[Economic Report of the President (2010)]
[Administration of Barack H. Obama]
[Online through the Government Printing Office, www.gpo.gov]

 
CHAPTER 5

ADDRESSING THE LONG-RUN
FISCAL CHALLENGE

After several years of budget surpluses, the Federal Government
began running consistent, substantial deficits in the 2002 fiscal
year. Because the deficits absorbed a significant portion of
private saving, they were one reason that the economic expansion
of the 2000s was led by consumption and foreign borrowing rather
than investment and net exports. More troubling than the deficits
of the recent past, however, is the long-term fiscal outlook the
Administration inherited. Even before the increased spending
necessary to rescue and stabilize the economy, the policy choices
of the previous eight years and projected increases in spending
on health care and Social Security had already put the government
on a path of rising deficits and debt. Thus, a key step in
rebalancing the economy and restoring its long-run health
must be putting fiscal policy on a sound, sustainable footing.

This chapter discusses the fiscal challenges the Administration
inherited, the dangers posed by large and growing deficits, and the
Administration's measures and plans for addressing these challenges.
The Administration and Congress are already taking important steps,
most notably through their efforts toward comprehensive health
care reform. The legislation currently under consideration addresses
rapidly rising health care costs, which are one of the central
drivers of the long-run fiscal problem. The fiscal problem is
multifaceted, however, and was decades in the making. As a result,
no single step can fully address it. Much work remains, and
bipartisan cooperation will be essential.

The Long-Run Fiscal Challenge

When President Obama took office in January 2009, fiscal policy was
on a deteriorating course. Figure 5-1 shows the grim outlook for the
budget projected by the Congressional Budget Office (CBO) under the
assumption that the policies then in effect would be continued.\1\ As
the figure makes clear, the budget was on an unsustainable trajectory.
_____________________
\1\This figure presents the CBO January 2009 baseline budget outlook
through 2019, adjusted to reflect CBO's estimates of the cost of
extending expiring tax provisions including the 2001 and 2003 tax
cuts and indexing the Alternative Minimum Tax (AMT) for inflation,
reducing the number of troops in Iraq and Afghanistan to 75,000 by
2013, modifying Medicare's "sustainable growth rate" formula to
avoid scheduled cuts in physician payment rates, holding other
discretionary outlays constant as a share of gross domestic product,
and the added interest costs resulting from these adjustments
(Congressional Budget Office 2009a). After 2019, the figure presents
CBO's June 2009 Long-Term Budget Outlook alternative fiscal scenario,
which also reflects the costs of continuing these policies
(Congressional Budget Office 2009f).




The figure shows that CBO projected that the deficit would be
severely affected in the short run by the economic crisis. The
decline in output was projected to send tax revenues plummeting and
spending for unemployment insurance, nutritional assistance, and other
safety net programs soaring. As a result, the deficit was projected to
spike to 9 percent of gross domestic product (GDP) in 2009 before
falling as the economy recovered. It is natural for revenues to
decline and government spending to rise during a recession. Indeed,
these movements both mitigate the recession and cushion its impact
on ordinary Americans.


The key message of the figure, however, concerns the path of the
deficit after the economy's projected recovery from the recession. The
deficit was projected to fall to close to 4 percent of GDP in 2012 as
the economy recovers, but then to reverse course, rising steadily by
about 1 percent of GDP every two years. Figure 5-2 shows that if that
path were followed, the ratio of the government's debt to GDP would
surpass its level at the end of World War II within 20 years, and
would continue growing rapidly thereafter. At some point along such a
path, investors would no longer be willing to hold the government's
debt at any reasonable interest rate. Thus, such a path is not
feasible indefinitely.




