NEXT: The Stakes
March 01, 2012
Our nation's long-term fiscal outlook is unsustainable. Publicly held debt currently equals 70 percent of gross domestic product, the most common measure of an economy's size. Our current policy path leads to debt of nearly 200 percent of GDP over the next 30 years. In all likelihood, such high and rising levels of debt would have a disastrous impact on the U.S. economy long before they reach that level.
Fortunately, the past year has brought substantial progress in raising awareness of America's fiscal challenges. The bipartisan National Commission on Fiscal Responsibility and Reform, led by Democrat Erskine Bowles and Republican Alan Simpson, catalyzed the public discussion. Since then, both congressional Republicans and President Obama have presented frameworks for long-term deficit reduction; a bipartisan group of senators has sought to build on the work of the Bowles-Simpson commission; a number of independent organizations have offered blueprints for putting the budget on a sustainable long-term path, and the President signed into law the Budget Control Act (BCA) of 2011, which included provisions intended to improve America's budget path over the next 10 years.
Despite broad awareness that the country must address its fiscal problems, and the enactment of the BCA, lawmakers have made scant progress toward addressing our true long-term structural challenges. Those challenges stem primarily from the aging of the population and fast growth of health care costs, which will push expenditures on Medicare, Medicaid, and Social Security far above projected levels of federal revenues over the next 25 years. Yet, this year, Washington focused largely on controlling deficits over the next 10 years — not over the long term — and its major legislative achievement, the BCA, focused most of its attention on discretionary spending. That helps, but that part of the budget is not the cause of our structural long-term deficits. Moreover, the failure of the "supercommittee," as the bipartisan group established by the BCA was known, to identify $1.5 trillion in deficit reduction over the next ten years has reinforced deep concerns about political gridlock in Washington and underscored how much work lawmakers still have to do to reach an agreement to address the country's long-term fiscal challenges.
Federal Spending & Revenues
Data from PGPF's Long Term Model of the Federal Budget, baseline assumptions; and the Office of Management and Budget, The Budget of the United States Government for Fiscal Year 2013, February 2012. Compiled by PGPF.
What the country needs is a grand fiscal bargain that would stabilize long-term debt at levels that our economy can afford, make resources available for critically needed investment, and substantially improve the prospects for future economic growth. If federal lawmakers can tame future budget deficits and put the nation on a fiscally sustainable path, the United States will become an environment more favorable to innovation, business development, and job creation. Such a plan would also keep Social Security, Medicare, Medicaid, and other social safety net programs strong for those who need them. Finally, while a comprehensive agreement would put this problem behind us and allow our policymakers to focus on other national needs, it would also reduce risk of a fiscal crisis.
However, if we continue on our current path, we will have to devote more and more resources to financing our debt. Using even an optimistic set of baseline assumptions, hundreds of billions of dollars a year will be sent to foreign creditors. We will have less money to invest in areas such as education, research, and infrastructure, which underpin a productive workforce and a thriving
economy. Social Security and, particularly, Medicare benefits will be put increasingly at risk by deteriorating federal finances. Perhaps worst of all, the consequences of our inaction will fall on future generations of Americans, who will have to pay our bills.
People on all sides agree that such outcomes are unthinkable and must be prevented. To change our current course, Americans must understand our fiscal challenges and be willing to support the difficult choices that policymakers confront as they search for solutions. This guide aims to provide an objective, nonpartisan look at the fiscal facts and the decisions policymakers have to make. Those decisions must be made in the broader context of the economy and society we are trying to build. Questions of social welfare, generational equity, and the desire to encourage or discourage certain behaviors all have a bearing on economic growth and the individual programs and policies contained in the federal budget. Because the federal budget touches every American, it is a reflection of who we are as a nation and the priorities we seek to establish for the future.
Our Current Path
Stated simply, the federal government’s budget is currently in deficit because the government spends more each year than it receives from taxes and other sources of revenue. To cover that annual shortfall, the government has to borrow from the public. Over time, annual budget deficits can add up to sizable government debts.
