How Bad is the Budget Outlook?

The Congressional Budget Office offers two visions of the future in its new long-run budget outlook.

The first imagines a world in which lawmakers take pay-as-you-go budgeting really seriously. The budget baseline assumes that existing laws execute exactly as written: all the 2001 and 2003 tax cuts expire, the alternative minimum tax hits millions more families, real bracket creep drives taxes far above historical norms, Medicare payments to doctors are cut by more than 20%, discretionary spending grows only with inflation, and all the offsets in the recent health legislation – taxes on “Cadillac” health plans, cuts in provider payments, etc. – happen as scheduled. If Congress tries to avoid any of those changes, it would have to pay for them through offsetting spending cuts or tax increases.

In that strict—and unrealistic—PAYGO world, our debt would continue to increase faster than the economy, rising from about 60% of gross domestic product today to about 80% in 2035. That’s far above where we want to be. PAYGO policymaking cannot fix the budget pressures of an aging population and rising health costs. But you have to give PAYGO some credit. If Congress really acted that way on every future budget decision, it’s unlikely that we would have a fiscal crisis in the next decade or more.

Of course, no one believes that Congress will really be that disciplined. That’s why CBO offers a second vision, in which lawmakers give in to temptation. They extend most of the tax cuts, patch the AMT, limit bracket creep, increase payments to Medicare docs, allow discretionary spending to rise with GDP, and turn off some of the health legislation offsets after 2020.

If policymakers give in to all those temptations, the debt skyrockets, rising from about 60% of GDP today to 185% by 2035. And that’s assuming no negative effects on the economy. As my colleagues Len Burman, Jeff Rohaly, Joe Rosenberg, and Katie Lim have pointed out, out-of-control deficits would weaken the economy by crowding out investment and driving up interest rates, so the debt-to-GDP ratio would actually grow even faster.

CBO doesn’t include those economic effects in its official long-run projections. However, it does separately examine what would happen to the economy because of reduced investment. The results aren’t pretty. When CBO runs the giving-in-to-temptation world through its model, it discovers that the U.S. economy ceases to exist after 2027.

OK, maybe that’s a bit strong. What happens is that crowding out gets so severe that CBO’s model breaks down, overwhelmed by the debt explosion.

These findings provide ammunition to both sides of the great deficit debate. Budget hawks will point to the temptation scenario as further evidence that we are on a reckless fiscal path that threatens our economic well-being. Budget doves will emphasize the PAYGO scenario as evidence that we can muddle along for years without needing to fear an economic backlash.

I think the hawks have the better of this argument. Even under perfect PAYGO, our fiscal condition would deteriorate in coming years. Moreover, the odds that lawmakers will show that much discipline in the near term are nil. For example, the PAYGO law enacted earlier this year allows Congress to extend most of the 2001 and 2003 tax cuts and to avoid cuts to Medicare doctor payments without finding any offsets. Real life PAYGO doesn’t come close to the rigorous standards of CBO’s PAYGO scenario.

Nevertheless, I don’t really think that the U.S. economy will blink out of existence in 2027. We will find a way a muddle through. But to do so, we need to face up to CBO’s bleak vision of our fiscal future and the temptations that lawmakers will face. Now is not the time for sudden austerity—the G-20 bandwagon non-withstanding—but it is the time to develop a plausible plan to bring taxes and spending into long-run balance.

This post first appeared on TaxVox, the blog of the Urban-Brookings Tax Policy Center. 

Edited (7/6/10): Added “most of” in fourth paragraph (CBO’s alternative fiscal scenario extends most of the 2001 and 2003 tax cuts, but it allows the rates reductions for high-income taxpayers to expire).

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