WASHINGTON (MNI) – The following are excerpts from a report on the
economic impacts of the U.S. federal government’s budget imbalance
published Friday:

Under current policies, the aging of the U.S. population and
increases in health care costs will almost certainly push up federal
spending significantly in coming decades relative to the size of the
economy. Without changes in policy, spending on the government’s major
mandatory health care programs — Medicare, Medicaid, the Children’s
Health Insurance Program, and health insurance subsidies to be provided
through insurance exchanges — as well as on Social Security will
increase from the present level of roughly 10 percent of the nation’s
output, or gross domestic product (GDP), to about 16 percent over the
next 25 years. If revenues remain at their past levels relative to GDP,
that rise in spending will lead to rapidly growing budget deficits and
mounting federal debt.

In June 2010, the Congressional Budget Office (CBO) issued
long-term budget projections under two scenarios that reflected
different assumptions about future policies for revenues and spending.1
The extended-baseline scenario was based on the assumption that, by and
large, current law would continue without change. Under that assumption,
revenues would climb to a higher share of GDP than has typically been
seen in recent decades.

Even so, federal debt held by the public would rise from 62 percent
of GDP at the end of fiscal year 2010 to about 80 percent of GDP by
2035. Only once before in U.S. history — during and shortly after World
War II — has federal debt exceeded 50 percent of GDP. CBO also prepared
budget projections under an alternative fiscal scenario, which
incorporated several changes to current law that are widely expected to
occur or that would modify some provisions of law that might be
difficult to sustain for a long period. Under that scenario, debt would
soar above its historical peak (about 110 percent of GDP) by 2025 and
continue climbing thereafter.

To prevent debt from rising to unsupportable levels, policymakers
would eventually have to restrain the growth of spending, raise revenues
significantly above their historical share of GDP, or pursue some
combination of those two approaches. Addressing the long-term budget
imbalance would, at a minimum, require stabilizing the ratio of debt to
output. In deciding when and how to do that, an important consideration
is, what are the costs of delay?

Effects of Delaying Action Waiting to put fiscal policy on a
sustainable course would lead to higher levels of government debt, which
would be costly in several ways:

– Higher debt would reduce the amount of U.S. savings devoted to
productive capital (resources that produce economic benefits over time)
and thus would result in lower incomes than would otherwise occur,
making future generations worse off.

– Higher debt would necessitate greater federal spending on
interest payments, meaning that larger changes in revenues and
noninterest spending would be needed to make fiscal policy sustainable.
If those changes took the form of bigger cuts to spending programs, they
would be more difficult for people to adjust to than smaller cuts would
be. If the changes took the form of bigger increases in marginal tax
rates, they would create larger disincentives to work and save, which
would reduce incomes more than smaller tax increases would. B Higher
debt would make it harder for policymakers to respond to unexpected
problems, such as financial crises, recessions, and wars.

– Higher debt would increase the likelihood of a fiscal crisis, in
which investors would lose confidence in the government’s ability to
manage its budget and the government would thereby lose its ability to
borrow at affordable interest rates. At the same time, waiting to put
fiscal policy on a sustainable course could make some current
generations better off than they would be otherwise. In particular, a
delay would tend to help older generations by deferring the tax
increases or cuts in benefit payments and government services that they
would face. For certain policies, that gain would outweigh the greater
reduction in future incomes and the larger ultimate adjustment to taxes
and spending that would result from delay, because the effect of those
differences is muted for people who have completed all or part of their
working lives. Whether that advantage of waiting would outweigh the
costs to older generations from the other effects of higher debt — the
government’s reduced ability to respond to unexpected needs and the
greater risk of a fiscal crisis — is unclear.

CBO estimates that stabilizing the debt-to-output ratio in 2015
would require reducing federal outlays or raising taxes by about 2
percent to 2.5 percent of GDP initially — equivalent to roughly $300
billion to $400 billion today — as well as making policy changes that
would roughly equalize the growth rates of spending and revenues
thereafter. The initial action would represent a cut of 12 percent to
12 percent in total noninterest spending projected for 2015, an 11
percent increase in total revenues projected for that year, or some
combination of smaller spending and tax changes. By comparison,
stabilizing the debt-to-output ratio in 2025 would require a policy
change in the first year equal to 5.5 percent to 6 percent of GDP — or
about $800 billion to $900 billion in today’s economy — followed by
policy changes that would roughly equalize the growth rates of spending
and revenues. That initial change would amount to a cut of 24.5 percent
to 26 percent in projected noninterest spending in 2025, or an increase
of 26.5 percent in projected revenues.

Waiting until 2025 to resolve the long-term budget imbalance — and
thus allowing the debt-to-GDP ratio to rise by roughly 40 additional
percentage points before it was stabilized — would result in lower
levels of the capital stock, the supply of labor (as measured by total
hours worked), economic output, and consumption. Specifically, the
higher debt resulting from a delay in fiscal stabilization would have
several long-term effects on the overall economy:

– A growing portion of people’s savings would go toward buying
government debt rather than toward investing in productive capital
goods, such as factories and computers. That “crowding out” of
investment would reduce the size of the nation’s capital stock by
between 7 percent and 18 percent compared with what it would be if
action was taken in 2015.

– The smaller capital stock would result in lower wages, which
would diminish people’s incentive to work. In addition, if the fiscal
stabilization was accomplished through an increase in tax rates, the
incentive to work would be further diminished. In all, the delay would
reduce the supply of labor by between half a percent and 2 percent.

– The lower capital stock and labor supply would in turn reduce
output by between 2.5 percent and 7 percent, and total consumption by
between 1.5 percent and 5.5 percent, compared with what they would be if
action was taken in 2015.

Rising Federal Debt and Its Consequences

The amount of federal debt held by the public has surged in the
past few years, from 36 percent of GDP at the end of 2007 to 62 percent
at the end of 2010 — the highest level of debt relative to output since
shortly after World War II. The levels of taxes and spending that caused
the increase in debt have had some beneficial short-term effects by
increasing demand for goods and services in a time of economic weakness.
But in the long term, the rise in debt will have a negative impact on
economic output and incomes, unless it is reversed.

In the next few years, as the economy recovers and policies adopted
to counteract the severe recession and the turmoil in financial markets
are phased out, annual budget deficits will probably shrink markedly and
debt will accumulate more slowly. Over the long run, however, the budget
outlook is daunting. The growing imbalance between revenues and
noninterest spending projected under both of the scenarios in CBO’s
latest Long-Term Budget Outlook (particularly under the alternative
fiscal scenario) would lead to larger deficits and mounting debt.
Moreover, the government would need to issue ever-greater amounts of
debt to pay rising interest costs, which would cause the debt to grow
even faster. Although temporary budget deficits are generally beneficial
when the economy’s output is below its potential, persistent deficits
impose significant economic costs.

** Market News International Washington Bureau: 202-371-2121 **

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