The federal government’s annual budget deficits have been $1.3 trillion or higher for each of the past three years — in the neighborhood of 10 percent of GDP. However, much of the rise in the deficit is cyclical and reflects the current weakness of the economy. Although our recent deficits have been historically large, the government’s debt today is still manageable — it is about 70 percent of GDP — and global financial conditions are still relatively favorable for the U.S. Moreover, the large deficits of recent years have helped prop up and stabilize our economy as it suffered the deepest and longest recession since the Great Depression.
Federal Debt Held by the Public
Data from PGPF's Long Term Model of the Federal Budget, baseline assumptions; the Congressional Budget Office, The Long-term Budget Outlook, June 2009; and OMB, The Budget of the United States Government for Fiscal Year 2013, February 2012. Compiled by PGPF.
However, once the global economy recovers, continued high levels of government borrowing will eventually push up interest rates, making it more difficult for the private sector to create jobs and make new investments in factories, equipment, and housing. Because government borrowing will reduce the funds available for the private sector, budget deficits will crowd out private investment, slow the long-run growth of the economy over time, and raise the risk of fiscal crisis.
Although the BCA imposes limits on federal spending and establishes a process to curb projected deficits and debt even further, beyond 2021, the United States will still face a daunting long-term fiscal challenge. That is because structural deficits — deficits rooted in long-term demographic, longevity, and health care spending trends coupled with revenues that will not keep pace — and the growing cost of paying interest on the national debt are projected to push the debt to dangerously high levels. The BCA did not address those longer-term fundamental budgetary pressures.
Many economists believe that a debt-to-GDP ratio of 60 percent or less is a desirable fiscal goal. Carmen Reinhart and Ken Rogoff, two highly regarded economic historians, have shown that debt above 90 percent of GDP can be risky for economic growth. If we do not change our current policies, official projections show that our debt is on an explosive and unsustainable path. The Congressional Budget Office projects that U.S. public debt will climb to nearly 100 percent of GDP by 2021 and then soar to more than 200 percent of GDP by 2040. By 2035, federal debt could cause the economy to shrink by 7 to 18 percent, which would be equivalent to reducing income in the United States by $3,000 to $8,000 per person in 2011. Moreover, long before debt reached 200 percent of GDP, financial markets would probably lose confidence in the United States and provoke an economic crisis that would cause interest rates to skyrocket, the value of the dollar to plummet, and unemployment rates to soar.
Demographics, Health Care Costs, and the Future of the Social Safety Net
Over the next two decades, the combination of low birth rates, the retirement of 78 million baby boomers, and lengthening life expectancies will result in a doubling of the number of Americans over age 65. Furthermore, the number of people age 85 and over is projected to triple by 2050. Longer life spans are good news, but they add to budget difficulties because health care spending on people over 85 is seven times higher than spending on adults under 65. Not only will more seniors be drawing Social Security and Medicare benefits, but they also will draw benefits for more years than older individuals of previous generations. And as the U.S. population ages, proportionally fewer workers will be available to pay for retiree benefits.
In addition, spending for the federal government’s two largest health care programs — Medicare and Medicaid — is, like the rest of the nation’s health spending, growing faster than the economy. That growth is widening the gap between benefits and the revenues available to pay for them. Today, one-fourth of the federal budget (excluding interest) is spent on health care: That portion is projected to grow to a third in 20 years, and to increasingly larger shares of the budget in future decades.
The reality is that as the number of beneficiaries increases and health care costs grow, Social Security and, especially, Medicare will require larger shares of federal resources, increasing pressure within the budget. These programs, which form the core of the social safety net that many Americans rely on, could become financially precarious and leave the most vulnerable members of our society at risk — unless policymakers put our nation's budget on a sustainable path.
