A Defense of Discretionary Spending Cuts and the Perilous Inevitability of a VAT

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Discretionary outlays are not inconsequential. Despite what many are saying, a closer look at the long-run budget picture actually bolsters the case of those who seek large and immediate cuts to spending. To gain appreciation for the fiscal predicament of the United States government, consider that the ambitious Roadmap for America’s Future, authored by House Budget Committee Chairman Paul Ryan, would reduce federal health care spending by nearly 40% by 2040 relative to current promises but still result in the public debt reaching 100% of GDP. The Roadmap produces budget surpluses of sufficient magnitude in the subsequent 40 years to completely retire the federal debt. But the transition to a “funded” system would result in annual deficits averaging about 4% of GDP, which would be the largest sustained deficits in American history. This is not a failing of the Roadmap, but rather a reflection of the depths of the fiscal crisis. When the most ambitious, well-devised long-run budget plan in Washington would still allow the public debt to reach Greek-like levels it’s clear that the nation is on a fiscal trajectory that is not just unsustainable, but also potentially destined for a crisis resolution.

As e21 contributor Chuck Blahous points out in a Policy Review article, the accounting method for the inherited payment obligations creates a bias against long-run reforms. That is certainly the case here, as Ryan’s Roadmap would produce large surpluses, on average, over the course of the next 80 years that would be sufficient to retire all of the current debt in addition to the incremental debt incurred over the next thirty years. However, the ability to run large persistent deficits in the interim may not be so easy. The U.S. continues to borrow hundreds of billions of dollars from abroad each year and the pace of this borrowing is unlikely to slow down as the baby boom generation transitions from savers to retirees. As the current fiscal problems illustrate, economic downturns also lead to unforeseen collapses in tax receipts. An expected deficit of 4.5% of GDP could easily turn into a deficit of more than 10% of GDP in the event of a crisis. Thus, the fact that the proposal would eliminate the debt in the fullness of time is no guarantee that the thirty years of debt accumulation would go smoothly, with foreign creditors continuing to provide endless financing at low interest rates.

An interesting, but unfortunate, side effect of the focus on entitlement spending has been a de-emphasis of the need to restrain discretionary outlays. On the discretionary spending front, the Roadmap calls for holding non-defense discretionary outlays at 2009 levels until 2020, at which time they would grow at the rate of inflation plus 0.7%, which is roughly the anticipated population growth rate. Defense spending would be unaffected by these changes. This means that relative to the most recent Congressional Budget Office (CBO) baseline, Congress has to cut spending by $914 billion simply to conform to the Roadmap’s spending limits. Therefore, Congress must come up with nearly $1 trillion in cuts over the next 10 years to maintain fiscal order even before accounting for any changes to entitlement spending.

These fiscal facts are important for those who argue that the zeal of some incoming Members of Congress is misplaced. A recent article in The Hill argues “cutting discretionary but not entitlement spending can lead to a constituent backlash without the political win of real deficit reduction.” But a return to fiscal year 2008 deficit levels would be real deficit reduction. Discussions of deficit reduction can often become infected by a time horizon bias. Entitlement programs like Social Security and Medicare are addressed over 75-year windows, pursuant to their annual Trustees’ reports. Judged over this time horizon, the savings from seemingly small annual discretionary spending cuts are actually quite large. For example, some in the House propose reducing nondefense discretionary spending to fiscal year 2008 levels, which would be $509 billion. This would be a $154 billion reduction relative to CBO’s 2011 baseline. However, if future spending were to grow at an annual rate of 2.7% (CBO’s estimate of inflation plus population growth) from the 2011 enacted level, the present value of the difference in spending would be $7.5 trillion. The Roadmap would save $8.6 trillion, in present value terms, relative to a 2.7% annual growth rate from current spending levels.¹

These figures should make two points especially clear: (1) delaying fiscal tightening and large spending reductions is not a good idea; and (2) while entitlements are certainly the most significant part of the story, they are not the only part. Large cuts to current discretionary spending are essential to maintaining long-run fiscal balance. Far from failing to provide “the political win of real deficit reduction,” large spending cuts today may end up being a big part of what prevents the U.S. from joining other developed nations in instituting a value-added tax (VAT). Given the experience in Europe, a VAT would be applied to about 41% of GDP. This means a 2% VAT could generate about $300 billion in 2011. Dialing up the VAT to 5% would still be a low rate by international standards but could bring in $1.2 trillion by 2021. Given the conventional wisdom that scoffs at discretionary spending cuts as political theatre with no substance, it is no surprise that the panelists at a recent Senate Budget Committee hearing all agreed that a VAT was nearly inevitable as a mechanism to raise additional revenue at a low economic cost. The magnitude of the spending cuts favored by some in Congress is not a reflection of their overzealousness, but rather the magnitude of the problem.

Endnotes

1. A discount rate of 4.5% is used in the calculations.