Home > Deficit Commission, Fiscal Policy, Sovereign Debt Crisis > The Looming U.S. Fiscal Crisis

The Looming U.S. Fiscal Crisis

In a previous post (see Deficit Commission Fantasies), I argued that the Deficit Commission was an exercise in fantasy since their goal for reducing the deficit was much too small to eliminate the impending U.S. fiscal crisis.  Here I will provide some analysis designed to illustrate just how large the government deficit may be in the future without substantial policy changes by the government. To do this requires using a document provided by the Congressional Budget Office (CBO) on their web site (www.cbo.gov).

The CBO is an organization created to advise Congress on various policy issues.  Consistent with its mission, CBO issued a document last summer entitled “CBO’s 2011 Long-Term Budget Outlook.” This document provides the CBO’s best estimates of what will happen to the government’s deficit and stock of government debt under two scenarios.

One scenario provides a forecast based upon the continuation of current law. So, for example, it assumes that tax increases imposed by Obamacare will occur and it assumes that increasing numbers of individuals will pay the Alternative Minimum Tax. Therefore tax revenues rise to the historically high level of 23 percent of GDP, well above the long-term average of 18 percent. And it assumes that government spending, aside from mandatory health care spending, interest payments, and Social Security, would decline as a share of GDP to levels not seen since before World War II.

The second scenario provides a forecast under the assumption that certain legislative changes will occur, changes which are widely expected to occur. These would include, for example, changes to the Alternative Minimum Tax to prevent more taxpayers from paying this tax, and it assumes that overall tax payments are about 18 percent of GDP, their historical average.  Further they assume that the the “doctor fix” will be made so that payments to physicians under Medicare will not decline as scheduled under the law. As will be seen, these and other assumed changes in the law generate a very different picture compared to the first scenario regarding debt and deficits.

One final bit of data is required. The CBO report provides forecasts as shares of GDP. To cast these numbers into dollar figures, I need to use a value for GDP for 2021 and 2035. I assume that GDP is twenty percent higher in 2021 than it was in 2011. I also assume a twenty percent increase in GDP between 2021 and 2035.  These twenty percent increases are in the range of GDP growth in recent years.

The tables below report the numbers under each scenario. The tables include the deficit and stock of debt as percentages of GDP. The table also includes the deficit and stock of debt in trillions of dollars.

Scenario 1

                                                                   2021                                   2035

Deficit                                                   3.1 ($0.6 Trillion)              4.2 ($0.9 Trillion)

Stock of Government Debt                    76 ($13.7 Trillion)              84 ($18.1 Trillion)

Scenario 2

                                                                    2021                                  2035

Deficit                                                   7.5 ($1.4 Trillion)             15.5 ($3.4 Trillion)

Stock of Government Debt                    101 ($18.2 Trillion)          187 ($40.4 Trillion)

Under Scenario 1, the CBO estimates don’t look terribly alarming. The deficit and stock of debt are in the range of recent experience. It seems reasonable to expect that the U.S. could finance deficits of these magnitudes.

Now consider Scenario 2. Remember that this scenario assumes that the government gets tax revenues, as a share of GDP, that is near historical levels. Here we see that there is indeed a serious budget problem. The stock of government debt rises to 187 percent of GDP in 2035, a level exceeding that of Greece.  There is every reason to believe that the U.S. government could not finance deficits of this size.

The Bottom Line

All governments have a budget constraint. That constraint states that deficits today must be offset by surpluses tomorrow. The analysis contained here shows that the U.S. government must engineer a substantial rise in tax rates in the future. If it does so, it seems likely that the government can finance the deficits that will arise in the future.  Without these tax increases, the U.S. will resemble Greece with increasingly higher interest rates needed to induce the private sector to lend and, without tax increases, a government default is likely to occur. Thus to do nothing to reduce the size of government spending almost certainly will result in default.

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Economics One

A blog by John B. Taylor

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