A Fiscal Cliff

New Perspectives on the U.S. Federal Debt Crisis

John Merrifield, Barry Poulson, John Merrifield, Barry Poulson

• Publisher: Cato Institute
• Year: 2020
• eBook ISBN: 9781948647892
• Topic: Didattica
• Subtopic: Politiche educative

"' A Fiscal Cliff ' is precisely the right book for perilous fiscal times. Giants in economics and public policy offer a spirited defense of fiscal rules critically needed to protect our children and grandchildren from a bleak future."
-Richard K. Vedder, Distinguished Professor of Economics Emeritus, Ohio University /p>

The unsustainable, and still rapidly growing, U.S. federal government debt is a classic case of ''in denial." Indeed, we are no closer to a solution to the debt crisis than we were ten years ago when the Simpson-Bowles Commission issued a report with recommendations to address the nation's debt crisis. The bipartisan Commission fell short of the supermajority vote required to submit their recommendations to Congress. President Trump declared a debt crisis, but didn't act like it. Various commissions and think tanks have made numerous recommendations. In 2019, a Congressional Committee was appointed to recommend budget process reforms, but that Committee could not agree on any recommendations to submit to Congress.

While the dominant sentiment is that maybe if we ignore it, it will just go away, the debt crisis will not just vanish. A Fiscal Cliff: New Perspectives on the U.S. Debt Crisis is a timely addition to a critical policy discussion.

CHAPTER ONE
THE FEDERAL FISCAL CRISIS:
AN OVERVIEW

JOHN MERRIFIELD

Because its most noteworthy symptoms may arrive suddenly, the declared debt crisis—an outcome of policies widely described as “unsustainable”—has not gotten the attention a bona fide crisis deserves. Certainly, many publications have stated the growing scope of the debt problem, and some have proposed solutions, but the public, Congress, and President Trump are not paying much attention. Debt concerns were not a major issue in the 2016 campaign. President Trump did declare a crisis, and before that candidate Trump announced his support for federal mineral rights sales as part of the solution, but the follow-up has been nonexistent, or else a well-kept secret.

“Unsustainable” means that one or more of the following will eventually occur:

1. An actual default, meaning failure to make payments due (see Baker Spring’s Chapter 9 in this volume) that will cause a huge financial crisis and hastily arranged spending cuts and tax hikes;
2. Printing money to avoid default, which may cause significant inflation;
3. Drastic spending cuts to avoid default;
4. Tax hikes to avoid default; or
5. Some near-term combination of slower spending growth (perhaps rules-based), faster economic growth, and mineral asset sales.

In the abstract, most people favor the last option. But specifics, such as the challenges created by faster growth, managing rapidly increased access to mineral deposits, and naming the programs to be cut or grown more slowly, will increase the opposition. That may be enough to force one of the other options. This chapter will explore these options, and our dynamic simulation model will assess the scope of the challenge to avoid default, inflation, higher taxes, or huge, sudden spending cuts.¹

Many people favor large spending cuts. They see a financial crisis as one of few feasible routes to the significantly smaller federal government they want. However, even drastic discretionary spending cuts will not be enough. As the next section shows, even total elimination of the cabinet departments created since World War II (except Health and Human Services) would not come close to eliminating the average Congressional Budget Office (CBO)–projected budget deficit.

The purpose of this chapter is to describe the pathways to a debt-to-gross domestic product (GDP) ratio of less than 60 percent by 2040 and some consequences of a failure to reach that ratio. To the extent there is a rough consensus on a sustainable level of debt for a developed country, a ratio of total debt to GDP of around 60 percent is it. Note that we don’t accept the conventional wisdom that only the debt owed to the public matters; readers can learn more about this question in Chapter 15 by Marvin Phaup. The total U.S. debt-to-GDP ratio is already more than 100 percent, about 30 percentage points above debt-to-GDP counting only debt held by the public. Interest must be paid on 100 percent of the debt. That’s a key reason why the debt problem is likely much more than a burden on future generations. Because rising debt together with higher interest rates can crowd out funding for government transfers and services or force accelerated debt growth, the options a to e named earlier will impact nearly everyone now alive.

