LTBO #2

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Today’s blog is the second in a non-successive series of articles about the CBO’s Long-Term Budget Outlook (LTBO). This article addresses the issue of why we need to take action immediately.

Quick Review

In LTBO #1, we saw the idea that the CBO analyzed our future budgets under two scenarios:

1. extended baseline scenario – assumes laws don’t change (e.g., Bush tax cuts expire, AMT is not adjusted and millions more people pay higher taxes as a result, etc.)
2. alternative fiscal scenario – assumes that laws will change (e.g., Bush tax cuts will be extended for all tax brackets other than the highest income group, etc.)

Most people would agree that the alternative fiscal scenario is more realistic. Obviously, we don’t know what the future holds, but the extended baseline scenario is modeling tax revenue that is equivalent to 23% of GDP (even though we’ve averaged 18.1% for the past 65 years). While this may be the direction we’re headed, we certainly have not made that decision yet. In addition, we don’t know what effect that will have on GDP growth.

We Must Act Now!

Using the alternative fiscal scenario, the outlook is dismal. By 2035, our debt will be 185% of GDP. Interest will be approximately 9% of GDP – meaning that half of our tax revenue will simply be paying off interest. It’s pretty obvious that something needs to be done.

The CBO analyzed the fiscal gap for the next 25 years (through 2035). The fiscal gap measures the shortfall over a given period (25 years in this case). They are asking the question of what has to be done in order to keep our debt-to-GDP at a constant level.

If you look at the next 25 years, our fiscal gap is estimated to be 4.8%. In other words, if we want to have the same debt-to-GDP ratio in 2035 (that we have now), we need to immediately either increase taxes or decrease spending (or some combination of the two) by 4.8% of GDP.

You need to realize that this is a HUGE amount. Remember that taxes have averaged 18% of GDP and spending has averaged 19% of GDP. So, we are talking about the need to either increase tax revenue or decrease spending by approximately 25% of current levels.

Look at what happens over the next 25 years if we don’t start right away:

1. if we don’t start until 2015, the fiscal gap is 5.7% (so we’ll have to cut spending or increase taxes by 5.7% of GDP for the following 20 years)
2. if we don’t start until 2020, the fiscal gap is 7.9%
3. if we don’t start until 2025, the fiscal gap is 12.3%

It should be obvious…we haven’t started fixing the problem and we’re going to have a significantly higher debt-to-GDP ratio in 2035.

The Bad News

The bad news is that I just told you the good news. It gets worse. I was just telling you what we had to do in order to have the same debt-to-GDP ratio in 2035. The demographics get worse over time (fewer people working, more people drawing benefits).

If we want to have the same debt-to-GDP ratio in 75 years (that we have now), we need to immediately solve a fiscal gap of 8.7% (of GDP). In other words, we’d have to either cut our spending in half or increase taxes by 50%.

The situation that we are in is like parents who are not saving for college. They are sending their child to private school right now. Everything seems to be fine. Some people are warning them that college is a lot more expensive. It seems obvious to everyone. At the same time, this family has always been fine and they’ve overcome obstacles before. Everyone figures that this will be okay…just like before.

Of course, if you want this to be a more realistic analogy, we’d find out that the family only makes $40,000 per year and has found a way to pay for private school. It turns out that they’ve been borrowing money and now they have a lot of debt. They’re not going to get any scholarships and China won’t give them a loan for their child’s education. To really make matters worse, the way that the family makes $40K is by having both parents work. Unfortunately, one is approaching mandatory retirement age. Their expenses are about to increase, fewer people will be working and their revenue is about to drop. Welcome to the United States.
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