Week in Review - Ok, You Fix the Budget

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Posted November 19, 2010

O.K., You Fix the Budget

FELIX SOCWELL

By DAVID LEONHARDT

IMAGINE that Democrats and Republicans somehow came together and agreed on a grand bargain to cut the deficit.

They decided to cut the pay of federal workers over the next several years, close military bases, reduce foreign aid, eliminate earmarks, expand the payroll tax and cut Social Security benefits for high earners, as the chairmen of a bipartisan commission recommended last week.

Democrats also accepted the plan from John Boehner, the presumptive House speaker, to make large cuts to social programs. Republicans accepted President Obama's proposal to let the Bush tax cuts expire on income above $250,000.

If the two parties managed to do all of this, how much of the country's long-term deficit would they eliminate?

About one-third of it.

The looming federal deficits are so large that they are likely to occupy much of Washington's attention for years. Arguably, this new deficit obsession - what some are calling the Age of Austerity - began this month. The midterm elections ushered in a Republican House majority pledging to shrink government, and on Wednesday the leaders of the bipartisan panel released the outline of a deficit-cutting plan for the panel's members to debate.

Like that panel, The New York Times has conducted its own analysis of the federal budget, but with a different final product. Rather than making recommendations, we are laying out a menu of major options, so that readers can come up with their own plan. We have received help along the way from the deficit panel, from Congressional and White House aides and from liberal, conservative and centrist budget analysts. The deficit puzzle on The Times's Web site is the result.

The ultimate goal is to help you judge the deficit proposals that are now emerging. Do you think they cut spending too much and should raise taxes more? Or the reverse? Are they too aggressive or too meek on military spending? How will they affect income inequality? How might they help or hurt economic growth?

As a starting point, it is worth thinking about the deficit as being two different deficits. The first is the medium-term deficit, which was created by the Iraq and Afghanistan wars, the 2003 Medicare drug plan, the Bush tax cuts, the recession and the government's responses, like the stimulus.

Assuming that current policies are continued - for instance, that all the Bush tax cuts become permanent - the deficit in 2015 will be about $400 billion larger than the level that economists consider sustainable. (Countries can run small deficits forever, because one year's economic growth effectively pays for the previous year's budget shortfall.)

And $400 billion is a significant sum. It will be equal to more than 2 percent of the country's economic output in 2015 - half of the Pentagon's annual budget and more than half of Medicare's. Yet it is still much smaller, as a share of the economy, than the deficits that have hobbled Greece and Ireland. It is also smaller than the deficit this country ran from 1990 to 1994.

The 2015 deficit does not need to be closed immediately, when the economy remains weak. The deficit panel's chairmen, Erskine B. Bowles and Alan K. Simpson, called for a phased-in program of modestly higher taxes and cuts to social programs and the military. Some conservatives have criticized that plan for raising taxes at all, and some liberals dislike its emphasis on spending cuts and eliminating middle-class tax breaks.

However it is closed, the medium-term deficit does not appear to pose a huge threat to the American economy. Maya MacGuineas of the New America Foundation points out that simply letting all of the Bush tax cuts expire, not just those benefiting the affluent, would nearly do the job.

The long-term deficit is a wholly different beast.

It comes from the projected growth of Medicare, Medicaid and, to a lesser extent, Social Security. It is the result of baby boomers' having paid far less in taxes than they will draw in benefits. "The reason we find ourselves in this situation," said Mr. Bowles, the former chief of staff for President Bill Clinton, "is that we've made promises we can't keep."

The deficit puzzle focuses on the year 2030 because it is far enough away that the boomers' retirement will weigh heavily on the budget but near enough that reasonable budget estimates exist. By 2030, the needed deficit cut will equal about 5.5 percent of annual economic output.

By comparison, domestic discretionary spending - all of it, including Head Start, college financial aid, the F.B.I., medical research and airline safety - will add up to about 3 percent of economic output, according to Congressional Budget Office projections. Military spending will equal about 4 percent.

So the solution will have to revolve around tax increases and changes to health care and Social Security. And the country cannot wait until 2030 to implement most of the changes, notes Alan Auerbach, an economics professor at the University of California at Berkeley. If it did, the interest on the national debt could become crushingly large. Deficit cutting will probably be a regular part of politics for the next couple of decades.

One obvious debate will be taxes versus spending. But relying exclusively on one would be extremely difficult. An approach based only on spending would mean deep cuts to programs that many Americans consider to be the essence of government: Medicare, Social Security and the military, among others. Closing the entire deficit through taxes would require enormous tax increases, mostly because Medicare spending is expected to continue growing much faster than income. To keep up, tax rates would have to keep rising.

The real issues, then, are how much taxes should rise, how much spending should be cut - and what kinds of each change should take place.

You could choose to raise taxes mainly on the rich, because their tax rates have fallen steeply over the last few decades while their pretax income has soared. Or, knowing that many of the rich still have higher tax rates than anyone else, you could start the exercise by saying goodbye to the Bush tax cuts on income below $250,000.

No matter what you pick, keep in mind the potential effects on economic growth. Arguably, economic growth is the most important yardstick for any plan, because growth can do much to reduce the deficit, as it did after World War II and in the 1990s.

This helps explain why many economists favor a version of tax reform that would lower marginal rates and close loopholes. Ordinary tax cuts have a mixed record on helping the economy; growth after the Bush tax cuts was mediocre, for example. But tax reform could save households and businesses from changing their behavior, often inefficiently, to qualify for tax breaks. The Bowles-Simpson plan suggests several reforms that would raise more tax revenue than today's code and help close the deficit.

Of course, when economists say loopholes, they are including the deduction on home mortgage interest and other popular items. That's the problem with deficit cutting: it involves painful choices, like the ones you see here and the ones in the Bowles-Simpson plan that led to last week's outcries.

The government has not yet solved the deficit problem, the economist William Gale of the Brookings Institution says, because voters have not yet demanded it. They have rewarded politicians who say they are worried about the budget much more than politicians willing to make specific benefit cuts and tax increases. All of us would prefer generous benefits and low taxes.

"Whatever the eventual solution is," Mr. Gale said, "it will probably be something that is not politically feasible now."

Copyright 2010 The New York Times Company. Reprinted from The New York Times, Week in Review, of Sunday, November 14, 2010.

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