Government Spending, Taxes, and Debt: The Choices Ahead Lecture by Robert M. Coen Emeritus Professor of Economics Northwestern University November 13, 2012 Web site: faculty.wcas.northwestern.edu/~rcoen

Outline Federal revenue, outlays, surplus, and debt since WWII Reasons for recent surge in deficits and debt CBO medium-term projections of deficits and debt to 2022 CBO long-term projections of deficits and debt to 2042 Implications of the projections Fiscal choices for the coming year Fiscal choices for the long-run History and prospects for tax reform Summing up

CBO Publications Utilized The Budget and Economic Outlook: Fiscal Years 2012 to 2022, January 2012 The 2012 Long-Term Budget Outlook, June 2012 An Update to the Budget and Outlook: Fiscal Years 2012 to 2022, August 2012

Definitions Surplus = Revenue - Outlays Negative surplus = deficit Debt = Accumulated deficits

Highlights of Deficit History Deficits increase during recessions, decline during expansions Up to 1970s, deficits in recessions offset by surpluses in expansions In 1970s, expansions eliminated deficit but did not produce surpluses 1980s to early 1990s, persistent deficits due to increased outlays Deficits decline in 1990s due both reduced outlays and higher revenue In , persistent deficits reemerge due to lower revenues Beginning 2008, record deficits

Why Do Deficits Increase During Recessions? Tax revenue declines as incomes, profits, and sales fall Outlays for unemployment benefits rise Outlays for food stamps rise Outlays for Medicaid rise Outlays for aid to state and local governments rise

Why Have Deficits Been So Large Since 2008? Automatic stabilizers at work in most severe recession Discretionary, temporary fiscal stimulus measures $150b package in early 2008, mostly one-off tax rebates, faster depreciation Tax credit for first-time home buyers in 2008 $787b stimulus package in early 2009 Personal tax cuts 288 Education 91 Business tax cuts 51 Aid to poor 83 Healthcare 148 Infrastructure 81 Bush tax rate cuts of 2001 and 2003, set to expire in 2010, extended through 2012 Emergency unemployment benefits enacted in for Payroll tax cut in Some non-reasons TARP, AIG bailout, takeover of Fannie Mae-Freddie Mac, auto bailout

Depth of Postwar Recessions Rise in Decline in unemployment rate real GDP

CBO Baseline Projection Assumptions Based on current law Lower tax rates, expanded tax credits and deductions enacted in 2001, 2003, and 2009 expire at end of 2012 Provisions limiting reach of AMT expired at end of 2011 Payroll tax cut, emergency unemployment benefits expire in Feb Automatic spending cuts of Budget Control Act of 2011 take effect Reductions in Medicare payment rates

CBO Baseline Projection, Total deficits $1,128 $1,546 $2,258 ($ billions) Deficit/GDP (Percent) Debt/GDP (Percent)

CBO Baseline = “Fiscal Cliff” (Federal revenue, outlays, and surplus in billions of dollars) Revenue2,435 2,913 Outlays 3,603 3,554 Surplus -1, %Δ Real GDP Unemp rate (%)

CBO Alternative Scenario Assumptions Based on current policy, not current law Expiring tax cuts extended (except payroll tax) AMT is indexed for inflation Medicare payments not cut Budget Control Act automatic spending cuts not applied (but caps on discretionary outlays are imposed)

CBO Alternative Scenario, Total deficit $1,128 $4,437 $9,975 ($ billions) Deficit/GDP (Percent) Debt/GDP (Percent)

Comparison of CBO Projections, Revenue, Outlays, and Surplus Baseline projection Alternative projection

Budgetary Effects of Selected Policy Alternatives Not in CBO Baseline (Billions of dollars) Baseline deficit 641 1,549 2,258 To reduce deficit: 45,000 troop reduction by Freeze discretionary at 2013 level To increase deficit: Maintain Medicare at current rates Remove BCA automatic cuts Extend income and estate tax cuts and index AMT for inflation 247 1,781 4,532 Same, but rates on rich expire 205 1,483 3,708 Alternative projection 1,037 4,437 9,975

CBO Long-Term Scenarios Extended baseline scenario Again follows current law Revenue grows steadily after 2022 because - Bush tax cuts expire More taxpayers subject to AMT New taxes imposed by Affordable Care Act Interactions with demographic change and economic growth Discretionary outlays fall to lowest levels since WWII Extended alternative scenario Again incorporates current policies to 2022 (Bush cuts continue) After 2022, revenue held at 18.5% of GDP After 2022, Medicare and HI costs not restrained Automatic cuts of BCA not imposed BCA Caps on discretionary kept Discretionary outlays fall to average level of past two decades

CBO Long-Term Projections, 2013 and 2042 (Percent of GDP) Base Alt Base Alt Social Security Medicare Medicaid Other Interest Total Outlays Revenue Surplus