Sources of the Long-Run Fiscal Challenge

The challenging long-run budget outlook the Administration inherited
has two primary causes: the policy choices of the previous eight
years and projected rising spending on Medicare, Medicaid, and
Social Security. The policy choices under the previous administration
contribute a substantial amount to the high projected deficits as a
share of GDP, while rising spending for health care and Social
Security is the main reason the deficits are projected to balloon
overtime. Both make large contributions to the difficult fiscal
outlook.
The previous policy choices involved both spending and revenues. On
the spending side, two decisions were particularly important. One was
the failure to pay for the addition of a prescription drug benefit to
Medicare, which is estimated to increase annual deficits over the next
decade by an average of one-third of a percent of GDP, excluding
interest, and more than that in the years thereafter (Congressional
Budget Office 2009g; Council of Economic Advisers estimates). The
other was the decision to fight two wars without taking any steps to
pay for the costs-costs that so far have come close to $1 trillion.
On the revenue side, the most important decisions were those that
lowered taxes without making offsetting spending cuts. In particular,
the 2001 and 2003 tax cuts have helped push revenues to their lowest
level as a fraction of GDP at any point since 1950 (Office of
Management and Budget 2010).
Figure 5-3 shows the impact on the budget deficit of these three
major policies of the previous eight years that were not paid for:
the 2001 and 2003 tax cuts (including the increased cost of
Alternative Minimum Tax relief as a result of those tax cuts), the
prescription drug benefit, and the spending for the wars in Iraq and
Afghanistan (which for this analysis are assumed to wind down by
2013), both with and without the interest expense of financing these
policies.\2\ At their peak in 2007 and 2008, these policies worsened
the government's fiscal position by almost 4 percent of GDP, and
their effect, including interest, rises above 4 percent of GDP into
the indefinite future. The fiscal outlook would be far better if
these policies had been paid for. Indeed, Auerbach and Gale (2009)
conclude that roughly half of the long-run fiscal shortfall in the
outlook described earlier results from policy decisions made from
2001 to 2008.
_____________________
\2\The figure shows the annual cost (as a percent of GDP) of
supplemental military expenditures for operations in Iraq and
Afghanistan through 2009 and CBO's estimate of the cost of reducing
the number of troops in Iraq and Afghanistan to 75,000 by 2013
thereafter; the cost of the Medicare Part D program net of offsetting
receipts and Medicaid savings; the cost of the 2001 and 2003 tax cuts
plus the additional cost of AMT relief associated with those tax
cuts, as estimated by CBO; and the interest expense of financing
these policies.

The other main source of the long-run fiscal challenge is rising
spending on Medicare, Medicaid, and Social Security. These burdens
stem primarily from the rapid escalation of health care costs,
combined with the aging of the population. Annual age-adjusted
health care costs per Medicare enrollee grew 2.3 percentage points
faster than the increase in per capita GDP from 1975 to 2007. If
this rate of increase were to continue, Federal spending on Medicare
and Medicaid alone would approach 40 percent of the Nation's income
in 2085, which is clearly not sustainable





(Congressional Budget Office 2009f). In addition, as a result of
decreases in fertility and increases in longevity, the ratio of
Social Security and Medicare beneficiaries to workers is rising,
straining the financing of these programs.
Figure 5-4 projects the growth in spending in Medicare, Medicaid,
and Social Security. Spending on the programs is projected to double
as a share of GDP by 2050. Over the next 20 years, demographics - the
retirement of the baby boom generation - is the larger cause of rising
spending. But throughout, rising health care costs contribute to
rising spending, and over the long term, they are by far the larger
contributor to the deficit.
Other important factors have also contributed to the increase in
entitlement spending. For example, the fraction of non-elderly adults
receiving Social Security Disability Insurance (SSDI) benefits has
approximately doubled since the mid-1980s, and the fraction of Social
Security spending accounted for by SSDI benefits has increased from
10 to 17 percent. Beneficiaries of SSDI are also eligible for health
insurance through Medicare. Total cash benefits paid to SSDI
recipients were $106 billion in 2008 and an additional $63 billion
was spent on their health care through Medicare. One contributor to
the increase in disability enrollment was a 1984 change in the
program's medical eligibility criteria, which allowed more applicants
to qualify for benefits in subsequent years (Autor and Duggan 2006).




The potential challenges to the budget from these three entitlement
programs have been clear for decades. Yet, policymakers in previous
administrations did little to address them. For example, in October
2000, CBO warned that spending on Medicare, Medicaid, and Social
Security would more than double, rising from 7.5 percent of GDP in
1999 to over 16.7 percent in 2040; nine years later, their forecast
for spending on these programs remains virtually unchanged
(Congressional Budget Office 2000, 2009f).
All told, the Obama Administration inherited a very different
budget outlook from the one left to the previous administration.
Figure 5-5 compares the budget forecast in January 2001
(Congressional Budget Office 2001) with the budget outlook in
January 2009 described above.\3\ In 2001, CBO forecast a relatively
bright fiscal future. After a decade of strong growth and
responsible fiscal policy, the budget was substantially in surplus,
and CBO analysts projected rising surpluses over the next decade,
even under their more pessimistic policy alternatives. Rising health
care costs would squeeze the budget only over the long term, and the
retirement of the baby boom generation was still more than a decade
away. The intervening time could have been used to pay off the
national debt and accumulate
_____________________
\3\The 2001 forecast includes the January 2001 baseline forecast
adjusted to reflect CBO's estimated cost of holding nondiscretionary
outlays constant as a share of nominal GDP. Starting in 2012,the
deficit evolves according to the intermediate projection in the
October 2000 Long-Term Budget Outlook (Congressional Budget Office
2000).

substantial assets in preparation. But policymakers chose a
different path. They enacted policies that added trillions to the
national debt and doubled the size of the long-run problem. Combined
with a deteriorating economic forecast and technical reestimates,
the result was a much worse budget outlook in January 2009 than in
January 2001.





