kinds of temporary policies add to the current deficit in the short-term in order to help sustain the recovery, but will have little effect on the long-term problem. Defining the problem: the difference between current deficit and long-term deficits Public concern about large current deficits is focused on the wrong problem. The real threat to the economy, as well as to sustaining services that Americans rely on, stems from the projected growth in long-term deficits if current policies remain unchanged. This failure to focus on the real problem is starting to result in misguided policy decisions now. Trying to reduce today s deficits and failing to take steps like extending unemployment benefits and helping states weather recession-induced fiscal crises, on the grounds that we can t afford such measures is deeply misguided. Such actions will do very little to help the long-term deficit problem while causing significant damage to the economic recovery. 1

Current deficits are so high largely because of the effects of the recent economic downturn and efforts to combat it. Recessions especially one as long and deep as our country has experienced almost always result in large deficits for two main reasons. Some government programs and revenues have built-in features that help address the effects of recessions and moderate them. Emergency aid for things like unemployment insurance and food stamps automatically increases as more people qualify for them and as revenues decline as incomes and profits shrink. Economists call these programs automatic stabilizers because they go into effect without policymakers first having to enact new legislation and help bring the economy back into balance sooner than would occur without them. When the economy goes into a downturn, our government also typically adopts temporary policies to further counteract the downturn. Congress acted last year to prevent the economy from falling into a much worse recession by injecting money into the economy through temporary increases in spending and cuts in taxes. These policies were temporary, not permanent. Many will expire this year. Because these policies are temporary, they contribute very little to the growth of deficits and debt over the long-term. The long-term deficit problem, which is discussed further in the next section, is fundamentally different. The projected big long-term deficits are structural that is, they will remain after the economy is back on track and are not the temporary result of a recession. The long-term deficits are caused by ongoing policies that create an imbalance between spending and revenues over a number of years even when the economy is performing well. Long-term deficits and growth in debt are the real problem. Over the longer term, deficits and debt will skyrocket in coming decades if current spending and revenue policies remain unchanged. To address this problem, we need to understand more about what is causing it. There are three main drivers in the long-term growth in deficits and the debt: 1) the rapidly rising per-person cost of health care system-wide (that is, for privately-funded as well as publicly-funded health care); 2) the aging of the population, which pushes up costs for health care, costs for Social Security, and other retirement programs; and 3) revenues that are inadequate to pay for the benefits and services that the American public needs and expects. Under current policies, revenues will be about at the same level as a share of the economy as the average over the last three decades a level that was inadequate to cover the costs of government over the past 30 years. That level of revenues certainly will not be adequate to meet the future demands, including the need to provide for an aging population and meet rising health care costs. Even if we succeed in significantly slowing the growth of health care costs, those costs will almost certainly continue to grow faster than the economy as a result of advances in medicine that improve health and prolong life but add to costs. Some people say we have a general entitlement problem. This is not really the case. Total spending for all entitlement programs other than Social Security, Medicare and Medicaid, is 2

