A Reader’s Guide to the 2012 Budget

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The Debt Challenge

The President’s National Commission on Fiscal Responsibility called this our national “Moment of Truth” arguing:

Americans have become perhaps numbed to the fiscal reality by trillion-dollar spending bills, trillion dollar deficits, and trillion dollar debt increases. But the harsh reality is that Moody's explicitly warned in a report last month that the U.S. must reassess the future course of its debt if it hopes to keep its triple-A rating; a failure to do so would have dramatic consequences.

Sustained high deficits and accumulating debt threaten U.S. prosperity and freedom. In a more benign scenario, continued high deficits will lead to elevated interest rates; underinvestment in innovation, skills, technologies, and capital stock; and stagnation of wages, incomes and job growth. More threateningly, any international financial volatility could induce a U.S. financial crisis exceeding the 2008 meltdown.

At the same time, our debts increasingly accumulate in the hands of sovereign lenders who do not share American values. Combined with a struggling economy, the result will be a diminished ability to protect American interests around the globe and a more tenuous grasp on freedom.

This “moment of truth” requires leadership and the President’s forthcoming budget proposals for fiscal 2012 is the moment for that leadership. In this short paper, we provide a guide to evaluating the President’s success.

The Starting Point

The President’s 2011 budget is the best summary of the existing Administration strategy; that is, the starting point from which any new initiatives to address the debt threat will be introduced. We summarize this outlook in the following chart:

According to the Congressional Budget Office’s (CBO’s) analysis of the President’s Budgetary Proposals for Fiscal Year 2011, the deficit will never fall below $700 billion. Ten years from now, in 2020, the deficit will be 5.6 percent of GDP, roughly $1.3 trillion, of which over $900 billion will be devoted to servicing debt on previous borrowing.

The outlook for red ink is not the result of a shortfall of revenues. The CBO projects that over the next decade the economy will fully recover and revenues in 2020 will be 19.6 percent of GDP – over $300 billion more than the historic norm of 18 percent (the blue line in Chart 1). Instead, the problem is spending. Despite the presumption that the costly overseas military activities are assumed to cease and that the crisis-driven bailouts, takeovers, and stimulus are history, federal outlays in 2020 are expected to be 25.2 percent of GDP – about $1.2 trillion higher than the 20 percent standard (see red line in Chart 1).

More troubling is that last year’s policy plan was a roadmap to financial crisis. The credit rating agency Moody’s looks at the ratio of federal debt to revenues, and the fraction of revenues dedicated to paying interest as key metrics for retaining a triple-A rating. Specifically, the large, creditworthy sovereign borrowers are expected to devote less than 10 percent of their revenues to paying interest. Moody’s grants the U.S. extra wiggle room.¹   The upshot: no U.S. downgrade until interest equals 14 percent of revenues.

This is small comfort as Chart 1 indicates that in 2015 the federal government would cross the threshold and reach 14.5 percent, and then continue to rise to nearly 21 percent in 2020. In short, the President’s FY2011 Budget is a plan for downgrade.

Finally, as shown at the bottom of the chart, the explosion of spending drives the U.S. debt (relative to GDP) to over 90 percent by 2020. As documented in Reinhart and Rogoff [2009], this is the level of debt burden historically associated with sovereign debt crises and restricted access to world capital markets.²   So, while the Administration might gamble that foreign countries would continue to purchase U.S. treasuries despite near-term downgrades, moving ahead these pressures would disrupt the markets' confidence in the value of U.S. securities, eventually dragging down the entire U.S. economy.

Path 1: Leadership and Real Solutions

In light of the implications of last year’s budget plan for the federal balance sheet and U.S. economy, it is imperative that this year’s Budget depict a new direction. Indeed, ostensibly in recognition of the importance of changing course the President created the National Commission on Fiscal Responsibility and Reform (sometimes referred to as the Fiscal Commission).

Thus, one way to evaluate the leadership provided by the President’s 2012 Budget is the degree to which it reflects the guidance provided by his Commission. The report of the Commission effectively makes 4 key points:

• The debt is a big problem that will require aggressive action to fix it.
• The problem is spending; every aspect of spending must be reined in.
• Health care – including the new reform law – must be on the table. For example, the Fiscal Commission proposed repealing a component called the CLASS Act.
• Additional revenues require tax reform – any plan to simply jack up rates in the current system is a non-starter.