The Role of the Recovery Act and Other Rescue Operations

One development that has had an important effect on the short-term
budget outlook since January 2009 is the aggressive action the
Administration and Congress have taken to combat the recession. By
far the most important component of the response in terms of the
budget is the American Recovery and Reinvestment Act of 2009. The
Recovery Act cuts taxes and increases spending by about 2 percent of
GDP in calendar year 2009 and by 2 1/4 percent of GDP in 2010.
Crucially, however, the budgetary impact of the Recovery Act will
fade rapidly. As a result, it is at most a very small part of the
long-run fiscal shortfall. By 2012, the tax cuts and spending under
the Recovery Act will be less than one-third of 1 percent of GDP.
Other rescue measures, such as extensions of programs providing
additional support to those most directly affected by the recession,
also contribute to the deficit in the short run. But these programs
are much smaller than the Recovery Act. And like the Recovery Act,
their budgetary impact will fade quickly.
Figure 5-6 shows the overall budgetary impact of the Recovery Act
and other rescue measures, including interest on the additional debt
from the higher short-run deficits resulting from the measures. The
impact is substantial in 2009 and 2010 but then fades rapidly to
about one-quarter of 1 percent of GDP. Moreover, because these
estimates do not include the effects of the rescue measures in
mitigating the downturn and speeding recovery - and thus raising
incomes and tax revenues - they surely overstate the measures'
impact on the budget outlook.





An Anchor for Fiscal Policy

The trajectory for fiscal policy that the Administration inherited,
with budget deficits and government debt growing relative to the size
of the economy, is clearly untenable. Change is essential. But there
are many alternatives to the trajectory the Administration inherited.
In thinking about what path fiscal policy should attempt to follow,
it is therefore important to examine how deficits affect the economy
and what policy paths are feasible.

The Effects of Budget Deficits

Two factors are critical in shaping the economic effects of budget
deficits: the state of the economy, and the size and duration of the
deficits. Consider first the state of the economy. A central lesson of
macroeconomics is that in an economy operating below capacity, higher
deficits raise output and employment. Transfer payments (such as
unemployment benefits) and tax cuts encourage private consumption and
investment spending. Government investments and other purchases
contribute to higher output and employment directly and, by raising
incomes, also encourage further private spending.
In the current situation, as discussed in Chapter 2, monetary
policymakers are constrained because nominal interest rates cannot be
lowered below zero, and so they are unlikely to raise interest rates
quickly in response to fiscal expansion. As a result, the fiscal
expansion attributable to the Recovery Act is likely to increase
private investment as well as private consumption and government
purchases. Finally, in a precarious environment like the one of the
past year, expansionary fiscal policy may make the difference between
an economy spiraling into depression and one embarking on a self-
sustaining recovery, and so have a dramatic impact on outcomes. As
described more fully in Chapter 2, these benefits of fiscal
expansion were precisely the motivation for the Administration's
pursuit of the Recovery Act and other stimulus policies over the
past year.
When the economy is operating at normal capacity, the effects of
higher budget deficits are very different. In such a setting, the
stimulus from deficits leads not to higher output, but only (perhaps
after a delay) to a change in the composition of output. To finance
its deficits, the government must borrow money, competing against
businesses and individuals seeking to finance new productive
investments. As a result, deficits drive up interest rates,
discouraging private investment. Hence, deficit spending diverts
resources that would otherwise be invested in productive private
capital - new business investments in plant, equipment, machinery, and
software,or investments in human capital through education and training -
into government purchases or private consumption. To the extent that
the private investments nonetheless occur but are financed by
borrowing from abroad, the country has the benefit of the capital, but
at the cost of increased foreign indebtedness. The result is that
Americans' claims on future output are lower.
In sum, in normal times, higher budget deficits impede the
rebalancing of output toward investment and net exports described
in Chapter 4; lower deficits contribute to that rebalancing. In
addition, budget deficits were one source of the "global imbalances"
discussed in Chapter 3 that have been implicated by some analysts as
part of the cause of the financial and economic crisis. Finally,
higher budget deficits and the higherl evels of debt they imply may
reduce policymakers' ability to turn to expansionary fiscal policy in
the event of a crisis.
Although determining the impact of large budget deficits on capital
formation and interest rates is a difficult and contentious issue, the
bulk of the evidence points to important effects. For example, several
studies find that increases in projected deficits raise interest rates
(Wachtel and Young 1987; Engen and Hubbard 2005; Laubach 2009). A
careful review concludes that the weight of the evidence indicates
that budget deficits raise interest rates moderately (Gale and Orszag
2003). Examining the international evidence, another study reaches a
similar conclusion (Ardagna, Caselli, and Lane 2007).
The economic impact of budget deficits depends not only on the
condition of the economy but also on their magnitude and persistence.
A moderate period of large deficits in a weak economy will speed
recovery in the short run and leave the government with only modestly
higher debt in the long run. Even in an economy operating at capacity,
a temporary period of high deficits is manageable, as the experience
of World War II shows compellingly. Once full employment was reached,
the high wartime spending surely crowded out investment and thus
caused standards of living after the war to be lower than they
otherwise would have been. But that cost aside, the enormous temporary
deficits that reached 30 percent of GDP at the peak of the war created
no long-run problems.
In contrast, the effects of large deficits and debt that grow
indefinitely and without bound relative to the size of the economy are
very different - and potentially very dangerous. If a government tried
to follow such a path, eventually its debt would exceed the amount
investors were willing to hold at a reasonable interest rate. At that
point, the situation would spiral out of control. Rising interest
costs would worsen the fiscal situation; this would further reduce
investors' willingness to hold the government's debt, raising
interest costs further; and soon. Eventually,investors would be
unwilling to hold the debt at any interest rate.