projected to grow more slowly than the economy as a whole. Entitlements other than Medicare, Medicaid, and Social Security are not the source of the problem. Arguments that the Bush-era tax cuts have not contributed to the deficit problem also are incorrect. The Center on Budget and Policy Priorities projects that if current policies remain unchanged and the 2001 and 2003 tax cuts are made permanent, the deficit will total nearly $1.3 trillion in 2019. In that year, the cost of the Bush-era tax cuts including the extra interest we will pay as a result of those tax cuts will total $700 billion that year. The tax cuts thus will account for 55 percent of the deficit in that year. The Center on Budget has also calculated that if the Bush tax cuts were allowed to expire on schedule at the end of 2010 or if the cost of extending them was paid for the size of the imbalance in the federal budget through 2050 would be reduced by nearly two-fifths. For more on the deficit see: Blog: Whose Deficit is it Anyway? June 11, 2010. Paper: Getting the Facts Straight, Feb 17, 2010, Paper: Where Today's Large Deficits Come From Feb 17, 2010, Testimony: Robert Greenstein on the Long-Term Budget Problem Facing the United States, Jan 21, 2010 Defining the solutions: We can and should adopt legislation to reduce spending and increase revenues that takes effect once the economy is back on track. Solving the real fiscal problem means ensuring that, in the long run, we do not have more debt than our economy can bear on an ongoing basis. This requires an approach not much different than the calculations a careful family makes when it decides what size mortgage payments and credit card debt it can afford. (Remember that such a careful family can also decide it is appropriate to increase its level of debt in order allow it to meet its needs in the short run if a member of the family faces a spell of unemployment or the family needs to cover a temporary increase in expenses for medical services or to repair damages to its home.) Our goal for the federal budget should be to prevent the size of the debt from increasing as a share of the economy that is, to stabilize the ratio of debt to GDP. It is not necessary to balance the budget to achieve this goal. Solving the long-term deficit problem is going to be difficult and will take time, but it can be done if we adopt a balanced and thoughtful approach. All aspects of the budget need to be considered. Nothing should escape scrutiny. Some spending cuts will be necessary. But revenues must also be part of the solution. We should start by looking at the causes of our current long-term problem. See also: Testimony: Greenstein on the Need to Implement a Balanced Approach to Addressing the Long-Term Budget Deficits, March 23, 2010. Press Release: Setting The Right Fiscal Target: Policymakers Should Stabilize Debt As Share Of Economy Over Next Decade, Jan 12, 2010. 3

Health Care The relentless rise in health care costs system-wide is the most significant factor in the growth of federal deficits, because of its effects both in pushing up Medicare and Medicaid costs and in reducing federal tax revenues. (Rising health care costs causes tax revenues to decline because a growing share of workers compensation is devoted to non-taxable health care benefits rather than to taxable wages and salaries.) Health care costs per person in both the private and public sectors have climbed much faster than the economy for over 30 years and are expected to continue to do so. Reducing the growth of health care costs is the key to reducing Medicare and Medicaid costs in a sensible and sustainable manner. The health reform law enacted earlier this year, which extends health care coverage to more than 30 million uninsured people, includes provisions (research projects, pilot programs, and experiments in alternative ways to pay for health care) that will inform policymakers about changes that could slow the growth of health care costs without reducing health care quality. As the results of these studies become available over the next few years, further changes must be made in the health care system to slow the rate of growth in health care costs. However, even if these efforts are highly successful, health care costs almost certainly will continue to rise somewhat faster than the economy, because medical advances will continue to be made that improve people s health and prolong their lives, but add to costs in so doing. Hence, reductions in other spending and increases in revenues also will be necessary to put the federal budget on a sustainable path. Note: Despite the inaccurate claims of some critics, the health reform bill enacted earlier this year will reduce the deficit by $143 billion over 2010-2019, and about $1 trillion in the following decade, according to the Congressional Budget Office. See also: Paper: How Health Reform Helps Reduce the Deficit, May 10, 2010. Paper: Health Reform Will Help Reduce the Deficit, March 25, 2010. Social Security Social Security expenditures will grow over the next two decades with the aging of the baby boomer population. The increase, however, is not that large. Social Security costs in 2050 are projected to be only about 1 percent of GDP higher than they are today. Social Security does face a financing shortfall. Under current policies, resources in the Social Security trust funds eventually will be inadequate to pay full scheduled benefits. Last year s report of the Social Security trustees estimated that starting in 2037, Social Security s resources will be sufficient to pay only about three-quarters of scheduled benefits. Various government and non-governmental entities have laid out options for closing Social Security s financing gap, and there are sensible ways to achieve ensure long-run Social Security solvency. The Social Security challenge is manageable in size and relatively straightforward to address through incremental reforms. Such changes would also contribute modestly to closing the overall federal fiscal shortfall. 4

