How Bad is Our Fiscal Crisis?

Economists on the left and right are expressing concern — in some cases alarm — over the fiscal health of the U.S. government. Currently, we are running a deficit equal to about 10% of GDP; but the government is still able to borrow at 3%. No other country in the world could do that. And we may not be able to do it much longer. We may be living in the calm before the storm. As in the case of Greece — and possibly all of southern Europe — international investors may decide that we have neither the will nor the ability to pay back our debtors. In that case, the government’s borrowing costs will soar.

How bad are things? How much of the problem is health care? Can we tax our way out of it?

Another day older
And deeper in debt

My own view is that the crisis is going to begin at the bottom and rise to the top. Already we have seen some local governments declare bankruptcy. Expect more of that. In the next several years, I believe some very large cities are going to announce that they cannot pay their bills. State governments will be next. Whereas local governments can declare bankruptcy, state governments can only default. A default by the state of California seems almost inevitable.

But is it conceivable that the U.S. government could default? Actually, yes. Every projection shows the gap between spending and tax revenues rising through time. And the problem at the federal level is basically the same as it is at the state and local levels: We made promises, mainly promises of benefits for retirees, that we were unwilling to fund.

Two years ago the first of the baby boomers started claiming early retirement under Social Security. Next year, they will start signing up for Medicare. Before they are through, 78 million people will quit working, quit paying taxes, quit contributing to our retirement system and start drawing benefits instead. And we are not ready for them. Not in Social Security. Or Medicare. Or Medicaid. By not ready, I mean we have put no money aside to pay for the benefits the baby boomers think they have been promised.

In terms of short-term cash flow, the Obama administration is forecasting that federal spending will be at 25% of GDP by 2020, while revenues will be less than 20%. To keep the deficit at no more than 3% of GDP (not zero, but 3%), an Urban Institute/Brookings tax analysis suggests that tax rates must rise by 40% beginning in 2015. That means the bottom 10% rate would have to climb to 14% and the top 35% rate would go from 35% to 48%.

The problem is not just a federal problem. State and local governments have unfunded retiree obligations of $2 trillion or more. Private companies have made (defined benefit) promises that are underfunded. And one-third of the baby boomers have an employer promise of post-retirement health care — almost none of which has been funded!

What I am describing is a huge gap between what the baby boomers think they have been promised and the resources available to meet those promises. What I am describing is oncoming generational warfare.

So let’s think about solutions. As described previously at this blog, President Obama has appointed a commission on the federal debt, the National Commission on Fiscal Responsibility and Reform. Although nothing is for certain, many believe a value-added tax (VAT) will figure prominently in the proposed solutions.

But is a VAT tax, or any other tax, really an answer to our problems? Professor Laurence Kotlikoff and his colleagues have modeled the U.S. economy in the middle of a world economy to project the consequences of various policy proposals. For example, suppose we continue on the current path and fund the growth of entitlement spending with a VAT tax or a payroll tax or a consumption tax. What will the future look like for the United States as well as Europe?

  • In the United States, the average tax on wage income will rise from 40.6% today (that’s a 15.3% payroll tax plus a 15% income tax plus state and local taxes) to 55% by 2030 and 62.1% by midcentury.
  • If Europe follows the same path, the average tax on wage income will rise from 60.1% today to 72.5% in 2030 and 79.3% by 2050.

Tax rates of this magnitude would be enormously harmful to the economy and are probably uncollectable. (Note that these are average tax rates; marginal tax rates would be much higher.)

Is there a better solution? Yes. We must move immediately from a pay-as-you-go (unfunded) entitlement system to one which is funded and in which each generation pays its own way. For Social Security and Medicare we have described how to do that elsewhere.

