Prime Numbers: Deficit Cuts A Priority for Americans

The federal budget deficit—and how to deal with it—is increasingly on the minds of Americans. In a recent NBC News/Wall Street Journal poll, people ranked Washington’s red ink as their second most important priority behind job creation. The deficit was the only issue increasing in importance since January. National security, health care, wars, and even jobs declined in importance. In July, 70 percent of people surveyed by the Pew Research Center said deficit reduction was “very important,” and 51 percent said cutting the deficit was a higher priority for them than either lowering taxes or boosting spending to spur the economy.

The shift in the national mindset on the federal debt comes at a tricky time for the U.S. economy. Debate is picking up again over the need for even more deficit-boosting stimulus to help keep the recovery on track. In his July 21 testimony before Congress, Federal Reserve Chairman Ben Bernanke said that in the short term it was important to maintain a “reasonable degree” of stimulus for the economy. However, he also warned, “We need to be taking steps to reassure the American people and the markets that our fiscal situation is going to be well controlled.”

In its Mid-Session Budget Review, released Friday, the Office of Management and Budget projected a deficit of $1.47 trillion, or 10 percent of GDP, for fiscal 2010, ending Sept. 30. That’s down slightly from $1.56 trillion forecast back in February, but up from $1.41 trillion in fiscal 2009. OMB shows the deficit narrowing to $1.42 trillion in 2011, about $150 billion higher than previously projected.

By 2013, the gap will slip to $736 billion, or 4.3 percent of GDP. To get there, the White House forecasts additional revenues from an economy growing 3.8 percent per year between 2009 and 2013. That’s a solid pace, but it’s no sure thing, as many private forecasters are lowering their growth forecasts for the next several quarters.

Deficit hawks argue that more stimulus would risk a sudden change in market attitudes, especially fears of higher interest rates, that could end up hurting the economy more than the extra stimulus would help. At the same time, any significant efforts to pare the budget gap, via tax hikes or spending cuts, would put the fragile economic recovery at risk.
 
President Obama recently pointed out that based on a 2010 deficit of $1.47 trillion and outlays of $3.60 trillion, 41 cents of every federal dollar spent is borrowed. But he is caught squarely in the middle, especially with the November elections approaching. Another Pew survey shows that 56 percent of respondents disapprove of the way Obama is handling the deficit issue, while only 35 percent approve. Obama’s promise to cut the budget gap in half by 2013 will do nothing to solve the unsustainable long-term situation.

What happens to the Bush Administration’s 2001 and 2003 tax cuts, set to expire Dec. 31, will play a big role in the deficit outlook. Obama has proposed allowing the Bush tax cuts to sunset only for single filers earning above $200,000 per year, and above $250,000 for joint filers, while retaining current tax rates for those below that threshold. The waning effect of last year’s stimulus package is already set to exert a drag on growth in 2011, and any net tax increases resulting from these plans will be an added weight, especially since high income earners account for 30 percent of consumer spending.

Based on Obama’s plans, J.P. Morgan Chase economist Michael Feroli estimates that higher tax rates on high-income individuals plus other likely changes, such as a phasing out of personal exemptions, limits on itemized deductions, and a higher rate on dividends and capital gains, would increase individual income taxes by about $75 billion, which would cut consumer spending by an estimated $60 billion.

Feroli admits there is much uncertainty surrounding the size and timing of any impact.  But if that reduction in spending occurred over two quarters, he says, it could reduce annualized GDP growth by 1.6 percent. Allowing the Bush tax cuts to expire across the board, as current law demands, could knock some $184 billion from spending over two quarters, a hit of 5 percent on annualized GDP growth.

Of course, any short-term deficit relief from new taxes and economic growth is merely nipping around the edges of the real problem, the long-run structural budget imbalance built into current policy, as outlined in the non-partisan Congressional Budget Office’s update of the Long-Term Budget Outlook. Under the CBO’s 25-year scenario, which includes several changes to current law that are widely expected, publicly-held federal debt as a percentage of GDP will grow to 87 percent in the next ten years, from 53 percent in 2009. In 15 years, it will reach the historical peak of 109 percent hit during World War II, and then shoot up to 185 percent in 25 years.

A 2003 Federal Reserve study showed that each percentage point rise in the ratio of federal debt to GDP lifted long-term interest rates by four basis points, or 0.04 percent. Applying that relationship to the CBO’s projections implies that borrowing costs ten years from now would be 1.4 percentage points higher than they would be at the 2009 debt-to-GDP level.

Although financial markets so far have not recoiled over these dire projections, growing deficits eventually will matter, as the CBO report warned. Big deficits rob national savings, pushing up interest rates and crimping private investment, which eats into economic growth. They limit the government’s ability to respond to recessions, and can erode investors’ confidence in the government’s fiscal responsibility.

Poll results suggest that investors and taxpayers want to see, at least, an exit strategy from the current unsustainable path of federal debt. The President’s National Commission on Fiscal Responsibility and Reform is charged with coming up with a plan by Dec. 1 to both stabilize the deficit by 2015 and cut federal debt over the long term. However, any recommendations require agreement among 14 of the Commission’s 10 Democrats and 8 Republicans. Given the panel’s deep differences, any consensus will very difficult to reach.