America’s deficit: Confronting the monster
At last, plans are appearing to cut America’s deficit. But will politicians and the public embrace them?
Nov 18th 2010 | WASHINGTON, DC | from PRINT EDITION
[Greg Ip] BARACK OBAMA and his Republican opponents have spent much of the past month sniping at each other, but on November 15th they suddenly found themselves agreeing. Mitch McConnell, the leader of the Senate Republicans, called for a ban on earmarks, the pet projects politicians like to pop into spending bills. Mr Obama, who also wants a curb on them, quickly applauded.
A cynic would say that such agreement was easy, since the stakes are so low. Earmarks attract plenty of bad press, but the money is trivial—less than 0.5% of federal spending. On the more pressing question of how to close America’s gaping deficits, Democrats and Republicans remain far apart. Only a week before, the chairmen of a bipartisan commission set up by Mr Obama in February to find ways to get the deficit down floated a proposal focused on cutting spending. Republicans liked this, but Nancy Pelosi, the Democrats’ leader in the House of Representatives, called the idea “simply unacceptable”.
This sound and fury, however, may signify something important. The two sides are no longer arguing over whose taxes to cut or which entitlements to expand, but whose taxes will rise and which entitlements will shrink. It may all come to naught; or it may signal the dawn of a new age of austerity, similar to the era of tax increases and entitlement cuts that prevailed from 1982 to 1997.
America’s budget deficit in the fiscal year that ended on September 30th stood at $1.3 trillion; at 9% of GDP, the second-largest since the second world war. (Fiscal 2009 was the biggest.) That figure reflects the effects of the recession and the temporary stimulus, both of which will fade. The real problem is the future. On current policies the Congressional Budget Office (CBO) reckons that the federal debt, now 62% of GDP, will hit 87% by 2020. Add in state and local-government borrowing, and the total approaches 110%.
According to the IMF, America’s structural deficit and the growth in its debt over the medium term are among the worst in the rich world. The United States also stands out for its lack of any plan to deal with this. Germany has passed a balanced-budget constitutional amendment. Britain’s coalition government has launched an ambitious four-year plan to slash its massive deficit. Nicolas Sarkozy, France’s president, has finally triumphed in a bruising battle to raise the pension age.
America has a good and a bad excuse for its inaction. The good one is that the economy isn’t ready. Economic growth in the second half of this year has been a painful 2% at an annual rate. The unemployment rate, at 9.6%, remains near its peak. The effects of the stimulus are wearing off, so fiscal policy now veers towards contraction. If taxes rise or spending falls immediately, the economy could slide back into recession, as happened in Japan in 1997.
Giveaway and takeaway
But there is also a bad reason for delay: America’s political culture is unused to austerity. The country’s fiscal policy alternates between “giveaway” and “takeaway”, says Gene Steuerle, a Treasury official in the 1970s and 1980s and now a scholar at the Urban Institute, a think-tank. From 1946 to 1981 was an era of giveaway: entitlements expanded, most notably with Medicare and Medicaid in 1965, and taxes were cut, most famously in Ronald Reagan’s first year in office, in 1981. In 1982, however, fiscal policy flipped to takeaway. Mr Reagan’s tax cuts and defence build-up, compounded by the 1981-82 recession and sky-high real interest rates, produced record structural deficits. Pete Domenici, then a junior Republican senator, remembers going to the White House with other Republicans in 1982 to talk to Reagan about the deficit. He recalls the president’s stunned disbelief when he told him that he could run up more debt than all his predecessors combined.
Taxes were raised in 1982, 1983, 1984, 1987, 1990 and 1993. In 1986 a sweeping tax reform eliminated many exemptions. Takeaway also ruled on entitlements: in 1983 a bipartisan deal led to cuts in future Social Security (pensions), a gradual increase in the retirement age and a higher payroll tax. In 1996 Bill Clinton and Republicans in Congress remade welfare, limiting how long recipients (mostly single mothers) could receive benefits, and shifting most responsibility to the states.
