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Why is it so hard to close the budget gap

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Ed Dolan
Ed Dolan

Closing the US budget deficit and reducing debt will require a combination of approaches as no single solution can close the large gap. The documents discusses various options for both cutting spending and raising revenues, but notes that each faces political challenges as interest groups support existing policies. Spending cuts could target waste but make only a small dent, and entitlement reform is difficult due to existing benefits. Revenue increases through tax rate hikes or limiting deductions/credits could help but would also face opposition. An overall solution will likely require multiple, simultaneous actions across spending and taxes.

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Free Slides from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Budget Basics (4): Why is it So Hard to Close the Budget Gap? Post prepared June 30, 2010 Terms of Use: These slides are made available under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics , from BVT Publishers.
Closing the Gap: Saying It vs. Doing It Previous items in this Budget Basics series show that the US budget deficit and debt are unsustainable in the long term It is easy to say how to close the budget gap—cut spending or raise taxes. So why is doing it so hard? What we need to know: How big is the budget gap? Where does spending go? Where does revenue come from? Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
How Big is the Budget Gap? The size of the budget gap depends on several factors . . . Delay means a bigger gap to close later Tightening policy too soon could slow recovery and make the gap worse What assumptions to make about growth, demographics, and interest rates? How close to a balanced budget do we need to get to ensure sustainability? As a working estimate of the budget gap, we will use the cyclically adjusted primary deficit, about 7% of GDP in 2009. Some other estimates are larger or smaller. Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The Congressional Budget Office has estimated the budget gap at 8 percent of GDP as of 2009, growing to 15 percent if no effort is made to close it before 2040
An Easy Promise: Cut Wasteful Programs Politicians love to make the easy promise of closing the gap by cutting programs that we don’t need and that do not work Where can we look for such programs, and how big might they be? Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The Blue Dog Coalition is a group of centrist Democrats who view themselves as a voice of fiscal responsibility. Their proposals include: Cut programs that don’t work Eliminate duplication and inefficiency Review and terminate unnecessary federal programs http://www.house.gov/melancon/BlueDogs/Press%20Releases/2010%20-%20Blue%20Dog%20Blueprint%20for%20Fiscal%20Reform.pdf
Nondefense discretionary spending The first place many people look for waste is nondefense discretionary spending , which includes all programs, except defense, that are subject to annual Congressional appropriations However, this part of the budget is surprisingly small—just 19% of all federal spending, or 4.7% of GDP, in 2010 Even cutting every bit of waste here would only make a start on closing the gap Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Discretionary Expenditure by Agency Defense spending is another 4.8% of GDP. There is waste in defense spending, too If essential functions like federal courts, the treasury, and embassies are protected, defense spending would have to be cut by more than half, while eliminating most other departments entirely (education, labor, commerce, NASA, etc.), to close a 7% gap solely by cutting discretionary spending Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Entitlements and the Budget Gap Long-run projections show that growth of entitlement spending, especially Medicare and Medicaid, is more important than discretionary spending in explaining the U.S. federal budget gap Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Excess Cost Growth of Medicare and Medicaid Some of the increased entitlement spending is due to an aging population. That part