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Spending, Not Tax Cuts, Is the Real Driver of the Fiscal Mess

Friday, April 16, 2010

It’s hard to argue that our looming budget problems derive from ‘too little taxes’ when by any historical standard taxes will rise to record levels even before the fiscal gap is addressed.

To balance the budget over the next 25 years, the Congressional Budget Office (CBO) says, would require an immediate and permanent increase in tax revenues, or reduction in spending outlays, equal to 5.4 percent of gross domestic product (GDP). To put that in context, that equals a 29 percent increase in all federal tax revenues relative to historical levels. That means not just income taxes, but payroll taxes, corporate taxes, capital gains and dividends taxes, and other sources of revenue. And it doesn’t mean just a 29 percent increase in tax rates, but—to account for the disincentive effects of higher taxes—even higher rates so that total revenue rises by 29 percent. That’s a pretty big deal.

And when you go out over longer periods—50 years and 75 years—the CBO projects an even larger “fiscal gap” of 6.9 percent and 8.1 percent of GDP, respectively. Pretty clearly, the federal budget sorely needs, and one way or another will face, a very significant fiscal consolidation.

When you go out over longer periods—50 years and 75 years—the CBO projects an even larger ‘fiscal gap’ of 6.9 percent and 8.1 percent of GDP, respectively.

To solve that budgetary shortfall it helps to know what’s driving it in the first place. The causes of our looming budget deficits have been the subject of some disagreement. While everyone recognizes the rising costs of Social Security, Medicare, and Medicaid, some on the left have blamed much of the looming shortfall on tax cuts passed during the Bush administration. President Obama himself has said that “extending the Bush tax cuts will cost three times as much as what is needed to fix Social Security's solvency over the next 75 years.”

Yet a CBO projection on the future fiscal gap shows that spending, not tax cuts, is the real driver. The chart below compares average federal revenues and outlays over the next 25 years with those over the past 25 years. (The time frame chosen matters little; the qualitative results are the same regardless of whether we look at 25 years, 50 years, or some other period.)

Biggs 4.15.2010

From 1984 through 2009, federal tax revenues averaged 18.3 percent of GDP while spending averaged 20.7 percent of GDP, for a typical annual budget deficit of 2.4 percent of GDP. (Nobody said we were angels in the past, either.)

Over the next 25 years, however, the CBO projects that tax revenues will increase to 19.9 percent of GDP. That’s equivalent to raising all federal taxes by about 9 percent. And this is under CBO’s “alternative fiscal scenario,” which assumes that the Bush tax cuts are extended and the Alternative Minimum Tax is indexed to reduce its intrusion on the middle class. Without these assumptions, tax revenues would rise even higher.

The real driver of the fiscal gap is rising federal spending, which will increase from an average of 20.7 percent of GDP over the last 25 years to 25.3 percent of GDP over the next quarter-century.

The real driver of the fiscal gap is rising federal spending, which will increase from an average of 20.7 percent of GDP over the last 25 years to 25.3 percent of GDP over the next quarter-century. That’s a 22 percent increase, for anyone who’s counting. Most of this spending increase will be driven by Social Security, Medicare, and Medicaid as the Baby Boomers retire, the population ages, and healthcare spending rises.

Now, just because spending is driving the fiscal gap doesn’t logically mean the imbalance has to be solved by cutting spending. But it’s hard to argue that our looming budget problems derive from “too little taxes” when by any historical standard taxes will rise to record levels even before the fiscal gap is addressed. Moreover, to the degree that you care about the effects of higher tax rates on the economy, and the effects of a larger government share of spending on individuals’ abilities to lead their own lives as they wish, cutting spending might be the place to start.

Andrew G. Biggs is a resident scholar at the American Enterprise Institute. From 2008 to 2009 he served as principal deputy commissioner of the Social Security Administration and as secretary of the Social Security Board of Trustees.

FURTHER READING: Biggs explained “Why Immigration Can’t Save Social Security,” “Obama Budget Rigs Healthcare Numbers,” and “How Different Is Grandma’s Spending?” He decried “Shooting the Messenger: CBO in the Crosshairs” and warned of the “Entitlement Apocalypse.” His scholarly work includes a recent dive into “The Market Value of Public-Sector Pension Deficits.”

Image by Darren Wamboldt/Bergman Group.

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