In the next (second) section, we describe the mounting consequences of kicking the can down the road. We can do that without an inordinate use of space because we have published estimates for reaching total debt-to-GDP ratio of approximately 60 percent had we deployed the Merrifield-Poulson (MP) fiscal rule option with a 20-year time horizon starting in fiscal year (FY) 1994,² and another recent estimate for a 20-year time horizon, MP deployment in FY 18.³ In the third section, we examine the prospects for, and alleged requirements of, significantly faster economic growth. The fourth section explores the 2040 results of reduced spending growth, whether total or just discretionary. The fifth section looks at the potential use of federal mineral rights sales—something candidate Donald Trump said was part of his deficit and debt reduction strategy—to impact the 2040 debt-to-GDP ratio.⁴ Finally, prior to a summary and concluding remarks, the sixth section examines some consequences, good and bad, of imminent, or actual, default.

KICKING THE CAN DOWN THE ROAD

The planned FY 19 deficit⁵ was nearly $1 trillion, which is about five times the combined budgets of five of the cabinet departments created after World War II: Education, Energy, Housing and Urban Development, Transportation, and Homeland Security. But the gross debt increased from 2018 to 2019 by $1.15 trillion. Typically, unplanned spending causes the national debt to grow by more than the planned deficit.

Had we adopted the MP fiscal rule in 1993, taking effect in 1994, the 2015 debt-to-GDP ratio would have been 54.5 percent; below the 60 percent level that is a rough consensus view of what is sustainable, especially when it is the total debt, not just the debt in the hands of the public. The MP rule is similar to the better-known Swiss debt brake.⁶ The MP rule limits the rate of discretionary spending growth to a prescribed multiple of the population growth rate plus inflation, or less than that when total debt or debt growth is above prescribed tolerance levels. For example, suppose the debt-to-GDP tolerance level is 60 percent, and the actual debt to GDP of X percent is above 60 percent. X − 60 is part of the braking formula that determines how far below the prescribed multiple of population growth plus inflation the allowed spending growth rate is.

Keeping the debt-to-GDP ratio below the sustainable 60 percent level, compared to its actual 2015 value of nearly 100 percent, would have only required an approximate 2 percentage point cut in the growth rate of discretionary spending from its actual average value of more than 5 percent to 3.3 percent. Naturally, with our aging population, and the addition of the George W. Bush prescription drug entitlement, keeping the debt-to-GDP ratio below 60 percent going forward probably would have required a further cut in the rate of increase in discretionary spending. But having failed to seize that opportunity, the costs of attaining debt to GDP below 60 percent is now much higher.

With the CBO’s 2017 Long-Term Budget Outlook as the counterfactual,⁷ it took an approximate discretionary spending freeze for 20 years just to keep the 2037 debt-to-GDP ratio where it is now, at about 100 percent. While that is far below the current-law CBO projection for 2037, 100 percent is still unsustainably huge. With the March 2017 outlook as the counterfactual, bending the CBO 2037 debt-to-GDP projection below 60 percent would require an approximate mix of discretionary spending growth limited to 1.35 percent per year, and $700 billion per year in combined asset sales and entitlement savings. The federal government’s most valuable assets are mineral rights; it owns rights to more than $50 trillion in mineral assets by one current estimate.⁸ Either (a) a discretionary spending growth rate of just 1.35 percent or (b) $700 billion per year in savings or extra revenues without higher tax rates would be a major achievement. Using the CBO’s March 2017 projections, we need both to achieve a sustainable debt level by 2037. Even if we can defy the current conventional wisdom at the CBO and the estimates from Obama administration economists and regain the longtime norm of at least 3 percent GDP growth, it would still take holding discretionary spending growth to 1.2 percent per year and entitlement savings or asset sales of $300 billion per year to get the debt-to-GDP ratio below 60 percent by 2037. And that was before the deficit-increasing 2018⁹ and 2019¹⁰ “budget deals.”

The CBO’s 2018 Long-Term Budget Outlook takes into account the 2017 tax cut, and the Trump administration–approved spending increases. With those policy changes and the passage of another two years, it takes an additional $100 billion per year ($800 billion vs. $700 billion) to reach debt-to-GDP ratio of 60 percent by 2037, or an additional two and a half years at $700 billion per year to get below the 60 percent threshold. That’s alongside a 1.2 percent limit on the growth rate of discretionary spending. Kicking the can down the road has been very costly.