The spending problem is dominated by spending on entitlements – Social Security, Medicare, Medicaid, and the new health insurance entitlements. Spending for these programs in 2011 will equal 10.4 percent of GDP, growing to 12.5 percent in 2021. Medicare and Medicaid spending increases are largely due to rising health care costs, exacerbated by the Patient Protection and Affordable Care Act (PPACA). A serious approach to ensuring future prosperity will place the health entitlements at the center of attention.

With respect to Social Security, the Fiscal Commission included a thoughtful plan to address the program’s insolvency which included gradually increasing the retirement age, slowing the growth in future benefits particularly for high income earners, and enhancing benefits for low-wage workers, the very old and the long-time disabled. Social Security reform is widely perceived to be analytically simpler and suffering only from a lack of Presidential leadership. If the President is to rise to the obligation of addressing the top threat to the Nation, Social Security reform could easily be a centerpiece of the budget presentation.

Cutting spending will not solve everything, yet if we continually resort to increasing tax rates for the half of Americans that do pay income taxes, economic growth will stall. Should revenue be increased, it needs to be bundled into pro-growth tax reform that not only addresses the fiscal needs of the nation but also takes into account the fragile business environment we face; America needs employers to create jobs. The right reform would recognize the importance of low marginal tax rates, the need to support the upward mobility of Americans, and the danger of inefficient tax-subsidies to favored forms of consumption. On the corporate side it would move to a territorial system, which would attract more businesses and make us competitive with the rest of the world.

In a comprehensive effort, serious entitlement spending reform would be accompanied by discretionary spending proposals that roll back the double-digit increases since 2008 and enforce those spending reductions with multi-year spending caps and tough sequesters when caps are breached. Budget Chairman Paul Ryan has made a strong step in this direction by rolling back the 302(a) discretionary allocations to 2008 levels for the remainder of FY11, but more work needs to be done.

The final test of real leadership will be to discard the tired politics around the 2001 and 2003 tax laws and look forward to raising revenue using a radically reformed tax code that is pro-growth and supports international competitiveness. Again, as an example, the Fiscal Commission developed three options for tax reform, all of which lower the corporate rate and move to a territorial system. Each would simplify the tax system, eliminate tax expenditures and lower rates.

Indeed, the simplest test is that the 2012 Budget should look nothing like those of the recent past, characterized by rising debt and explosive spending. It should comprehensively address the real problem of spending and reform broken programs.

Path 2: Politics and Gimmicks

While real leadership is desirable, one cannot rule out a budget strategy dominated by short-term political considerations at the expense of the next generations. Indeed, there is troubling evidence that the President intends to pursue cosmetics over course changes.

In his State of the Union address, the President called for a 5-year freeze on discretionary, non-security spending at 2010 levels. (The FY 2011 Budget contained a 3-year freeze.) Unfortunately, discretionary spending decisions are made annually. In the absence of multi-year caps and enforcement mechanisms, any “freeze” past one year is meaningless. The White House has steadfastly opposed any such budget disciplines. In their absence adding two more years of paper freezes is empty.

Worse, as the Fiscal Commission’s lessons indicate, comprehensive spending cuts are needed. A “freeze” that touches a mere 12 percent of the budget, and locks the federal outlays to one of the highest spending years in our history flunks the test of leadership.

More significantly, the President made only quick mention of Social Security in his State of the Union – focusing on what not to do instead of proposing solutions – and skipped the rest of entitlement spending. It was not an auspicious start to any reform effort – identifying problems but tying the hands of any solution.

More recently Office of Management and Budget (OMB) Director Jack Lew continued the signals with a do-little drumbeat on the opinion pages of the New York Times. He argued that the “tough cuts” that the President plans to enact were exemplified by a $350 million cut to Community Service Block Grants, a $125 million cut from the Great Lakes Restoration Initiative and a $300 million cut from Community Development Block Grants. Beating its collective chest over less than a $1 billion in cuts just so it can increase spending by a comparable amount on other new “investments” with no net change in the deficit – while the CBO projects a deficit of $1.5 trillion – leaves the Administration looking silly and impotent in the face of crisis. In addition, these cuts have been offered up by several Presidents before, with the full knowledge that the programs are favorites of many Members in Congress and will likely be held “safe” when the rubber hits the road. We hope these cuts are being suggested in earnest.

