Taming the Deficit Forge a Grand Compromise for a Sustainable Future William Frenzel, Charles W. Stenholm, G. William Hoagland, and Isabel V. Sawhill Summary Currently projected deficits are unsustainable and pose serious risks to the economy, make us dangerously dependent on other countries, impose a “debt tax” on every taxpayer, send the bill for current spending to future generations, and weaken the government’s ability to invest in the future or respond to emergencies. The next President will have to act to meet the deficit challenge. Specifically, Presidential candidates should commit to restoring fiscal balance over the next five years and to constructing a sustainable fiscal course over the long term by reforming entitlements and taxes as soon as possible. They should emphasize to the public that the deficit matters and pledge to work in a bipartisan way to tame it; they should agree to putting all options on the table, provide an outline of the reforms needed on both the tax and spending sides of the ledger, and be candid with the American people about the magnitude of the problem. Candidates also may want to propose reforms to the budget process, but these alone will not restore fiscal balance. This paper presents detailed proposals in order to illustrate what a defensible deficit reduction package might contain. None of the authors entirely support every component, but the package as a whole shows that it is possible for people of good will to come together and produce a deficit reduction plan that gets the job done. The Brookings Institution | 1775 Massachusetts Ave., NW | Washington, DC 20036 | 202.797.6000 | Fax 202.797.2495 www.opportunity08.org | [email protected] 08: A Project of the Brookings Institution Taming the Deficit 2 Context The federal government is spending beyond its means. Surpluses of the late 1990s have been transformed into deficits that hovered around $300 to 400 billion a year in the first half of the current decade and stood at $248 billion in FY06. Although the picture seemed to improve somewhat by early 2007, any good news is likely to be short-lived, for two major reasons. First, and most important, the retirement of the baby boom generation and rapidly rising per capita health care costs will soon produce substantially larger deficits, unless action is taken to reform Social Security, Medicare, and Medicaid. Second, although official projections show the deficit withering away, this rosy outlook is due to the statutory requirement that the Congressional Budget Office (CBO) adopt several unlikely assumptions, including the complete expiration of recently enacted tax cuts. Under a more realistic scenario, deficits could swell to $535 billion by 2016 and continue increasing in subsequent decades as the population grows older and health care spending keeps climbing. By the early 2030s, assuming health care costs grow at their historical rate, the three major entitlement programs will absorb all of the federal government’s projected revenues (Figure 1). To prevent the elimination of the rest of government, either taxes would have to be raised by half, or benefits for seniors would have to be drastically curtailed. In short, projected deficits are enormous and unsustainable, and almost everyone agrees that there is no plausible rate of economic growth that will enable us to “grow our way out” of the problem.1 Why Deficits Matter Why is it vital for any candidate for President to address this issue? Continuing deficits pose a serious threat to the economy. At present, the effects of deficits are masked by the willingness of other countries to lend us money, thereby allowing us to live beyond our means. Three-fourths of recent-year deficits have been financed by foreigners, 1 According to the Congressional Budget Office, an increase in the growth rate of real GDP of one-half of one percent per year for each of the next five years would reduce the deficit by only $75 billion. Budget and Economic Outlook: Fiscal Years 2007 to 2016, Appendix C, p. 123.including the central banks of China, other Asian nations, and oil-exporting countries in the Middle East.2 Without this influx of money from abroad, our economic strength would erode. It would be more expensive for both businesses and households to borrow; interest rates could rise by two percentage points, increasing the cost of a typical mortgage by more than $2,500 per year3; the value of the dollar would fall; a recession would likely follow; and growth in the American standard of living would slow. The exact scenario is unpredictable, and it could be a gradual adjustment (soft landing) or a full-scale economic crisis. Either way, our mounting indebtedness to foreign countries means that we are losing control of our economic destiny. FIGURE 1. PROJECTED SPENDING GROWTH FOR MAJOR ENTITLEMENT PROGRAMS Social SecurityMedicareMedicaidAverage Federal Revenue (1965-2005)0.05.010.015.020.025.030.02005 2010 2015 2020 2025 2030 2035 2040 2045 2050Percent of GDPScenario 1: Health Spending Rises at Historical Rate Source: Congressional Budget Office, The Long-Term Budget Outlook, December 2005, Scenario 1. 2 Authors’ calculations, based on data from: U.S. Treasury Department, Major Foreign Holders of Treasury Securities, through August 15, 2006; U.S. Bureau of the Public Debt, Monthly Statements of the Public Debt, through July 31, 2006. 3 Authors’ calculations, assuming a 20 percent down payment on a $225,000 house, with a 30-year fixed-rate mortgage. (In 2005, $225,000 was the median sale price for an existing single-family home, as reported by the Joint Center for Housing Studies at Harvard University, The State of the Nation’s Housing: 2006, October 2006.) Opportunity 08: A Project of the Brookings Institution Taming the Deficit 3Opportunity 08: A Project of the Brookings Institution Taming the Deficit 4 Besides threatening the economy, continuing deficits enlarge the national debt and require that more tax dollars be devoted to servicing it. These interest payments absorb nearly one-tenth of all tax revenue and, in 2005, cost the average family more than $1,600.4 When Americans pay their taxes each year, they increasingly are paying for the privilege of borrowing more and forgoing the opportunity to reduce tax burdens or devote these dollars to defense, education, or other programs. Deficits