Comments (23)

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  1. Devon Herrick says:

    The whole premise of stimulus spending seems flawed. Adherents to Keynesian economics believe government intervention is needed to make up for slack demand during recessions. Debts accumulated during by deficit spending can then be paid down during periods of prosperity. One problem with this approach is stimulus spending tends to stimulate the economy in areas that often would not experience growth absent stimulus spending. Also, cities, states and government workers become addicted to pork barrel projects as people take jobs, buy houses with mortgages and arrange their lives around spending that is (theoretically) supposed to stop at some point. Once committed, there is immense pressure by those whose lives will be affected to continue the spending.

  2. Joe S. says:

    John, the answer to your question is: it’s very bad.

  3. Vicki says:

    Great musical pairing. That song is an oldie but goodie.

  4. Sid Bondurant, MD says:

    The President told us what he wants to do. His response to a reporter at the G20 meeting was telling. He said he had promised cap and trade (tax), health reform, social justice (don’t ask, don’t tell elimination), and he had delivered on part of it and will “keep on doing what I promised.” He then added something I do not remembering him promising. He said that Defense Sec. Gates had a history of making big cuts in programs. So, there you have it. Cut defense and increase social program spending. Can you say, “Recipe for Disaster?”

  5. Tom H. says:

    Dr. Bondurant, I totally agree. We are headed toward disaster.

  6. Nancy says:

    Ditto Vicki’s comment. Great song.

  7. monkeywrench says:

    Our government has become too expensive and will soon be bankrupt. The only solution would be for it to immediately cut spending and lower taxes, but the moochers, looters and other parasites will never do this because they’d be out of a job and have to find employment in the productive part of the economy which they helped to hamstring with all of their taxes, tort costs and regulations.

  8. Neil H. says:

    Answer to another of your questions: No, we cannot tax our way out of this mess.

  9. William G. Shipman says:

    You and I have been at this for a long time. Is it just possible that our fellow citizens have now awakened to what lies ahead if we do not fundamentally change course, a course of both Democrat and Republican making? If so, and it’s a big if, we may be at the very beginning of a new and exciting chapter for our country. We may be entering a period of less government, not just limited government, market-based solutions for Social Security and Medicare, greater liberty and choice, as well as greater reliance on self as opposed to the government. If this actually happens, President Obama—his administration, economic staff, and policies anathema to America’s rich history—may have unintentionally provided the spark. How counterintuitive.

  10. John Goodman says:

    Bill Shipman,

    I hope you are right.

  11. Greg Scandlen says:

    I have yet to see any ideas for resolving this crisis, or even any theories of how it could be resolved. I’m afraid the only thing that is going to get this country to do what is necessary is a very deep depression. One that robs all levels of government of virtually all resources and results in the people dealing directly with one another through barter. People with worthwhile skills will survive, others (read both public and private bureaucrats) will either learn skills or starve.

    BTW, Harrisburg, PA is close to declaring bankrutcy.

  12. Uwe Reinhardt says:

    I find it enormously refreshing that conservatives have once again discovered that deficits do matter, after years of denial by the Wall Street Journal. It took only a few years from Dick Cheney’s proclamation that deficits don’t matter to today and that pay-go was anachronistic — but this is progress.

    I agree with you, John, that the whole country is overleveraged. For many years now the nations as a whole has spent about 4% to 6% more than its GDP, borrowing the rest from abroad.

    So there will have to be a complete review of how as a people we finance ourselves and what all we debt finance. And, yes, that includes public pensions and health care as well.

    Right now, if people in a country live within their means, save and have a positive net export balance thay are actually called nasty names — e.g., China and Germany.

  13. Frank Timmins says:

    Mr. Shipman, that is exactly what the Tea Party movement is all about. The Leftists don’t fear the Republican party, but they very much fear the Tea Party activists (even though the delivery vehicle for Tea Party changes is the Republican party).

    This awakening could not happen too soon. As a matter of fact one wonders if this November will be too late given the stepped up agenda of the current government. Some of the foolishness is reversible (such as the healthcare act), but other things such as populating the supreme court with ideologues stay with us a long time.

    We should make no mistake. The current governmental leadership has every intention to remake the country into a socialist welfare state controlled by the “enlightened elite”. We should force the RINOs to recognize this and act accordingly instead of trying to “compromise”.