Feasible Long-Run Fiscal Policies

Investors have no qualms about holding some government debt. Indeed,
many desire the safety of such an investment. And crucially, in an
economy in which private incomes and wealth, as well as the
government's tax base, are growing, the amount of debt investors are
willing to hold also grows. Thus, the key to a sustainable deficit
path is a fiscal policy that keeps the level of debt relative to the
scale of the economy at levels where investors are willing to hold
that debt at a reasonable interest rate. Most obviously, paths where
the ratio of the deficit to GDP and the ratio of the debt to GDP grow
without bound cannot be sustained. Equally, however, paths that would
lead the debt-to-GDP ratio to stabilize, but at an extremely high
level, are also not feasible.
Historical and international comparisons, as well as the very
favorable terms on which investors are currently willing to lend to
the United States, show that the Nation is not close to such
problematic levels of indebtedness. In 2007, before the recession, the
debt held by the public was 37 percent of nominal GDP. In 2015,
because of the direct effects of the recession and, to a lesser
extent, the fiscal stimulus, the President's budget projects the
public debt (net of financial assets held by the government) will be
65 percent of GDP. By comparison, it was 113 percent of GDP at the end
of World War II; in the United Kingdom, the ratio at the end of World
War II was over 250 percent. Table 5-1 shows the projected 2010
government debt-to-GDP ratio (including state and local government
debt) for a wide range of developed countries. Japan's debt-to-GDP
ratio is 105 percent, Italy's is 101 percent, and Belgium's is 85
percent, and all of these are projected to rise. None of these
countries enjoys the same depth and breadth of demand for its debt as
the United States does, yet none has difficulty financing its debt.
Thus, although it is hard to know the exact U.S. debt-to-GDP ratio
that would begin to pose problems, it is clearly well above current
levels.