FASTER ECONOMIC GROWTH

Much faster economic growth is the only way to lower the debt-to-GDP ratio to a sustainable level without politically daunting, massive, savings-generating entitlement reform, or politically difficult, perhaps economically impossible levels of annual revenue from mineral asset sales. Despite recent quarterly growth at a 4.2 percent and a 3.5 percent annual rate, and 2.9 percent for all of 2018, the CBO has the annual growth rate quickly reverting to the 2 percent rate that many economists assert is the new normal. That school of thought says it would be very difficult to budge the fundamentals enough to even regain the longtime normal of just over 3 percent. And there is at least one analyst who believes that more than 3 percent is undesirable:

President Trump promised to increase economic growth to 4 percent. That’s faster than is healthy. Growth at that pace leads to an overconfident irrational exuberance. That creates a boom that leads to a damaging bust.¹¹

We might need to risk that increased instability. Perhaps an overriding reality is that the debt crisis may force acceptance of many risks, or trade-offs, that might otherwise be unacceptable.

TAX RATE REDUCTION

Notable economists,¹² including longtime Fed chair Alan Greenspan,¹³ argue that the 2017 tax cuts unleashed “animal spirits” that created sustainable momentum. Phil Gramm and Michael Solon make the same point.¹⁴ The upshot of such effects is that tax cuts can be a key ingredient of a well-crafted economic policy reform that increases revenue more in the long run than it reduces revenue in the short run. Indeed, despite the 2017 tax rate cuts, FY 2018 revenue was still slightly higher than in 2017; though likely less in 2018 than without the rate cuts. Our analysis, via the calculator posted at www.objectivepolicyassessment.org /vetfiscalrules is that a tax cut of 1 percent of GDP, combined with fiscal restraint via the MP fiscal rule, yields much-accelerated economic growth; enough so that after five years, a tax rate cut yields more revenue than a tax rate increase of the same amount.

TRADE POLICY

President Trump appears to be attempting to be the first president to win a trade war. And it may not be just unrealistic with regard to hope triumphing over experience. If “victory” yields more than an elimination of the newly imposed trade barriers, economic growth and debt restraint will get a boost. Probably more important than the slight economic and fiscal boost emanating from freer trade is to avoid the consequences of the usual trade war stalemate where machismo and concentrated gains in import-competing industries prevent trade wars from terminating quickly or at all. Key historical examples include (a) how long it took to substantially erode the Smoot-Hawley tariffs that at least greatly deepened the Great Depression, or were a principal cause, and (b) the persistence of some trade barriers, such as the “Chicken Tax” that resulted from a trade dispute in 1964.¹⁵ Because of French and German tariffs on U.S. chicken exports, President Lyndon Johnson imposed a 25 percent tariff on imported trucks that still exists, undiminished by successive General Agreement on Tariffs and Trade (GATT) and World Trade Organization (WTO) rounds of tariff reductions. Early signs point to noteworthy persistence of some of the recently imposed barriers, even if the Trump administration achieves its trade war objectives.¹⁶ Higher costs to consumers and industries, alongside disruptions associated with industry adjustment to domestic sources of raw materials and intermediate goods, could induce a recession. Long-term malaise could result from not being competitive with countries that do not deny themselves access to the world’s lowest prices. Since the CBO counterfactual that projects a 2040 debt-held-by-the-public to GDP of 124 percent—about 150 percent for total debt—does not include the effects of recessions, or greater malaise than already implied by the projected 2 percent growth rate, trade policies are among the most likely causes of fiscal and economic outcomes that are even worse than the terrible outcomes that the CBO projects without major policy change to induce fiscal restraint.¹⁷

IMMIGRATION POLICY REFORM

A wide-open immigration policy seems like a surefire strategy for large-scale debt reduction that many people favor, without its possible economic growth and fiscal benefits. Given Alex Nowrasteh’s assertion that, “there is no strong fiscal case for or against sustained large-scale immigration,¹⁸ it may take some wise targeting of immigration eligibility to significantly increase federal tax revenues more than outlays.

The most recent noteworthy attempt at immigration policy reform, 2013’s S. 744, would have had many of the needed fiscal effects.¹⁹ Still, even though S. 744’s projected benefits were small in relation to the scale of the fiscal crisis, the projected fiscal benefits are worth examining. Two chapters in Benjamin Powell’s The Economics of Immigration also asserted noteworthy effects that can be scaled up.²⁰ For example, Richard Vedder found higher rates of entrepreneurship in states with higher concentrations of legal immigrants. That replicated an earlier finding by Wadhwa and others that legal, skilled immigrants have started a disproportionate percentage of new engineering and technology companies.²¹ Alex Nowrasteh noted that one CBO model determined that if S. 744 became law, it would lower the projected federal budget deficit by $875 billion over 20 years. A second, more dynamic, CBO model determined that if S. 744 became law, it would boost GDP by 5.1 to 5.7 percent over 20 years, and lower the projected federal budget deficit by $1.197 trillion over 20 years.²²