could be reduced only if Congress were willing to cut benefits already promised to people who are retired or approaching retirement. Another way to cut the budget gap would be to slow the excess cost growth of medical spending, that is, bring the rate of increase of medical costs down to or below the average rate of price increase for the economy as a whole Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Cutting Health Care Costs: The Good News The good news is that international comparisons show it is possible to deliver quality health care at a lower cost than in the United States The ranking of health care systems shown here includes measurements of quality of care, access to care, efficiency, equity, and quality of life In a recent study by The Commonwealth Fund, the US ranked lower than six other countries with less costly health care systems. Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The complete Commonwealth Fund report is available at http://www.commonwealthfund.org/Content/Publications/Fund-Reports/2007/May/Mirror--Mirror-on-the-Wall--An-International-Update-on-the-Comparative-Performance-of-American-Healt.aspx
Cutting Health Care Costs: The Bad News The bad news: Cutting health care costs is difficult. Many cost-cutting measures were proposed, but rejected, during the recent US health-care debate Reform medical malpractice Remove tax subsidies to employer-provided health insurance Introduce single-payer system or a public insurance option Phase out fee-for-service payment system and other incentives for overtreatment Pay only for treatments that are proven to be cost effective Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Source: Pdclipart.org
Closing the Gap by Raising Tax Rates Another way to try to close the budget gap would be to raise tax rates within the current tax system These estimates by the Urban Institute-Brookings Tax Policy Center show how much income tax rates would have to rise to cut the deficit to 2% of GDP If only the top two rates were raised (roughly, households over $250,000 income), rates would go extremely high The estimates are static , that is, they do not take into account any tendency for higher tax rates to cause increased efforts at tax avoidance Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The complete Tax Policy Center study is available at http://www.taxpolicycenter.org/UploadedPDF/412018_seeking_revenue.pdf
Closing the Gap by Closing Loopholes and Preferences Tax revenue could also be increased by closing loopholes and preferences, more generally known as tax expenditures If all nonbusiness tax expenditures were eliminated, income tax revenue would be higher by about 5% of GDP—enough to close a large part of the budget gap However, many tax expenditures serve public policy purposes, so eliminating them would have significant opportunity costs Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The complete Tax Policy Center study is available at http://www.taxpolicycenter.org/UploadedPDF/1001234_tax_expenditures.pdf
Closing the Gap With a Value Added Tax Additional revenue could be raised with a value added tax (VAT) , a type of tax on sales of goods and services used by most advanced countries Based on a study by The Tax Center, a 15% VAT could raise revenue of 3% to 6% of GDP, depending on assumptions about interaction with other taxes and whether food, housing, and medical care were excluded Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The Tax Policy Center study on VAT is available at http://www.taxpolicycenter.org/UploadedPDF/412062_VAT.pdf
The Bottom Line No single spending cut or revenue increase will be enough to to close the budget gap and ensure long-run fiscal sustainability A combination of approaches will be needed Eliminate waste in discretionary spending Control growth of entitlement spending, especially Medicare Raise tax rates Reduce tax loopholes and preferences Introduce new taxes like a VAT Closing the gap will be hard. Every tax and spending line in the budget has political supporters—if not, it would not be there in the first place Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ “ The choice facing policymakers is not whether to address rising deficits and debt but when and how to do so.” —CBO