The Choice of a Fiscal Anchor

It is essential that the United States follow a fiscal policy that
stabilizes the debt-to-GDP ratio at a feasible level. In thinking
about the specific level of that ratio that policymakers should aim
for, it is useful to think about the implications that different
levels of the budget deficit have for the level of government debt in
the long run. In particular, consider paths where the deficit as a
percent of GDP stabilizes at some level. If the deficit-to-GDP ratio
and the growth rate of nominal GDP are both steady, the debt-to-
GDP ratio will settle down to the ratio of the deficit-to-GDP ratio
to the growth rate of nominal GDP.\4\ For example, if the deficit
is 1 percent of GDP and nominal GDP is growing at 5 percent per
year, the debt-to-GDP ratio will stabilize at 20 percent. Similarly,
if the deficit-to-GDP ratio and the growth rate of nominal GDP are
both 4 percent, the debt-to-GDP ratio will stabilize at 100 percent.
Instead of thinking about various possible long run targets for the
debt-to-GDP ratio, policymakers can consider possible targets for the
deficit-to-GDP ratio and their accompanying implications for the
long-run debt-to-GDP ratio.
_____________________
\4\To see this, consider the case where the deficit-to-GDP ratio equals
the growth rate of GDP. Then the dollar amount of debt issued in a
year (that is, the deficit) equals the dollar increase in GDP. If the
debt-to-GDP ratio is 100 percent - the amount of debt outstanding equals
GDP - then the percent increase in debt exactly equals the percent
increase in GDP, and the debt-to-GDP ratio holds steady at 100
percent. If, however, the amount of debt outstanding is less than
nominal GDP, then adding a dollar to the debt results in a larger
percentage increase in the debt than does a dollar added to GDP.
Hence, the debt-to-GDP ratio will rise. If the amount of debt
outstanding is more than nominal GDP, then the percent increase in
debt is smaller than the percent increase in GDP and the debt-to-GDP
ratio falls. Thus, the debt-to-GDP ratio converges to the ratio of the
deficit-to-GDP ratio to the growth rate of GDP, which in this case is
100 percent.

The choice among different deficit-to-GDP ratios involves tradeoffs.
Lower deficits, and thus lower debt in the long run, have obvious
advantages: a higher capital stock, lower foreign indebtedness,
smaller global imbalances, and more fiscal room to maneuver. But lower
deficits have disadvantages as well. They require smaller government
programs, higher taxes, or both. Because Medicare, Medicaid, and
Social Security will grow faster than GDP in coming decades even after
the best efforts to make those programs as efficient as possible,
significant cuts in government spending would impose substantial
costs. And higher taxes can reduce incentives to work, save, and
invest.
Based on these considerations, the Administration believes that an
appropriate medium-run goal is to balance the primary budget - the
budget excluding interest payments on the debt. Including interest
payments, this target will result in total deficits of approximately 3
percent of GDP. With real GDP growth of about 2.5 percent per year and
inflation of about 2 percent per year, nominal GDP growth will be about
4.5 percent per year in the long run. Thus a target for the total
deficit-to-GDP ratio of 3 percent implies that the debt-to-GDP ratio
will stabilize at less than 70 percent. Because the debt-to-GDP ratio
is projected to rise to about 65 percent in a few years, such a target
implies that the debt-to-GDP ratio will change little once the economy
has recovered from the current recession. A debt-to-GDP ratio of
around two-thirds is comfortably within the range of historical and
international experience. It represents substantial fiscal discipline
relative to  the trajectory the Administration inherited. Stabilizing
the ratio rather than continuing on a path where it is continually
growing is imperative, and stabilizing it at around its post-crisis
level has considerable benefits and is a natural focal point.


Reaching the Fiscal Target

Bringing the primary budget into balance and keepingit there will not
be easy. Noninterest spending outstrips tax revenues by a large margin
in the budget inherited by the Administration. More importantly, the
trajectory of policy implied that spending would continue to exceed
revenues even after the economy had recovered and that the deficit
would rise steadily for decades to come. The economic developments
and policy decisions that put fiscal policy on that course took place
over many years. Thus, moving policy back onto a sound path will not
happen all at once.

General Principles

In broad terms, the right way to tackle the long-run fiscal problem is
not through a sharp, immediate fiscal contraction, but through
policies that steadily address the underlying drivers of deficits over
time. Large spending cuts or tax increases are exactly the wrong
medicine for an economy with high unemployment and considerable unused
capacity: just as fiscal stimulus raises income and employment in such
an environment, mistimed attempts at fiscal discipline have the
opposite effects. Any short-run fiscal contraction can best be
tolerated at a time when the Federal Reserve is no longer constrained
by the zero bound on nominal interest rates, and so has the tools to
counteract any contractionary macroeconomic impacts.
The dangers of a large immediate contraction are powerfully
illustrated by America's experience in the Great Depression. In 1937,
after four years of very rapid growth but with the economy still far
from fully recovered, both fiscal and monetary policy turned sharply
contractionary: the veterans' bonus program of the previous year was
discontinued, Social Security taxes were collected for the first time,
and the Federal Reserve doubled reserve requirements. The consequences
of this premature policy tightening were devastating: real GDP fell
by 3 percent in 1938, unemployment spiked from 14 percent to 19
percent, and the strong recovery was cut short.
The impact of actions taken today to gradually bring the long-run
sources of the deficit problem under control would be very different.
Such policies do not involve a sharp short-run contraction that could
derail a nascent recovery. Because the effects cumulate over time,
however, they can have a large effect on the long-term fiscal outlook.
Policies that provide gradual but permanent and growing deficit
reduction have another potential advantage. By improving the outlook
for the long-term performance of the economy, they can improve
business and consumer confidence today. As a result, deficit-improving
policies whose effects are felt mainly in the future can actually
boost the economy in the short run. There is considerable evidence
that such "expansionary fiscal contractions" are not just a
theoretical possibility (see, for example, Giavazzi and Pagano 1990;
Alesina and Perotti 1997; Romer and Romer forthcoming).
In keeping with these general considerations, the Administration is
taking actions in three important areas that will have a material
impact on the deficit in the medium and long terms.