  14. Don Levit says:

    This is an issue in which both leftists and rightists can agree on.
    Not only can we not tax our way out of this, I don’t think we can grow our way out of it either (I agree with Obama on this statement).
    The only way to deal with cost overruns is to just say “N0, enough is enough.”
    A few excerpts from the 2009 Financial Report to the U.S. Government highlights the seriousness of our situation:
    Page 36 – “The federal government is on an unsustaianable long-term fiscal path driven primarily by rising health care costs and known demographic trends.
    Absent a change in policy, under this scenario, the interest costs on the growing debt together with spending on major entitlement programs could absorb 92 cents of every dollar of federal revenue in 2019. Clearly, this is not sustainable.”
    Go to:
    Don Levit

  15. Virginia says:

    Excellent post. I tend to agree with Mr. Scandlen. It’s going to take some real pain for us to do anything that makes sense.

  16. David Lenihan says:

    Great post John. There are many ways to tax and unfortunately my crystal ball says that the elected “elite” (self-proclaimed) will choose the route of least resistance, namely the dramatic devaluation of our currency via the printing press….the cruelest tax of all.

  17. John Seater says:

    I do not see the basis for several commenters’ assertions that “we cannot tax our way out of this.” The federal debt at the end of World War II was larger than the GDP, and it did not take long for it to fall. That didn’t happen by magic. Partly we raised revenue by taxation, partly the economy grew out of the debt. If we could do it then, we can do it now.

    There is only a problem if government continues to spend the way it has been spending. That spending level is unsustainable, but it is not inevitable. Nothing required that the irresponsible spending programs be started, and nothing requires that they now keep going. We can stop them any time we like. They are no more of an obligation than repayment of the debt. Indeed, I would argue that they are much less of an obligation. They were put in place by a coalition of two groups: on the one hand, worthless politicians eager to buy votes and, on the other hand, worthless people eager to steal from their more productive fellow citizens. There is no moral justification for their actions, so there also is no moral impediment to terminating their fiscally unsustainable spending programs immediately. Termination is especially justifiable because it allows us to meet the genuine moral obligation of repaying the debt.

    Government at all levels wants to spend huge amounts of money so the politicians can buy votes. That’s what politicians do for a living, but it isn’t a defensible justification for their spending. There is no need to default on the debt or especially high taxes as long as we are willing to default on the politicians’ cynical promises. Debt is a promise, and existing government spending programs are a promise. Taken together, they happen to be incompatible with the physical reality of the lifetime budget constraint (the economic equivalent of conservation of mass). We can’t pay for both the debt and the spending at any tax rate that will not lead to outright revolt. So which promise are we going to default on – repayment of the debt or the irresponsible political spending programs, most of which are unconstitutional anyway? The sooner we face up to what has to be done, the easier it will be to do it.

  18. Bart Ingles says:

    We must move immediately from a pay-as-you-go (unfunded) entitlement system to one which is funded and in which each generation pays its own way.

    The problem is that it costs money to move from defined-benefit to defined-contribution, which means you need either a one-time increase in revenue or a one-time decrease in benefits in order to pay for the transition. And we haven’t even been able to cap the growth in defined benefits let alone reduce or eliminate them.

    It seems to me that a cap in the Social Security COLA to perhaps inflation minus one percent is a logical first step. This by itself would have the effect of encouraging growth in defined-contribution plans.

