The Fiscal Cliff Is the Immediate Issue
Congress and the president could not agree on a long-term solution to reduce the federal budget deficit before the recent presidential elections, so a large number of expiring programs were extended to December 31, 2012. Now that the elections have come and gone, what is left are seven contentious tax and spending laws set to expire at year-end. Federal Reserve Chairman Ben Bernanke coined the term “fiscal cliff” for the pileup of costly programs. The major tax cuts and spending increases set to expire are the Bush era tax cuts, temporary payroll tax cuts, sequestration spending cuts, federal emergency unemployment insurance, various tax code incentives, the alternate minimum tax fix, and the doctor payment reduction fix to Medicare and Medicaid. Collectively, the fiscal cliff amounts to more than $600 billion, or about 4 percent of gross domestic product in calendar year 2013.
There is near unanimous agreement among economists and policy analysts that stepping off the fiscal cliff for a full year is such a huge fiscal drag that the action would cause another recession in the United States. For this reason, a compromise to prevent the tax increases and spending cuts from all being triggered at the same time is consuming the current political discourse. It is very unlikely that agreement can be reached before year-end; the consensus view is that the lame duck Congress will remain gridlocked and, recognizing that they cannot reach an agreement, will pass a continuing resolution and pass the issue off to the next Congress.
Entitlements Loom Large
Stepping off the fiscal cliff is of immediate concern and must be dealt with, but entitlements are the elephant in the negotiating room, even though they are not directly a fiscal cliff issue. Resolving the tax and spending provisions in the fiscal cliff will buy some time; however, there cannot be a solution to the long-term federal deficit imbalance without addressing Social Security, Medicare, Medicaid, and other mandatory healthcare programs.
No matter what happens to the seven expiring programs, entitlements will be a rapidly growing share of federal expenditures. The Congressional Budget Office (CBO) projects that under current policies and practices, outlays for Social Security and major healthcare programs alone are projected to total 12.2 percent of GDP in 2020, compared with an average 7.3 percent share over the past 40 years. Another mandatory expenditure that will only go up is interest on the national debt. Interest rates on treasury securities are currently as low as they can go and should rise in the future. Net interest expense for the national debt is projected to rise to 3.1 percent of GDP in 2020 from a 40-year average of just 2.2 percent. The outlays for all other programs and activities—primarily military and discretionary spending—in the federal budget are estimated to fall to 8 percent of GDP in 2020 from an average of 11.4 percent over the past 40 years. Therefore, to close the deficit (the gap between revenue and expenses), a “grand bargain” must be reached that addresses the unsustainability of the current structure of the entitlement programs.
Retirees Grow Faster Than Workers
Demographics are the main reason the cost of entitlement programs will grow at an accelerating rate. The fundamental driver is that the World War II baby boom cohort is reaching retirement age while birth rates have been falling for decades. Figure 1 illustrates this demographic problem: for 50 years, there were about 3.9 people in the labor force ages 16-64 for each person 65 or older in the population. The ratio started to shrink in 2007 and will fall continuously, and in 2022, there will be only 2.6 people in the labor force ages 16-64 for each elderly person. The retirement of the baby boom generation will mean fewer workers to support retirees.
An explosive combination of factors coincides with an aging America:
- The number of elderly will grow rapidly
- Longevity is improving, so there will be more retirees living longer
- The biology of aging means older people have more chronic illnesses
- Medical care costs are increasing faster than overall prices
Altogether, there are more retirees, living longer, who are sicker and consuming increasingly expensive medical care. As shown in Figure 2, Americans’ longevity is expected to continue rising, but people are not delaying retirement and are instead taking Social Security benefits. Regardless of whether baby boomers work slightly longer, a massive number of retirees will draw on government entitlement programs such as Social Security, Medicare, and Medicaid—programs that were not structured or adequately funded to serve a rapidly aging population structure. The demographic shift will occur at the exact time the federal government needs to implement austerity measures and as state and local governments face huge, unfunded healthcare and pension liabilities.
A Grand Bargain Is Essential
There are two measures for the federal fiscal situation—federal debt (the balance sheet) and the annual federal budget deficit (income less expenses). The federal debt held by the public debt-to-GDP ratio is about 74 percent in 2012 and the annual deficit will equal about 7 percent of GDP. Figure 3 shows the annual deficit projected under three scenarios: the president’s February budget, the CBO’s alternative fiscal scenario (which is basically a forward projection of current policy), and the implementation of the 2010 Simpson-Bowles deficit reduction commission plan. A rule of thumb is that if the annual federal deficit is negative by more than 3 percent, the difference increases the national debt-to-GDP ratio. Current policy, as reflected in the alternative fiscal scenario, is clearly not sustainable. The ratio of debt to GDP would rise from 74 percent this year to 93 percent in 2020 and continue rising thereafter at an increased rate.
Last week saw the opening bids in negotiations over a grand bargain to solve the short-term issue of the fiscal cliff and stabilize the long-term deficit-to-GDP ratio. The president proposed increased tax rates and limited deductions for households in the top two tax brackets. The Republicans have countered with ending or limiting deductions but not increasing tax rates. The president wants half the entitlement cuts the Republicans prefer. Both sides, however, would cut the 10-year deficit by roughly the same amount. The president calls for $2 in revenue for every $1 in spending cuts and the Republicans are offering to agree on the opposite—a $1 tax revenue increase for every $2 in spending cuts.
The budget dispute between Republicans and the president is not really about the fiscal cliff or even the debt ceiling. These are dates and proxies used as leverage to force negotiations to bring about a grand bargain that would achieve a long-term solution to the unstable fiscal imbalance.
 This is referred to as the alternative fiscal scenario.