Comprehensive Health Care Reform

The first and single most important step toward improving the
country's long-run fiscal prospects is the enactment of
comprehensive health care reform that will slow the growth rate of
costs. Beyond the obvious importance for Americans' well-being and
economic security, the health reform legislation being considered by
Congress would save money. The rapid growth of health care costs is
a central source of the country's fiscal difficulties. CBO has
estimated that both the bill passed by the House in November 2009
and the bill passed by the Senate in December 2009 would
significantly reduce the deficit over the next decade (Congressional
Budget Office 2009e, 2009d). But the more important factor for the
long-run fiscal situation is that, as discussed in more detail in
Chapter 7, the bills contain crucial measures that experts believe
will lead to lower growth in costs while expanding access to
coverage, increasing affordability, and improving quality. Given
the central role of rising health costs in the long-run deficit
projections, these measures would therefore lead to substantial
improvements in the budget situation over time.
In November 2009, CBO's analysis of the Senate health care bill
found that "Medicare spending under the bill would increase at an
average annual rate of roughly 6 percent during the next two decades -
well below the roughly 8 percent annual growth rate of the past two
decades" (Congressional Budget Office 2009c). In December, the
Council of Economic Advisers estimated that the fundamental health
care reform in the Senate bill would reduce the annual growth rate of
Medicare and Medicaid costs by a full percentage point below what it
would otherwise be in the coming decade, and by even more in the
following decade (Council of Economic Advisers 2009b). These
reductions reflect specific measures directed at identifiable
sources of wasteful spending and fraud combined with institutional
reforms that will help counter the forces leading to excessive cost
growth.
Such a reduction in the growth rate of health care costs would have a
more profound effect on the long-run fiscal situation of the country
than virtually any other fiscal decision being contemplated today.
Even if the slowdown in cost growth held steady at 1 percentage point
annually rather than rising in the second decade, it would reduce the
budget deficit in 2030 by about 2 percent of GDP relative to what it
otherwise would be. In today's terms, this is equivalent to almost
$300 billion per year. Most of these savings reflect the direct impact
of lower health care costs on Federal spending. To the extent that
health care reform also slows the growth of private sector health
insurance costs, which are tax preferred, employees in the private
sector will benefit from higher wages and the Treasury from increased
revenues; this becomes a second source of budget savings. And these
direct savings are magnified by lower interest costs resulting from
the reduced debt accumulation in the years preceding 2030 (Council of
Economic Advisers 2009a). The need to expand coverage would reduce the
overall impact of health care reform on the budget deficit somewhat.
However, these costs of expansion would be more than offset even
within the coming decade. Thereafter, reform will lower the deficit by
increasing amounts over time.