There are, however, real limits to how large the savings from sensible Social Security reform can be and how quickly they can be achieved without undercutting the role of Social Security ensuring a decent life for the elderly or people with disabilities and in reducing poverty. Social Security benefits are much less generous than many people assume. The average Social Security retirement benefit is now only $1,170 a month, or about $14,000 a year. Social Security checks now replace about 39 percent of an average worker s pre-retirement wages significantly less than similar programs in most other Western countries. And because of the currently scheduled increase in the normal retirement age and the projected rise in Medicare premiums (which are deducted from Social Security checks), that figure will gradually fall from 39 percent to about 32 percent over the next two decades, under current law. Over 90 percent of the aged receive Social Security, and on average it accounts for nearly two-thirds of their income. It provides over 90 percent of income for nearly one-third of its beneficiaries. Any changes made to Social Security need to keep this in mind. It s also important to put the Social Security shortfall into perspective. The Social Security shortfall does contribute to the government s long-run fiscal challenge, but as noted, the contribution is relatively modest. Fast-growing health-care costs and major losses of revenues from the tax cuts enacted in 2001 and 2003 (if those tax cuts are made permanent) are much larger causes of the long-term fiscal gaps we face. Indeed, if all of the Bush tax cuts are made permanent as some who claim to be concerned about deficits insist be done they will add about three times as much to the deficit over the next 75 years as would be added if we simply continued paying scheduled Social Security benefits without taking any action to close Social Security s financing gap. It also should be noted that President Obama has called for extending the Bush tax cuts for people with incomes up to $250,000, but allowing the cuts to expire for wealthier taxpayers. Some policymakers and interest groups are pushing for the tax cuts for the wealthy to be extended as well. Failing to allow the tax cuts for people making over $250,000 to expire would create a funding hole about as big over the next 75 years as Social Security s entire 75- year shortfall. (Extending the tax cuts for the wealthy would add $825 billion to deficits and debt over 10 years.) It is simply false to assert that the tax cuts for people at the top of the income scale are modest and affordable but that the Social Security shortfall constitutes a severe fiscal threat. For more see: Paper: What the 2009 Trustees Report Says and Social Security, May 18, 2009. (The Trustees Report for 2010 has not been issued yet, in order to give analysts time to determine the impact of health reform on Medicare growth.) Note: Questions were raised earlier this year about whether Social Security will need a bailout in the near future. While the recession has affected the program s finances, there is no imminent threat to Social Security. Social Security continues to run annual surpluses and remains capable of paying scheduled benefits in full for the next 25 years or so. For more see: Paper: Social Security Does Not Need a Bailout, April 15, 2010. 5

Discretionary spending Domestic (annually appropriated) discretionary spending is not the cause of federal deficit growth. Leaving aside the temporary increase in last year s Recovery Act, domestic discretionary funding has not generally grown faster than the economy over the past three decades despite significant increases for areas like homeland security and veterans health. And under current policies, it will grow more slowly than the economy in coming decades. We cannot solve the long-term deficit problem just by cutting domestic discretionary spending. Major cuts in discretionary spending would reduce critical investments in education, basic research, infrastructure, and other areas important to long-term economic growth. Placing multi-year caps on discretionary spending should be done only as part of a broader solution to the deficit problem, as was done in 1990 and 1993 when multi-year discretionary spending caps were part of deficit-reduction packages that also included revenue increases and reductions in payments to health-care providers. Revenues Federal revenues must also be considered in determining how to address the long-term budget problem. The tax cuts enacted in 2001 and 2003 have already added $2.8 trillion to the federal deficit. Allowing the 2001 and 2003 tax cuts for couples making over $250,000 (and singles over $200,000) to expire on schedule on December 31 would represents the best course of action for the budget and the economy. Continuing these tax cuts would add approximately $825 billion to the deficit over the next 10 years. Exempting small business income from the scheduled increase in the top tax rates, as some may propose, would do little for the economy in the short term; only the top 3 percent of people with any business income would benefit. Over the long term, such an exemption would likely harm the economy and the budget by encouraging tax avoidance and reducing revenues. For more, see Paper: High Income Tax Cuts Should Expire on Schedule, April 1, 2010. Paper: Tax Rates for Richest 400 Taxpayers Plummeted in Recent Decades, Even as Their Pre-Tax Incomes Skyrocketed, Feb 23, 2010. Estate tax The 2001 Bush tax cuts phased out the federal estate tax resulting in a one-year repeal in 2010. President Obama has proposed to retain the estate tax at the 2009 levels. In 2009 estates valued at up to $3.5 million per individual, or $7 million per couple, would be exempt from the estate tax. Under current law, the value of an estate above $1million would be taxed at a 55 percent rate. 6