Worse, a check of the 2008 appropriations levels indicates that proposed “cuts” still leave the Great Lakes Restoration Initiative and the Community Development Block Grants better funded than when the President took office. Pretending a spending expansion constitutes a cut does not pass a test of leadership.

What, then, should Americans expect to see if the President continues down the path of budget gimmicks and deferred decisions? On the discretionary side, the 5-year “freeze” on non-security spending will be front and center – much like the hole in a donut. In addition, Defense Secretary Gates has outlined Pentagon cuts to the tune of $78 billion over five years. These cuts unsurprisingly do not touch the big drivers in military personnel costs – compensation, health care and retirement benefits. Despite calls for fiscal discipline, Secretary Gates has also requested that savings from trimming personnel be shifted to more “effective” uses. So the bottom line remains: will Secretary Gates’ efforts to trim result in a net spending reduction?

In the absence of real meat to his discretionary program, the President is likely to build upon his call for efficiencies in government and reinvention of its services. Of course, if history is any guide the easiest way for a President to address such a goal is for the Budget to hand off the problem to a Commission. President Obama did that last year the with the Fiscal Commission, and is likely to adopt few, if any, of its recommendations. He will likely again seek cosmetic cover instead of real changes by recommending a Grace-style Commission to reorganize government.

As discussed above, do not expect any real entitlement spending reform. Instead, the Budget will perpetuate the fiction that the PPACA will actually bring down the growth of national health care spending and that it will be possible to impose hundreds of billions of dollars of provider cuts in Medicare. As the analyses of the Administrations own Actuary and other non-partisan analysts have made clear, these assumptions are flatly wrong at worst – and fiscally risky at best.

Revenue-neutral corporate tax reform is a promise of the Administration’s and it will certainly be in the budget. Ignoring a fundamental lesson of the Fiscal Commission – tax reform is a necessary step to raise more revenue – the budget will also raise taxes on high-income individuals and small businesses after 2012 by permitting the 2001 and 2003 tax laws to sunset for those groups. More of the same, delayed two years.

Still the Budget will have a problem, as even the gimmicky freeze does little to change the dangerous spending levels that exist past 2015 in Chart 1. Here the most likely approach will be to assert that the PPACA “bends the cost curve” and display a marked improvement in the outlook past 2021. Adding presentations for a second 10 years could be used to ameliorate the perceptions created by the dismal 10 year budget window. There exists no evidence to support such a display, so any so-called budgetary improvement on these grounds would be simply an act of politics.

Conclusion

This is a national moment of truth that calls for genuine leadership. One hopes that the 2012 Budget contains the comprehensive approach to spending reforms that would arrest the dangerous accumulation of debt and meet this call. However, there exists the real chance that instead it will be a document that codifies the pursuit of the short-term, the political and the cosmetic at the expense of the opportunity to improve prosperity and freedom for the next generations.

Douglas Holtz-Eakin is President of the American Action Forum. Jennifer Pollom is Chief of Staff of e21. Cameron Smith is Special Assistant to the President at the American Action Forum. This paper is a joint publication of e21 and AAF.

Endnotes

1. Moody’s determines debt reversibility from a ratio of interest payments to revenue on a base of 10 percent. Wider margins are awarded to various governments to indicate the additional “benefit of the doubt” Moody’s awards. The US finds itself on the upper end at 14 percent. The ratios are “illustrative and are not hard triggers for rating decisions.” See: Aaa Sovereign Monitor Quarterly Monitor No. 3. Moody’s Investor Service. March 2010.

2. Reinhart and Rogoff use a broader metric of debt – gross federal debt instead of debt in the hands of the public. Using the latter is conceptually better suited to evaluating the probability of a financial crisis, but using the former indicates the US has already crossed the threshold. Carmen Reinhart and Kenneth Rogoff, This Time Is Different: Eight Centuries of Financial Folly, 2009.