Restoring Balance to the Tax Code

The second major step the Administration is taking to address the
long-run fiscal challenge is restoring balance to the tax code that
has been lost since 2001. The 2001 and 2003 tax cuts
disproportionately favored wealthy taxpayers. According to estimates
from the Urban-Brookings Tax Policy Center (2010), in 2010 the 2001
and 2003 tax cuts will increase the after-tax income of the poorest 20
percent of the population by 0.5 percent (about $51), the middle 20
percent by 2.6 percent ($1,023), and the top 1 percent by 6.7 percent
($72,910). About 67 percent of the tax cuts went to the top 20 percent
of taxpayers, and 26 percent to the top 1 percent. These tax cuts
for the wealthiest Americans took place when the incomes of ordinary
Americans were stagnating and inequality was reaching almost
unprecedented levels. In other words, the tax cuts
exacerbated the broader trend rather than mitigated it.
The President has consistently maintained that the tax cuts went too
far in cutting taxes for people making more than $250,000 per year and
that the country could not afford the tax breaks given to that group
over the past eight years. That is why one important plank of his
fiscal responsibility framework is to rebalance the tax code, so that
it is similar to what existed in the late 1990s for those making more
than $250,000 per year. Specifically, the Administration has proposed
letting the marginal tax rates on ordinary income and capital gains
for people making more than $250,000 per year return to the levels
they were in 2000. It has also proposed setting the tax rate on
dividends for high-income taxpayers to the same 20 percent rate that
would apply to capital gains - which is lower than the rate in the
1990s - and letting all other features of the 2001 and 2003 tax cuts
expire for these taxpayers. In addition, it has proposed limiting the
rate of deductions for high-income taxpayers to 28 percent, so that
the wealthy do not obtain proportionately larger benefits from their
deductions than other Americans do. None of these changes would take
effect until 2011, so they would not affect disposable incomes as the
economy recovers in 2010. Nonetheless, they would raise nearly $1
trillion over the next 10 years and even more over the longer run.
Equivalently, they would reduce the budget deficit by more than 0.5
percent of GDP in the medium run and somewhat more over time.
As just discussed, most of these changes would merely bring the tax
rates on high-income taxpayers back to their levels in the 1990s. To
the extent that some go further, on balance they are more than offset
by the fact that some common types of income - dividends, for
example - will have rates significantly lower than in the 1990s.
Looking at tax policy over U.S. postwar history more broadly shows
even more clearly how moderate the proposed changes are. Figure 5-7
shows the top marginal tax rates on ordinary income and capital gains
over time and their levels under the Administration's proposals. For
ordinary income, a top rate of 39.6 percent, while higher than in the
past eight years, is not high compared with the rates that prevailed
during most of the past several decades and even during most of the
Reagan administration. For capital gains, the 20 percent rate is
lower than in many previous periods and is certainly not unusual.
And for dividends, the 20 percent rate proposed by the
Administration would be lower than under any other modern president
save the last.



Statutory marginal tax rates, however, provide only a partial picture of
how the progressivity of the tax system has changed over time. The
number of tax brackets has declined and the thresholds at which
statutory bracket rates apply have changed; different sources of
income, such as capital gains and dividends, are now treated
differently in the tax code and taxed at lower rates; and exemption
amounts and standard deductions have been adjusted. Moreover, the
distribution of income across taxpayers and the composition
of taxpayers' sources of income have changed significantly overtime,
making it difficult to disentangle the effects of statutory changes
in the tax system from economic changes. To illustrate the impact of
historical statutory tax changes in isolation, Figure 5-8 applies
the tax rates for each year from 1960 to 2008 to a sample of taxpayers
who filed returns in 2005, after adjusting for average wage growth.\5\
The purpose is to show both how current taxpayers
_____________________
\5\Average tax rates are calculated for nondependent, nonseparated
filers with positive adjusted gross income in tax year 2005. Dollar
figures are adjusted to the appropriate tax year using the Social
Security Administration national average wage index (Social Security
Administration 2009), and the tax due is estimated using the National
Bureau of Economic Research's TAXSIM tax model. This tax model
incorporates the major tax provisions affecting the vast majority of
taxpayers and taxable income, and provides estimates of tax
liabilities that closely match the historical distribution of taxes
actually paid. However, the tax calculation ignores certain small tax
provisions and certain accounting changes that broadened the
definition of taxable income over time.