  19. Don Levit says:

    John Seater wrote: “They are no more an obligation than repayment of the debt. Indeed, I would argue they are much less of an obligation.”
    John, you are absolutely correct.
    Taxes are “nonexchange transactions.” This is because taxes cannot be specifically tied to benefits, which would be private property.
    Taxes are paid in for the “general welfare.”
    The FASAB is the accounting advisor for the federal government.
    In a paper entitled “Accounting for Social Insurance, Revised” dated Oct. 23, 2006:
    page 87 A nonexchange transaction arises when one party receives value without directly giving or promising value in return. In regards to social insurance benefits the federal government gives value to beneficiaries without receiving value in return (the government is not obligated to pay benefits, for it doesn’t receive value in return). The fact that benefits paid are not based on the amount of taxes paid confirms the nonexchange nature of social insurance.”
    Go to:
    Click on Exposure Drafts and Documents for Comment.
    John, “Sixteen Tons” was the first record I ever bought.
    It wasn’t until rrcently that I learned the last word is “store.”
    It sounds like “stowe.”
    Does Ernie really snap his fingers that loud?
    Don Levit

  20. Aaron Cohn says:

    How about reassessing the role of government? Redefining its role to only protecting our borders from attack, protecting citizens from violent crime one upon the other. This is about the only thing the government does well or efficiently anyway. Is it a proper role of government to feed people, or give them free medical care, or pay for their upkeep in old age? Our government does a lousy job at that & should return responsibility for that (& all the taxes it collects) to the people to use as they see fit. Only such strong medicine can possibly get us out of our current mess and simultaneously allow a strong economy. Who knows how to spend better, you or the federal government?


  21. John R. Graham says:

    Mr. Seater:

    There is a huge difference between World War 2 and today. The war stopped (quite suddenly) in 1945 so government spending collapsed immediately: Millions were demobbed.

    There was virtually no federal welfare state to consume the money no longer used by the military (Social Security only a decade old, no Medicare or Medicaid, no Department of Education, no HUD, no FEMA, etc.) so the government simply stopped spending money that it didn’t have. As a result, the US grew out of its debt.

    I think the crisis described by the other commenters might be even worse than we fear. The European experience shows that democratic government no longer shrinks when the military shrinks. Instead, other parts of the blob devour the budget that had belonged to the military.

    Dr. Bondurant notes that President Obama looks to Sec. Gates to cut programs. However, those dollars will go to expand Medicaid, green jobs, etc.: Not back to the people who earned them.

  22. John Seater says:

    John Graham:

    You are right about the difference between WWII and the current fiscal mess. As I said, the problem is control of government spending. However, there is no need to take the federal welfare system as a given. The war was imposed on us by the Japanese and the Germans. In contrast, the welfare system is self-imposed, and so is its continuation. We put it there. We can get rid of it. Unlike the war, all we have to do to end the welfare system is make up our minds to do so. It will go away as fast as we want it to. Every bit of the federal welfare system is unconstitutional, so there is no legal impediment to ending any or all of it at any pace that we find acceptable. What the states choose to do is up to each of them to decide.

    I personally favor eliminating most or all minor federal welfare programs within one year. The big ticket items are Medicare, Medicaid, and Social Security. Medicare can be eliminated fairly quickly if the federal government opens interstate commerce to competition among health insurance companies (which it has the constitutional authority to do immediately). Don’t forget that medical care, and thus medical insurance, would cost a whole lot less if the government would butt out and let the market work. Medicaid may need a somewhat slower phase-out. I don’t want to drop poor people abruptly on the street with no health insurance, but I do want to eliminate the program quickly. Social Security is the hardest of all because many people have been relying on it and as a result not contributing as much to private retirement plans as they would have done in Social Security’s absence. We need a phase-out, but it has to be short or else it will be infinite. Some hardship will be unavoidable. Maybe people more imaginative than I can think up self-terminating ways to ease the hardship. In any case, though, we must end the program or it will eat us alive, as it is doing now. It is possible in principle to fix the program without eliminating it, say by restricting indexation to inflation rather than real wages, but in practice the politicians inevitably will undo any such fix to buy votes as long as the program exists. The only permanent solution is to recognize the program’s unconstitutionality and eliminate it altogether.

  23. Jennie Fiedler says:

    Seeing the passing of the 28th amendment would be very encouraging,less government spending beginning with people who make careers out of being way over compensated in the first place. And yes, less government, more self reliance and market-based solutions. Great ideas, all.