Austerity was helped along by new budget rules. Most successful was the Budget Enforcement Act of 1990, which imposed caps on discretionary spending and also introduced the “Paygo” rule: any tax cut had to be offset by a spending cut, and any expansion of entitlements with a tax increase. By 1997 the deficit had fallen sharply.
Fiscal policy flipped back to giveaway in 1997. Ironically, this happened with the passage of the Balanced Budget Act that Mr Domenici helped negotiate with Mr Clinton. It aimed to balance the budget by 2002 by, among other things, curbing Medicare payments to doctors. But it also created a generous new child tax credit and cut capital-gains tax, the first significant tax cut since 1981.
A surge in tax revenue, pushed by the stockmarket bubble, then pushed the budget into surplus in 1998, four years ahead of schedule. With that, the culture of austerity died. Congress has regularly overridden the 1997 cuts in Medicare payments. Mr Bush cut taxes on income in 2001 and on capital gains and dividends in 2003. In 2003 he signed into law the first big entitlement in years, the prescription-drug benefit. In 2002 Paygo lapsed. Structural deficits soon re-emerged, but the bond market no longer seemed to care, as long as the global savings glut kept America’s borrowing costs low.
The Obama record
Almost from his first day in office Mr Obama promised to make “hard choices” on the deficit, and not to saddle America’s children with “a debt they cannot pay”. But his first two years have been firmly giveaway: not because of his $814 billion stimulus plan (an essential, and temporary, response to the crisis), but because he has allowed structural problems to fester. Though Paygo was reinstated this year, it exempted particular things that Mr Obama wanted, including keeping Mr Bush’s tax cuts for 98% of households.
The new health-care law does not aggravate the deficit, but nor does it do much to reduce it. The CBO reckons that federal health-care spending will almost double, from 5.5% of GDP this year to 9.8% in 2035—as it would also have done if reform had never happened.
So when Mr Obama appointed his bipartisan commission on deficit-cutting, it seemed a token gesture. The commission has yet to issue its final report, due on December 1st. But its chairmen—Alan Simpson, a former Republican senator, and Erskine Bowles, a former chief of staff to Bill Clinton—have put out a surprisingly bold draft proposal of their own. On November 17th a separate group of 19 experts headed by Mr Domenici, now retired, and Alice Rivlin, a former budget director for Mr Clinton, produced its own proposal.
The two groups share one aim: to get the federal debt down to 60% of GDP. The steps by which they get there, too, are remarkably similar (see table). Round the rich world a consensus has emerged that austerity should mean spending cuts rather than tax increases. Britain’s coalition government gets about 75% of its deficit reduction from spending cuts. The Simpson-Bowles proposal aims for 70%, while the Domenici-Rivlin commission targets slightly more than half.
Discretion versus valour
In America the easiest part of spending to target is discretionary items such as law- enforcement and defence, which must be authorised every year. Mr Obama has already promised to freeze discretionary spending, and in their “Pledge to America” congressional Republicans aimed to slash it by $100 billion. These promises are either hollow or implausible. Both Mr Obama and the Republicans exclude security and defence, which automatically cuts by more than half the amount of money at stake, to around $500 billion. Cutting, say, $100 billion from that would entail savage cuts to federal services without cutting the deficit much.
Excluding defence from cuts makes no sense, given its size and the amount of pork in the Pentagon budget. But even when defence is included, discretionary spending is less than 40% of the total. Entitlements, at nearly 60%, are the principal cause of long-term spending growth (see chart 2). Social Security is easiest to fix, because its annual shortfall stabilises after 2035. Indexing the retirement age to longevity would both reduce future costs and encourage people to work longer, boosting potential output. The Domenici-Rivlin report proposes a more elegant approach: it indexes lifetime benefits to longevity. As lifespans lengthen, a person could still retire at, say, 66, but with a smaller annual benefit. Further savings would come from slowing the rate at which benefits to upper-income earners grow and raising the maximum salary subject to the payroll tax.