More Related Content

Why is it so hard to close the budget gap

  • 1. Free Slides from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Budget Basics (4): Why is it So Hard to Close the Budget Gap? Post prepared June 30, 2010 Terms of Use: These slides are made available under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics , from BVT Publishers.
  • 2. Closing the Gap: Saying It vs. Doing It Previous items in this Budget Basics series show that the US budget deficit and debt are unsustainable in the long term It is easy to say how to close the budget gap—cut spending or raise taxes. So why is doing it so hard? What we need to know: How big is the budget gap? Where does spending go? Where does revenue come from? Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 3. How Big is the Budget Gap? The size of the budget gap depends on several factors . . . Delay means a bigger gap to close later Tightening policy too soon could slow recovery and make the gap worse What assumptions to make about growth, demographics, and interest rates? How close to a balanced budget do we need to get to ensure sustainability? As a working estimate of the budget gap, we will use the cyclically adjusted primary deficit, about 7% of GDP in 2009. Some other estimates are larger or smaller. Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The Congressional Budget Office has estimated the budget gap at 8 percent of GDP as of 2009, growing to 15 percent if no effort is made to close it before 2040
  • 4. An Easy Promise: Cut Wasteful Programs Politicians love to make the easy promise of closing the gap by cutting programs that we don’t need and that do not work Where can we look for such programs, and how big might they be? Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The Blue Dog Coalition is a group of centrist Democrats who view themselves as a voice of fiscal responsibility. Their proposals include: Cut programs that don’t work Eliminate duplication and inefficiency Review and terminate unnecessary federal programs http://www.house.gov/melancon/BlueDogs/Press%20Releases/2010%20-%20Blue%20Dog%20Blueprint%20for%20Fiscal%20Reform.pdf
  • 5. Nondefense discretionary spending The first place many people look for waste is nondefense discretionary spending , which includes all programs, except defense, that are subject to annual Congressional appropriations However, this part of the budget is surprisingly small—just 19% of all federal spending, or 4.7% of GDP, in 2010 Even cutting every bit of waste here would only make a start on closing the gap Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 6. Discretionary Expenditure by Agency Defense spending is another 4.8% of GDP. There is waste in defense spending, too If essential functions like federal courts, the treasury, and embassies are protected, defense spending would have to be cut by more than half, while eliminating most other departments entirely (education, labor, commerce, NASA, etc.), to close a 7% gap solely by cutting discretionary spending Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 7. Entitlements and the Budget Gap Long-run projections show that growth of entitlement spending, especially Medicare and Medicaid, is more important than discretionary spending in explaining the U.S. federal budget gap Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 8. Excess Cost Growth of Medicare and Medicaid Some of the increased entitlement spending is due to an aging population. That part could be reduced only if Congress were willing to cut benefits already promised to people who are retired or approaching retirement. Another way to cut the budget gap would be to slow the excess cost growth of medical spending, that is, bring the rate of increase of medical costs down to or below the average rate of price increase for the economy as a whole Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 9. Cutting Health Care Costs: The Good News The good news is that international comparisons show it is possible to deliver quality health care at a lower cost than in the United States The ranking of health care systems shown here includes measurements of quality of care, access to care, efficiency, equity, and quality of life In a recent study by The Commonwealth Fund, the US ranked lower than six other countries with less costly health care systems. Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The complete Commonwealth Fund report is available at http://www.commonwealthfund.org/Content/Publications/Fund-Reports/2007/May/Mirror--Mirror-on-the-Wall--An-International-Update-on-the-Comparative-Performance-of-American-Healt.aspx
  • 10. Cutting Health Care Costs: The Bad News The bad news: Cutting health care costs is difficult. Many cost-cutting measures were proposed, but rejected, during the recent US health-care debate Reform medical malpractice Remove tax subsidies to employer-provided health insurance Introduce single-payer system or a public insurance option Phase out fee-for-service payment system and other incentives for overtreatment Pay only for treatments that are proven to be cost effective Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Source: Pdclipart.org
  • 11. Closing the Gap by Raising Tax Rates Another way to try to close the budget gap would be to raise tax rates within the current tax system These estimates by the Urban Institute-Brookings Tax Policy Center show how much income tax rates would have to rise to cut the deficit to 2% of GDP If only the top two rates were raised (roughly, households over $250,000 income), rates would go extremely high The estimates are static , that is, they do not take into account any tendency for higher tax rates to cause increased efforts at tax avoidance Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The complete Tax Policy Center study is available at http://www.taxpolicycenter.org/UploadedPDF/412018_seeking_revenue.pdf
  • 12. Closing the Gap by Closing Loopholes and Preferences Tax revenue could also be increased by closing loopholes and preferences, more generally known as tax expenditures If all nonbusiness tax expenditures were eliminated, income tax revenue would be higher by about 5% of GDP—enough to close a large part of the budget gap However, many tax expenditures serve public policy purposes, so eliminating them would have significant opportunity costs Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The complete Tax Policy Center study is available at http://www.taxpolicycenter.org/UploadedPDF/1001234_tax_expenditures.pdf
  • 13. Closing the Gap With a Value Added Tax Additional revenue could be raised with a value added tax (VAT) , a type of tax on sales of goods and services used by most advanced countries Based on a study by The Tax Center, a 15% VAT could raise revenue of 3% to 6% of GDP, depending on assumptions about interaction with other taxes and whether food, housing, and medical care were excluded Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The Tax Policy Center study on VAT is available at http://www.taxpolicycenter.org/UploadedPDF/412062_VAT.pdf
  • 14. The Bottom Line No single spending cut or revenue increase will be enough to to close the budget gap and ensure long-run fiscal sustainability A combination of approaches will be needed Eliminate waste in discretionary spending Control growth of entitlement spending, especially Medicare Raise tax rates Reduce tax loopholes and preferences Introduce new taxes like a VAT Closing the gap will be hard. Every tax and spending line in the budget has political supporters—if not, it would not be there in the first place Post P100630 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ “ The choice facing policymakers is not whether to address rising deficits and debt but when and how to do so.” —CBO