Claims that estates owe half their value in estate taxes are not accurate. Other tax breaks are also built into estate tax law on top of the exemption levels. As a result taxable estates owe, on average, less than 20 percent of their value in tax well below the statutory rate of 45 percent. It is also inaccurate to claim that estates are taxed twice since much of the value of large estates often consists of unrealized capital gains. President Obama has proposed making permanent the 2009 estate tax rules. Under these rules, an estate pays no tax on the value of the estate up to $3.5 million for an individual more than a middle-class family that makes $70,000 a year earns in a lifetime and on a value of an estate worth up to $7 million for a couple. As a result, 99.7 percent of Americans who die owe no estate tax. Only the largest 1 in 500 hundred estates pay any estate tax whatsoever. Nevertheless, many policymakers want to go farther and eliminate more of the estate tax. Such measures would help only the very wealthiest Americans, while adding tens of billions of dollars more to deficits and debt. Reducing the tax below 2009 levels is not necessary to protect small businesses and farms, nearly all of which already are exempt from the tax under the 2009 rules. Only 110 small business and farm estates in the entire nation would owe any estate tax in 2011 if the 2009 rules were reinstated, according to the Tax Policy Center, and virtually none of them would have to be sold to pay the tax. Tax expenditures The tax code is packed with tax breaks that favor particular activities. Some of these support policies that enjoy broad public support, such as the mortgage interest deduction. Others are narrowly focused loopholes for special industries or individuals. These tax breaks are often called tax expenditures because they are, in effect, spending that is done through the tax code. Former Federal Reserve Chair Alan Greenspan has called them tax entitlements. Tax expenditures are costly. JCT estimates federal revenues declined by $1 trillion in 2007 alone as a result of tax expenditures for individuals and corporations. The cost of tax expenditures exceeds total spending on defense, or on non-defense discretionary spending. The Congressional Research Service found that tax expenditures rose from less than 6 percent of GDP in 1974 to nearly 10 percent in 1987. Tax expenditures are often regressive and inefficient. They also lack oversight and transparency. If we want to cut spending, we need to look at spending that is done through the tax code as well as what we normally think of as spending. For more see: Paper: New Analysis Shows "Tax Expenditures" Overall Are Costly and Regressive, Feb 23, 2009. 7

The impact of the solutions must be considered We will also need to consider the consequences or impact of the policy choices before us. We should not choose options that make lower-income individuals and families worse off, harm those who already have difficulty getting by, or push people into poverty. Even before the recession, low- and moderate-income people have been largely shut out from the benefits of economic growth for two generations. From 1979 to 2006 (27 years), the average after-tax income of the bottom fifth of the population rose only 11 percent, from $14,900 to $16,500 (including non-cash income, in 2006 inflation-adjusted dollars, according to CBO.) The second fifth rose 18 percent, to $45,400 less than 1 percent a year. The average income of the top fifth rose 86 percent from $98,900 to $184,400. The average income of the top 1 percent increased 256 percent from $337,100 to $1.2 million. During the last period of economic recovery (before the most recent recession) poverty increased and the median income of working-age households declined. 8