Rising health-care costs are more difficult to deal with, largely because of rising demand for services and an ageing population. Under both proposals, richer patients would pay for more of their Medicare coverage. The services available under traditional Medicare and Medicaid (for the elderly and the poor respectively) would also have to be rationed. Paul Ryan, the leading Republican on budget matters in the House, has proposed replacing traditional Medicare with vouchers to buy private insurance. The Domenici-Rivlin plan recommends that publicly funded private insurance should be offered alongside traditional Medicare. A new independent panel, created under Mr Obama’s health reform to monitor payments and services, may slow the rate of benefit growth if Congress lets it work. On Medicaid the federal government could switch from matching state spending to block grants, as it did with welfare. This puts the onus of controlling services and caseloads onto the states.
A more efficient way to claw back revenue would be reform of the tax system. The system is riddled with so-called “tax expenditures”—credits, exemptions, deductions and other loopholes that cost $1 trillion a year in forgone revenue. Some, like the earned-income tax credit, are closely targeted to the poor. But the rich benefit most, because the value of a tax break—for mortgage interest, employer-provided health insurance and many more—rises with the taxpayer’s tax rate. The lower rate on capital gains and dividends also mostly benefits the rich. Eliminating these breaks would broaden the tax base; it would probably also make it possible to lower marginal rates, even below the levels of Mr Bush’s tax cuts.
Preparing the public
Taxes may still have to be raised by other means to get the deficit down. At present, compared with other countries, America taxes income too heavily and consumption too little. A sensible solution would therefore be a value-added tax; every other rich country has one. The Domenici-Rivlin report suggests a 6.5% “debt-reduction sales tax”. A carbon tax, or a higher petrol tax, could play the same role.
The proposals are bold; but no one who is making them currently holds office. Will America’s politicians ever dare sign on? Research by Alberto Alesina of Harvard University has found that, contrary to political wisdom, governments that enact austerity measures are often re-elected: Denmark’s in the early 1980s and Sweden’s and Canada’s in the 1990s, for example. Support for Britain’s austerity-preaching Conservatives has remained strong, though the measures will not bite until next year.
Britain’s lessons are not much use in America, however. Its parliamentary system gives a government much more freedom to act, provided it has a majority. In America, a president must convince both the Senate and the House to go along. And nowadays even the minority party can block legislation in the Senate.
Mr Bowles and Mr Simpson may soften the bite of some of their proposals, but they will still be lucky to get 14 of their 18 members agreeing on a proposal by December 1st. Peter Orszag, Mr Obama’s former budget director, says it may not matter. “The key is not whether they get 14 out of 18 but what the administration does. Even if they get ten out of 18, if the administration is behind it, it has running room. But this would require a massive push from the administration.” And that, he adds, depends in turn on how far Mr Obama is willing to move towards the centre.
In Britain the Tories spent months before they were elected preparing the public for austerity. Voters in America do not seem remotely ready yet. In a recent CBS News poll 56% of respondents said Congress should focus on the economy and jobs; just 4% thought the deficit should be its priority.
It is true that both Reagan and Mr Clinton were re-elected after pursuing austerity in their first terms. But they were prodded by the bond market: yields were over 10% in 1982 and around 6% in 1993. Now yields are under 3%. Some, including members of Mr Obama’s economic team, think this shows that the market is more worried about deflation than deficits. They note that fiscal tightening in America in 1937 and Japan in 1997 prolonged economic suffering. To counteract this, the Domenici-Rivlin plan includes a $650 billion payroll-tax holiday in 2011.
Mr Domenici would love to see Mr Obama and Congress share the same urgency he felt as he walked into Reagan’s office in 1982. A fan of military metaphors, he calls the current challenge the greatest the country has faced since Pearl Harbour. “America is on the threshold of potential economic devastation,” he says. “The day of infamy is close.” The big difference, however, is that the public doesn’t know it yet. “It’s not like they bombed Hawaii.”