Choices for Next Year - Background How great a priority is reducing deficits and debt? We are still in recession Unemployment rate = 7.8% Capacity utilization = 78.3 (85 in mid-1970s) Economies of Europe and Asia forecast to slow Are deficits and debt obstacles to recovery? Two views. YES. They undermine confidence of business and consumers Are US deficit and debt out of line with other nations? No. Signs of faltering confidence in US bonds or dollar? No. Interest on debt growing large relative to tax revenue? No. But what about downgrade of credit rating by S&P in summer 2011? Uncertainty about future tax and spending policies NO. They aid recovery by adding to demand for goods and services

Central Government Debt, 2010 and Change from 2006 Percent of GDP Japan18422Netherlands5213 Greece14840Spain5219 Italy 10912Germany443 Belgium979 Finland426 Portugal8820Denmark407 UK8642Canada368 France6715Sweden34-8 Austria665Norway2614 US6125Switzerland20-5 Ireland6140Australia115 Source: OECD

Choices for Next Year Go over the cliff Likely to worsen recession Fixes medium-term imbalance without severe cuts in outlays Temporarily extend some or all tax cuts, unemployment benefits Adds about $250b to 2013 deficit Creates more inertia to keep them Administration: Extend all except for top income groups Adds about $200b to deficit Undertake tax reform, leave rates low or cut them further, but close loopholes – no time for this Pass a new stimulus package Whatever the choice, debt limit will have to be raised around February

Choices for the Long Run Constitutional amendment requiring balanced budget? Budget Act Required Congress to vote on it – failed Establish safe range of debt to GDP and stay in it? Permanently rescind tax cuts, keep Budget Control Act caps This is the CBO baseline Cong. Ryan: Hold revenue at “historical norm” ~ 18.5% Leaves little for nondefense discretionary outlays Cut income tax rates (10 and 25% rates), close loopholes Replace Medicare with private insurance plans Shrink and restrict programs for poor, turn over to states Simpson-Bowles: Raise some revenue, cut some entitlements Keep income tax rates low, close loopholes Raise gasoline tax Move away from income tax, toward consumption tax

Reflections on Income Tax Reform Reduce rates, broaden base, keep revenue unchanged or increased Appeals: Simplification Reduce distorting effects of tax Reduce waste of skilled labor on tax avoidance Last major reform in 1986 Reduced rates and number of brackets, top from 50 to 28 Eliminated deduction for interest paid, expect on mortgages Eliminated deduction for state-local sales taxes Eliminated favored rates for long-term capital gains

Reflections on Income Tax Reform Undoing of reform since Top rate raised to 31% 1993Top rate raised to 39.6% KG rate set at 28% 1997Child tax credit of $500 KG rate reduced to 20% % rate to fall gradually to 35% Child credit raised to $1K Estate tax reduced, eliminated it in 2010 (temporary) 2003 Accelerated reductions in top rates Dividends and KG rates reduced to 15% Numerous grants of accelerated depreciation Numerous new tax credits – biofuels, etc. Rate increases, more rate differentials, loopholes, complexity!

Reflections on Income Tax Reform How to make up for cutting rates? Costly loopholes: Earned income tax credit (poor) Untaxed employer contributions to health insurance (middle) Mortgage interest deduction (middle) Charitable deductions (middle and rich) Favorable rates for KG and dividends (rich) Accelerated depreciation, investment credits (rich) Tax exemption of interest on municipal bonds (rich) New proposal: Place cap on deductions/tax preferences Closing loopholes reduces “tax expenditures” Could hold rates constant, close loopholes, increase direct support

Taxes as Percent of GDP, 2010 Denmark48 Sweden46 Italy43 Norway43 France43 Netherlands39 Germany36 UK35 Canada31 Switzerland28 Japan28 US25 Source: OECD

Annual GDP Growth Rates, Taxes as Percent of GDP, 2010 Sweden2.446 Canada1.931 Switzerland1.828 UK1.735 US1.625 Norway1.543 Netherlands1.339 France1.243 Germany1.236 Denmark0.748 Japan0.628 Italy0.443 Source: OECD

Summary Size of deficit and debt manageable in short run Immediate concern is to sustain economic recovery Recovery will eliminate $ b of deficit Debt limit must be raised in early 2013 Recent budget imbalance not sustainable Sustainable budget requires both more revenue and lower outlays In CBO baseline (sustainable path) Revenue grows to 24.6% of GDP Yet drastic cuts are needed in discretionary outlays In CBO alternative (excessive growth in deficits and debt) Revenue held at 18.5% of GDP Outlays for interest on debt swamp budget US taxes comparatively low, room for some increase To promote growth, move more to consumption tax Restraining growth of outlays impeded by philosophical differences