One of the few things US Democrats and Republicans appear to agree on is that fiscal responsibility is for losers. As a result, the country’s looming financial breakdown gets barely a mention as elections approach. Last week’s bracing projections on the deficit from the Congressional Budget Office (CBO) passed almost unnoticed. How long this studied inattention can be sustained or what it will take to get Washington even talking about solutions is anybody’s guess. Meantime, the odds of an outright fiscal crisis within the next few years are rising steadily.
The CBO now expects a deficit of $1.6 trillion, or 5.6% of GDP, this fiscal year. That’s for an economy at full employment and growing pretty well. Under current law, the gap between spending and taxes will keep widening over the next decade, rising to $2.6 trillion (6.2% of GDP) by 2034. Despite steady economic growth, debt will rise from 97% of GDP this year to 116%. From there, it just keeps going up.
Believe it or not, this is a rosy scenario. First, the outlook includes no recession. The pandemic crushed output and demanded strong fiscal stimulus, a combination that added 20 percentage points to the debt ratio in a single year. The next economic setback is a matter of when, not if. Even a much milder reversal than that of 2020 would push the numbers forcefully in the wrong direction.
Second, the CBO’s “current law” forecast includes an unlikely degree of scheduled tightening. The projection assumes that caps on discretionary spending introduced last year will be maintained and that the Trump administration’s 2017 tax cuts will expire in 2025 as the law promised. A more plausible forecast will let public spending grow in line with the economy (as it usually does) and assume that tax rates won’t rise automatically (as they usually don’t). In that scenario, debt climbs to more than 130% of GDP by 2034 and keeps climbing, again assuming uninterrupted growth.
Didn’t US Congress pass the Fiscal Responsibility Act (FRA) last year, proving that it’s ready to do something about it? Well, the FRA did help a bit. The aforementioned spending caps and other tweaks (if maintained) lower the deficit by about $150 billion a year. In other words, without the FRA, the ten-year deficit would not be roughly $19 trillion, as the CBO projects, but a little more than $20 trillion. The measure failed to restore any semblance of balance. If Washington can’t summon a lot more fiscal responsibility, the US economy will be in trouble.
The crux of the matter is that the parties have different fiscal preferences, except when it comes to curbing borrowing. Republicans want lower taxes and lower spending. Democrats want high spending and higher taxes (on companies and the rich). How to strike a deal? Easy. Cut taxes and raise spending. This appeals to voters and offers the default option.
A large bipartisan majority in the House of Representatives recently passed a bill that captures the problem. It combined a big increase in the Child Tax Credit with more generous corporate-tax treatment of R&D and other capital spending. The first gives poor families a ‘refund’ of taxes they aren’t required to pay (public spending disguised as tax reform) and was long sought by Democrats. The other is a tax preference for some kinds of investment, which Republicans think is good for growth. In isolation, both parts are good policy. The CTC reform is an effective, well-targeted anti-poverty measure; accelerated depreciation is good for investment, which is good for growth. But the package will increase public borrowing and debt, and it needs to be paid for.
The House pretends it has taken care of that. This fiscal gimmickry involves deeming the CTC expansion and corporate-tax relief temporary, while offsetting their costs with savings from payments of the pandemic-era Employee Retention Credit (ERC). Yet the two changes aren’t really intended to be temporary, whereas the ERC savings are a one-off. It’s the old ‘current law’ versus ‘current policy’ ploy, one of the main devices used by policymakers to set aside disagreements and get things done, as they claim, thereby digging the country into a deepening fiscal hole.
The US fiscal irresponsibility consensus embeds rising public debt into the very structure of its economy. Every year’s delay in addressing the problem makes it harder to solve. At some point, the fiscal outlook will start driving long-term interest rates higher, which adds to debt, which worsens the outlook, and so on. In the end, without strong action, the result will either be a fiscal collapse of the kind seen elsewhere but not in the US, or else the dreaded ‘fiscal dominance’ through which the Federal Reserve inflates away the debt burden by letting prices rip. ©bloomberg