Federal Investment and Interest Costs
Data from OMB, The Budget of the United States Government for Fiscal Year 2013, February 2012; and Gagnon and Hinterschweiger, "The Global Outlook for Government Debt over the Next 25 Years: Implications for the Economy and Public Policy," PIIE, June 2011. Compiled by PGPF.
Defense, Taxes, and Other Programs
In addition to Social Security and health care programs, defense is the third major category of federal spending. The United States spends more on defense than the next 17 highest-spending countries combined, which is twice as much of our GDP as other developed countries. While members of both political parties want to ensure that America is protected, a robust national defense depends upon a strong and resilient economy.
On the other side of the federal ledger, the tax code is overly complex and does not provide sufficient revenue to meet either our current or projected spending needs. The tax code is full of income deductions, exclusions, and other special provisions — known as tax expenditures — many of which are intended to influence or distort the economic behavior of individuals and businesses and are supported by strong special interest groups. The federal government loses about $1.3 trillion each year from tax expenditures, which include a number of popular tax advantages such as the exclusion of employer-provided health benefits from individuals’ taxable income, the interest deduction for home mortgages up to $1 million, tax-advantaged retirement savings, accelerated depreciation of business investment, and other business investment incentives. Because tax expenditures are more valuable at higher marginal tax rates, their benefits skew toward higher-income earners.
Federal interest costs also add to our nation’s fiscal challenges. As the federal government runs deficits, it accumulates more debt, which causes interest costs to rise. Within 10 years, interest expense is projected to increase more than 2.5 times from its current level of 1.4 percent of GDP, to 3.7 percent of GDP. In addition, the projected rise in U.S. debt could cause lenders to question the creditworthiness of the United States and demand higher interest rates, greatly increasing interest costs and making it harder to find resources to invest in education, infrastructure, research and development, and other activities that will help our economy grow. For instance, if interest rates rise just 1 percentage point, the federal government's interest costs could increase by about $1 trillion over 10 years, according to the Congressional Budget Office.
Currently, about half of our publicly held debt is owned by foreign creditors (up from just 5 percent in 1970). Paying interest to these creditors diverts resources from our economy that could be used to finance investments to help us grow faster. According to a study by the Peterson Institute for International Economics, federal interest costs will grow from 1.3 percent of GDP today to 13 percent of GDP in 2035. That would be four times the current percentage of GDP that the federal government spends on education, research, and infrastructure combined.
Our growing dependence on foreign creditors could also put other countries in a position to influence unduly our domestic and foreign policy choices. To reduce this dependence on foreign credit, the United States government must borrow less, and the American public must save more.
The Benefits of a Fiscally Sustainable Future
By laying out a path for long-term deficit reduction now, policymakers can build a foundation for a competitive, prosperous economy, with critical investments, reasonable tax rates, and a strong social safety net — including Social Security, Medicare, and Medicaid. Given the fragility of our economic recovery, it is necessary to address short-term economic needs and return to robust growth and job creation. Aggressive deficit reduction now could harm the recovery. But over the long run, our fiscal challenge poses a more significant threat. If policymakers from both parties agree to a plan that can be implemented gradually after the economy has recovered, they can create an economic climate that is more favorable to growth as well as establish a credible path to long-term fiscal sustainability. If, instead, they continue to delay action, they will narrow our options and make the tough choices even more painful.
Putting the U.S. on this path will require difficult decisions by policymakers and the public alike, including a willingness to modify both spending and taxes. To stabilize debt at today's levels over the long run with spending cuts or tax increases alone would require cutting federal spending by about 30 percent or raising taxes by about 45 percent — and that is if policymakers act today. Clearly, all options have to be on the table. Agreeing now to a plan of both revenue increases and spending cuts is the most reasonable approach.
Finding solutions is a test of leadership and commitment: leadership on the part of elected officials who have the power to shape our fiscal future, and a commitment from all Americans to stand with those who are willing to make difficult decisions.
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