The political factors underlying S. 744’s cautious attempt to find a viable path to reform probably underlie William Galston’s proposed path to faster growth—eligibility limited to the most productive—without stirring up too much controversy, that is, without increasing the aggregate level of immigration:

There is only one way to boost the growth rate of the workforce: expand dramatically the number of working-age immigrants admitted each year. If the U.S. prioritized working-age entrants the way most other advanced countries do, it would increase annual labor-force growth by up to 0.3 percent.²³

The author of this introduction is a first-generation immigrant, but despite the fiscal benefits, he’s conflicted about the mixed effects of large-scale proposals that would yield massive population growth. Obviously, his personal struggle with the pros and cons are but a microcosm of the reasons why immigration policy is extremely controversial. But uncontroversial is the fact that the deepening debt crisis significantly increases the importance of the effects of accelerated legal immigration. As we continue to see, the fiscal crisis may make otherwise unacceptable trade-offs more palatable or even necessary.

TAX BASE CHANGE

Given the difficulty of achieving accurate, uncontroversial dynamic scoring for every potential tax policy change, a useful part of a debt-reduction strategy would be to adopt likely growth-accel...

Table of contents

• COVER PAGE
• TITLE PAGE
• COPYRIGHT PAGE
• CONTENTS
• FOREWORD
• PREFACE
• INTRODUCTION
• CHAPTER ONE: THE FEDERAL FISCAL CRISIS: AN OVERVIEW
• CHAPTER TWO: FEDERAL DEBT IN HISTORICAL PERSPECTIVE
• CHAPTER THREE: THE DEBT CRISIS IN INTERNATIONAL PERSPECTIVE
• CHAPTER FOUR: INTERNATIONAL EXPERIENCE WITH FISCAL RULES
• CHAPTER FIVE: THE UNITED STATES VS. SWITZERLAND AND SWEDEN: THREE APPROACHES TO FISCAL RESTRAINT
• CHAPTER SIX: UNDER THREAT: RULES-BASED FISCAL POLICY AND HOW TO PRESERVE IT
• CHAPTER SEVEN: RULES FOR SUSTAINABLE FISCAL POLICY: THREE PERSPECTIVES
• CHAPTER EIGHT: EFFECTIVE FISCAL RULES BUILD ON CONSENSUS
• CHAPTER NINE: MINUTES FROM MIDNIGHT: GROWING PRESSURE ON THE TREASURY MARKET COULD LEAD TO DEFAULT
• CHAPTER TEN: FISCAL RULES, FISCAL POLICY, AND DEBT: A DYNAMIC SIMULATION ANALYSIS
• CHAPTER ELEVEN: DEBT REDUCTION WITHOUT HIGHER TAXES: GRADUAL PRIVATIZATION OF FEDERAL MINERAL ASSETS
• CHAPTER TWELVE: SOCIAL SECURITY AND MEDICARE SPENDING GROWTH: IS IT JUST MORE SENIORS OR MORE PER SENIOR?
• CHAPTER THIRTEEN: CURB RISING DISASTER AND EMERGENCY SPENDING
• CHAPTER FOURTEEN: IMPROVING TRANSPARENCY AND ACCOUNTABILITY IN FEDERAL BUDGETING
• CHAPTER FIFTEEN: FEDERAL BUDGET PROCESS REFORM: ADDING A RESOURCE CONSTRAINT AND IMPROVING COST MEASUREMENT
• CHAPTER SIXTEEN: THE GOLDEN RULE OF PUBLIC FINANCE AND PROSPECTS FOR ITS REVIVAL
• CHAPTER SEVENTEEN: ADMINISTRATION VS. POLITICS IN THEORIES OF DEMOCRATIC BUDGETING
• CHAPTER EIGHTEEN: WHY DEFICITS?
• CHAPTER NINETEEN: FISCAL FEDERALISM AND DYNAMIC CREDENCE CAPITAL IN THE UNITED STATES
• CHAPTER TWENTY: CONTROLLING GOVERNMENT SPENDING: THE DIFFICULTY AND THE HOPE
• NOTES
• ABOUT THE EDITORS
• ABOUT THE CONTRIBUTORS
• ABOUT THE CATO INSTITUTE