Tough times, tough decisions

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By Drew Lyon and Lindy Paull

Image: Cold pack The faltering US economy and current recession may seem like the worst of times. But we may be facing an even more serious crisis in the coming decades: out-of-control budget deficits that could severely weaken our economy for generations to come. Even as the current recession runs its course, policy makers and the private sector must now focus on the difficult choices that will set our nation on a sustainable path.


Long-term thinking isn’t easy to come by these days. Given the current economic environment, the near-term focus is understandable—but it may also prove to be dangerous. As bad as our economic situation is right now, it could get a whole lot worse in the next decade and beyond. If left unchecked, the mounting US deficit—forecast to be as high as $2.1 trillion this fiscal year—has the potential to seriously damage the national economy and threaten the ability of businesses to compete in the global marketplace.

Policy makers must answer the fundamental question at the heart of the deficit issue: What is the right size of our government?

“If we confront this [economic] crisis without also confronting the deficits that helped cause it, we risk sinking into another crisis down the road,” cautioned President Obama at the Fiscal Responsibility Summit that he convened in February, a week after signing into law the American Recovery and Reinvestment Act of 2009 (the 2009 Recovery Act), which is intended to stimulate short-term economic growth.

A warning may have been sounded, but is anyone listening? Or will the president’s caution about growing deficits serve as a call to action before a new crisis erupts? While delaying action would be convenient, it would also be shortsighted. The budget was on an unsustainable path well before the current economic crisis. The real culprit? The government’s future spending commitments. Current and projected revenues simply will not be sufficient to keep up with the expected growth in spending for Medicare, Medicaid, Social Security, and other federal programs. (See Figure 1.)

Figure 1: Gap between growth in federal spending and revenue, 1962–2082
Chart: Gap between growth in federal spending and revenue, 1962–2082
Note: 2007 to 2082 are projections under CBO’s Alternative Fiscal Scenario.
Source: Long-Term Budget Outlook, CBO, December 2007, and supplementary data from CBO


The longer policy makers wait to address the situation, the larger the fiscal gap will become and the more difficult it will be to take corrective action. For example, if government spending stays on the current growth path and if steps to reduce the deficit are not taken until 2020, a permanent reduction in federal spending or increase in taxes of 9 percent of gross domestic product (GDP) will be needed. This is equivalent to eliminating 43 percent of all noninterest federal spending or increasing tax revenue by 49 percent.1 (See Figure 2.)

Figure 2: Spending reduction or tax increase needed to close the fiscal gap Chart: Spending reduction or tax increase needed to close the fiscal gap
Note: The fiscal gap is a measure of federal shortfalls over a given period. It represents the extent to which the government would immediately and permanently need to either raise tax revenues, reduce spending, or do both to make the government’s debt the same size (in relation to the economy) at the end of that period as it was at the beginning. Projections represent CBO’s Alternative Fiscal Scenario.
Source: Congressional Budget Office


President Obama, like President George W. Bush before him, has pledged to cut the deficit in half by the end of his first term. Yet to facilitate such a substantial reduction, policy makers must answer the fundamental question at the heart of the deficit issue: What is the right size of our government? To answer that question, policy makers must balance the desire for additional federal spending against the costs of higher taxes imposed on our society. Those costs include not only the higher taxes borne by our citizens and businesses but also the increase in distortionary costs of taxation that reduce economic growth and lower pretax incomes. The decision over the size of government is as much a decision about the appropriate level of taxes as it is a decision about the appropriate level of spending, since the two must be in balance over time. Such balancing requires tough choices and trade-offs as to what government can fund—social programs, defense spending, or international aid, for example—given limited means.

Every country and every society will answer the right-size question differently. Even within the advanced economies of the Organisation for Economic Co-operation and Development (OECD), there is a wide range of government spending as a share of the economy. In 2006, general government expenditures as a share of GDP ranged from 18.7 percent to 52.5 percent among 29 OECD countries. (See Figure 3.) Within such spending categories as public social expenditures, which include health, retirement, and income support programs, there is similar large variation in spending across countries. The point of such an exercise is to underscore that each country is unique and that the size of the US government and its sustaining revenue should be a well-informed choice, consistent with the values and principles of our country.

Figure 3: Government spending by select OECD countries, 2006

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1 Data are for 2004.
2 Data are for 2005.
Source: OECD, “National Accounts of OECD Countries, Volume IV, General Government Accounts, 1996-2007,” except Mexico GDP, which is from OECD, “National Accounts of OECD Countries, Volume I, Main Aggregates, 1994-2006”

Given the large future imbalances between spending and taxes if we stay on the current path, one way to address the right-size question is to examine, first, whether there are ways policy makers can reduce the growth in spending and, second, the capacity of the economy to bear higher taxes. If neither approach alone is sufficient to bring spending and taxes into balance, policy makers will need to seek a solution calling for both reduced spending and higher taxes.