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Don’t like the fiscal cliff? You’ll hate the fiscal future.

by Matt Mitchell on December 21, 2012

in Tax and Budget

Absent an eleventh-hour deal—which may yet be possible—the Federal government will cut spending and raise taxes in the New Year. In a town that famously can’t agree on anything, nearly everyone seems terrified by the prospect of going over this fiscal cliff.

Yet for all the gloom and dread, the fiscal cliff embodies a teachable moment. At the risk of mixing metaphors, we should think of the fiscal cliff as the Ghost of the Fiscal Future. It is a bleak lesson in what awaits us if we don’t get serious about changing course.

First, some background. Over the last four decades, Federal Government spending as a share of GDP has remained relatively constant at about 21 percent. This spending was financed with taxes that consumed about 18 percent of GDP and the government borrowed to make up the difference.

After a decade of government spending increases and anemic economic growth, federal spending is now about 24 percent of GDP (a post WWII high, exceeded only by last year’s number) and revenues are about 15 percent of GDP (the revenue decline can be attributed to both the Bush tax cuts and to the recession).

But the really telling numbers are yet to come.

The non-partisan Congressional Budget Office now projects that, absent policy change, when my two-year-old daughter reaches my age (32), revenue will be just a bit above its historical average at 19 percent of GDP while spending will be nearly twice its historical average at 39 percent of GDP. This is what economists mean when they say we have a spending problem and not a revenue problem: spending increases, not revenue decreases, account for the entirety of the projected growth in deficits and debt over the coming years.

Why is this so frightful? The Ghost of the Fiscal Future gives us 3 reasons:

1) As spending outstrips revenue, each year the government will have to borrow more and more to pay its bills. We have to pay interest on what we borrow and these interest payments, in turn, add to future government spending. So before my daughter hits college, the federal government will be spending more on interest payments than on Social Security.

2) When the government borrows to finance its spending, it will be competing with my daughter when she borrows to finance her first home or to start her own business. This means that she and other private borrowers will face higher interest rates, crowding-out private sector investment and depressing economic growth. This could affect my daughter’s wages, her consumption, and her standard of living. In a vicious cycle, it could also depress government revenue and place greater demands on the government safety net, exacerbating the underlying debt problem.

This is not just theory. Economists Carmen Reinhart and Kenneth Rogoff have examined 200-years’ worth of data from over 40 countries. They found that those nations with gross debt in excess of 90 percent of GDP tend to grow about 1 percentage point slower than otherwise (the U.S. gross debt-to-GDP ratio has been in excess of 90 percent since 2010)

If, starting in 1975, the U.S. had grown 1 percentage point slower than it actually did, the nation’s economy would be about 30 percent smaller than it actually is today. By comparison, the Federal Reserve estimates that the Great Recession has only shrunk the economy by about 6 percent relative to its potential size.

3) Things get worse. The CBO no longer projects out beyond 2042, the year my daughter turns 32. In other words, the CBO recognizes that the whole economic system becomes increasingly unsustainable beyond that point and that it is ludicrous to think that it can go on.

What’s more, if Congress waits until then to make the necessary changes, it will have to enact tax increases or spending cuts larger than anything we have ever undertaken in our nation’s history. As Vero explains:

By refusing to reform Social Security, lawmakers are guaranteeing automatic benefit cuts of about 20-something percent for everyone on the program in 2035 (the Social Security trust fund will be exhausted in 2035, the combined retirement and disability trust funds will run dry in 2033, and both will continue to deteriorate).

In other words, if we fail to reform, the fiscal future will make January’s fiscal cliff look like a fiscal step. I’ve never understood why some people think they are doing future retirees a favor in pretending that entitlements do not need significant reform.

You might think that we could tax our way out of this mess. But taxes, like debt, are also bad for economic growth.

But it is not too late. Like Scrooge, we can take ownership of the time before us. We can make big adjustments now so that we don’t have to make bigger adjustments in a few years. There is still time to adopt meaningful entitlement reform, to tell people my age to adjust our expectations and to plan on working a little longer, to incorporate market incentives into our health care system so that Medicare and Medicaid don’t swallow up more and more of the budget.

Some characterize these moves as stingy. In reality, these types of reforms would actually make our commitments more sustainable. And the longer we wait to make these inevitable changes, the more dramatic and painful they will have to be.

For all the gloom and dread, the Ghost of Christmas Yet to Come was Scrooge’s savior. In revealing the consequences of his actions—and, importantly, his inactions—the Ghost inspired the old man to take ownership of the “Time before him” and to change his ways.

Let us hope that Congress is so enlightened by the Ghost of the Fiscal Cliff.

  • http://www.facebook.com/burdinekl Kevin Burdine

    This article shows clarity in thinking which is so often void in Washington today. In a recent paper (MPPA degree), I described the fiscal cliff as the bumpy warning strip on the side of the road, warning that if you dont change course you are about to hit the ditch. I believe the coming debt crisis will be the one wreck we cant walk away from. By all standards, correcting our debt woes will be a long term process. Tax increases are likely to show a near immediate bump in revenue followed by a slump due to lack of growth and investment. Also, any practical range of tax rates results in revenue near 18% of GDP. The logical person must then conclude that the solution to our debt problem is to allow GDP to increase long term (not artificially propping up the economy in a boom and bust fashion of “stimulus.” The way to do that is to keep all taxes as low as possible while still maintaining roughly 18% revenue and reduce regulatory burdens. The increase in “wealth of nations” only comes from production (not printing or borrowing). Leaving more investment capital in the hands of consumers who know best how they should consume, and producers who have proven they know how to produce (and thus create jobs and further opportunities) should be our economic policy. The author is correct; we cannot tax our way out of a spending problem.

  • http://www.facebook.com/burdinekl Kevin Burdine

    This brings up a relative question… What is the optimal tax rate of any tax? No one can really put a number on i, but given that approximately 18% of GDP is the revenue ceiling, obviously, we can initially assume that any tax rate above a lower rate which yields 18% of GDP is excessive. Next, we must decide what is meant by optimal. Is the highest federal revenue optimal? If you contibute to a homeowners association, for example, I am certain you do not wish for the association’s revenue to as much as possible. Rather you wish it’s revenue to be just enough to cover necessary expenditures, because more means less in your pocket. So, why do politicians and even some economists look at tax rates any differently? Deciding what constitutes necessary spending deserves a separate thread (though I recommend returning to the Constitution as our guide). As a general theory i propose tax rates should be no more or less than a rate at which the benefits and opportunity costs are equal. Not that such an equilibrium is easy to determine… we havent even begun seriously considering the opportunity costs of increased tax rates yet and are still trying to maximize federal tax revenue.

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