Outlook for the Future

Budget Deficit | Terms to Know and Love | Long Term Effects | Outlook for the Future | Comparisons | Data | Works Cited

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Federal deficits reduce the future standard of living by lowering national saving which slows the accumulation of national wealth. Increases in government spending (increased government consumption) and federal tax cuts (increased public consumption) increase the federal deficit and reduce national saving. Even if the financial market (i.e. interest rates) is not significantly affected by the shifting of resources from from saving to consumption, decreased national saving can still occur. Although domestic investment is reduced by federal deficits, captial inflows from abroad tend to increase the productivity or both labor and capital.

Effects of Rising Debt on the Economy

• decrease national savings and reduce investment in domestic capital stock and foreign assets
  • decline in the growth of workers' productivity would decline and real wages
    • tapering off of economic growth, leading to a sustained contraction of the economy
  • some portion of the deficit could be financed by foreign investors
    • over time:
      • foreign investors would own larger shares of US output, leaving fewer resources available for domestic consumption
      • financing of the deficit by foreign investors could decline
      • the exchange value of the US dollar could plummet
      • interest rates could soar
      • consumer prices could climb
      • the economy could contract abrubtly
      • stock markets could collapse
      • the economic problems in the US could extend to the rest of the world, weakening the economies of US trading partners

Unsustainable Budgeting Strategies

The future of policies, and future policies are what matter!!!

"Budgetary paths are economically unsustainable not when federal debt hits a critical level but when the government adopts policies that cannot be carried out indefinitely." -CBO, December 2005 (The Long-Term Budget Outlook)

Policy: Higher Inflation

Positive: Could potentially reduce the real value of government debt.

Negative: Not a viable long-term strategy for managing recurring budget deficits.

Reasoning: The government would be able to repay its debt in “cheaper dollars.” This would initially make borrowing better off at the expense of creditors, but financial markets would eventually demand higher interest rates. This situation would in time lead to hyperinflation if the government continued to print new money in order to finance the deficit.

Using inflation to finance the deficit cannot address the fundamental problem: that spending exceeds revenues.

Policy: Faster Economic Growth

Positive: Would push up revenues in the short-run.

Negative: Raise spending in the long-run.

Reasoning: For example, Social Security benefits depend on individual workers’ wage histories. Therefore, an increase in the current real wage would lead to higher benefits being paid to workers in the long-run.

In high-debt scenarios, faster economic growth can only provide temporary relief.

Policy: Reduce Future Retirees' Benefits

Positive: Could encourage saving and increase the capital stock

Negative: The magnitude of the effects of the policy are very uncertain because they are dependent on the way that workers respond to the cuts in their future benefits:

1. Forward-looking workers: reduce current consumption in favor of increased saving.
2. Non-forward-looking workers: wait until retirement to reduce consumption.

Positive: Some reductions in future benefits to retirees' could increase the labor supply, because workers foresee a decrease in their expected future income. Workers may wish to work more now in order to make up for lost income in the future.

Negative: Some reductions in future benefits to retirees' could decrease the labor supply, by reducing the marginal return from an additional hour of work.

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Policy: Raise Taxes

Positive: Could alleviate future pressure on the budget.

Negative: Tax policies that increase marginal tax rates can potentially reduce workers' motivation to work and save. They can also increase inefficiencies in the economy, which tend to grow disproportionately with the tax rate.

• Note: economic distortions tend to be smaller for changes in tax policies such as reductions in the child tax credit, personal exemptions, and standard deductions, all of which have a lesser impact on marginal incentives to work and save.

Sustainable Budgeting Strategies

• Based on the assumption that people are forward looking and will adjust their behavior based on expectations about future tax rates and benefits
• Distinguishes between different generations in order to explore the impacts of retirement programs such as Social Security and Medicare

Higher-Revenue Policy

Extension of current law governing individual income tax

• Uses the additional revenues to finance higher spending on retirement related programs. As real income grows, people are pushed into higher tax brackets, causing the marginal tax rates to gradually rise.

• Results:

1. Increase in total federal revenues as a share of GDP, caused by an increase in the effective marginal tax rate on both labor and capital incomes.
2. Increase in spending as a share of GDP, as a result of the assumption that additional revenues are being spent on programs for the elderly.

Lower-Tax, Lower-Spending Policy

Keeps revenues close to their historical average share of GDP and eliminates the rise in the spending on programs for the elderly

• As real income grows, changes in the individual income tax system and/or reductions in other taxes will offset the expected rise in individual income taxes under current tax law. In addition, there is no additional spending on programs for the elderly, as well as an annual decline in other government spending as a percentage of GDP.

• Results:

1. Total federal revenues will be kept close to their historical average share of GDP.
2. Decrease in spending as a share of GDP results, including the absence of excess cost growth on health care programs.

Conclusion

In order to avoid the potential economic crisis that could result from allowing debt to continue to grow, policymakers must take immediate action to counter an unsustainable budgetary situation. Although there are a considerable number of policies and changes that could potentially lessen the magnitude of the deficit, the most important facet of the chosen policy is that it can be carried out indefinitely. The sustainability of budgetary paths is not based on the actual level of debt, but on the ability of the adopted policy to prevent government debt from growing uncontrollably.