would have fared under the tax rates that applied historically and how
the tax rates that applied to different income groups have changed
over time.
This analysis suggests that the effective tax rates that applied to
high-income taxpayers reached their lowestlevels inat least half a
centuryin 2008. Under the tax laws that applied from 1960 to the
mid-1980s, today's taxpayers earning more than $250,000 would have
paid an average of around 30 percent of their income in Federal
income and payroll taxes, with modest variations from year to year.
Moreover, while the tax rates that applied to these "ordinary" rich
have fallen considerably, tax rates for the very rich have declined
much more. Figure 5-8 shows that taxpayers whose real incomes put
them in the top 0.1 percent of taxpayers today - the one-in-a-
thousand taxpayers with incomes above about $2 million in 2009
dollars - would have paid more than 50 percent of their incomes in
taxes in the early 1960s.
Average tax rates on high-income groups fell precipitously in the
mid-1980s, with the sharp decline in statutory marginal rates. At the
same time, the tax rates that would have applied to today's middle-
income taxpayers (the middle 20 percent of taxpayers in 2005,those
making between about $29,500 and $49,500 per year) increased, on
balance, over the last half century. The result is a compression in
the tax burdens applied to taxpayers with different incomes - the
difference between the average tax rates on high-income groups and
those on middle-class households is narrower than at any other time
in modern history. All told, because of legislative changes in the
tax code, the after-tax income of the very-high-income group - their
disposable income and purchasing power - is more than 50 percent
higher than it would have been under historical tax rates and
brackets, while that of the middle class is slightly lower.
Under the Administration's proposals, tax rates on taxpayers earning
more than $250,000 would be very close to the levels that prevailed in
the 1990s, leaving statutory tax rates on higher-income taxpayers far
below the levels that prevailed until the mid-1980s. The rebalancing
of the tax code would not affect middle-class taxpayers-except, of
course, to the extent that a better fiscal picture enhances medium-and
long-term prospects for economic growth.
The need to restore balance is also evident in our corporate tax
system, which encourages businesses to move jobs overseas and to
transfer profits to tax havens abroad in order to avoid taxes at
home. The Administration's plan to reform international tax laws would
reduce these incentives.
Balance also requires that the largest and most highlyl evered
financial firms reimburse taxpayers for the extraordinary assistance
provided to them through the Troubled Asset Relief Program. The
President has proposed a modest Financial Crisis Responsibility Fee
to ensure that the cost of the financial rescue is not borne by
taxpayers. Moreover, the fee would provide a deterrent against the
excessive leverage that helped contribute to the crisis.

Eliminating Wasteful Spending

The third step the Administration is taking to confront the
long-term deficit is cutting unnecessary spending. The President
pledged to eliminate programs that are not working. Last year, the
Administration either proposed or enacted cuts to 121 specific
programs; these proposed cuts totaled $17 billion in the first year
and hundreds of billions of dollars over the 10-year budget window.
They include billions of dollars in terminations of defense programs
such as the F-22 fighter aircraft and the new Presidential
helicopter, cuts in subsidies for large, high-income agribusinesses,
and more than $40 billion in savings over the next 10 years from
eliminating unnecessary subsidies to financial institutions in the
private student loan market.
In its fiscal 2011 budget, the Administration is proposing another
important measure for spending restraint: a three-year freeze in all
nonsecurity discretionary spending starting in 2011. The freeze would
be a tough measure of shared sacrifice. By 2013, it would reduce
overall nonsecurity funding by $30 billion per year relative to
current inflation-adjusted funding levels.
The President also strongly supports restoring the pay-as-you-go
requirement (PAYGO) that was in place in the 1990s. This law, which
requires that lawmakers make the tough choices needed to offset the
costs of new nonemergency spending or tax changes, helped move the
government budget from deficit to surplus a decade ago. PAYGO is an
important tool to force the government to live within its means and
move the budget toward fiscal sustainability.
These measures mean that once the temporary rise in government
spending necessitated by the economic crisis has ended, spending will
be on a lower path than it otherwise would have been. Moreover, both
the multiyear freeze and steps to identify additional unnecessary
spending each year make the reduction gradual rather than sudden. As a
result, the cumulative reduction is substantial, yet there is never a
sudden, potentially disruptive drop in spending.


Conclusion: The Distance Still to Go

The actions the Administration has taken and is proposing would
reduce deficits by more than $1 trillion over the next 10 years and
by even more after that. These actions are significantly bolder
steps toward deficit reduction than any taken in decades, and they
will face serious opposition by those with vested interests. Even
with these actions, however, the primary budget is forecast to
remain in deficit in 2015. And the longer-run fiscal problem facing
the country still centers on the growth of health care costs and the
aging of the population. Thus, barring a substantial and sustained
quickening of economic growth above its usual trend rate, further
steps will be needed to get the deficit down to the target in
the medium and long run.
Regardless of the form they take, these additional steps to reduce
the deficit will involve sacrifices by a broad range of groups and
significant compromise. Thus, a bipartisan effort will be essential.
That is why the President is issuing an executive order creating a
bipartisan fiscal commission to report back with a package of
measures for additional deficit reduction. The charge to the
commission is to propose both medium-term actions to close the gap
between noninterest expenditures and tax revenues and additional steps
to address the longer-term issues associated with rising health care
costs, the aging of the population, and the persistent deficit. The
commission's recommendations will form an important foundation on
which to base policy decisions moving forward.
The Administration understands that addressing the long-run fiscal
challenge will be a long and difficult task requiring commitment and
shared sacrifice. But the President also believes that Americans
deserve for and expect policymakers to deal with the ever-rising
deficit. The changes eventually enacted will be central to the long-
run preservation of both America's financial strength and the
standards of living of ordinary Americans.