How to Fix the Deficit

The United States is in a fiscal bind. Last week saw the release of two reports which vividly illustrate the policy dilemma we face—but they also point to a strategy we could use to overcome it.

The first appeared on September 28, when CBO Director Doug Elmendorf presented an analysis of our fiscal policy choices before the Senate Budget Committee. Among his key findings: Cutting taxes is good for the economy in the short-term but bad in the long run. Making all the Bush tax cuts permanent, as Republicans are demanding, would increase real GNP between 0.5 and 1.4 percent in 2011 and 2012 but would decrease it between 1.1 and 1.6 percent in 2020. Making the cuts permanent for individuals with incomes of $200,000 or less, and married couples with incomes of $250,000 or less, would increase real GNP between 0.4 and 1.1 percent in 2011 and 2012 but decrease it between 0.9 and 1.3 percent in 2020.

It turns out, however, that we need not choose between the next two years and the next decade. CBO finds that a temporary extension of the tax cuts delivers about two-thirds of the short-term benefits provided by permanent extension—0.3 to 0.9 percent gains in real GNP if tax cuts are extended through 2012 for everyone, and 0.2 to 0.7 percent if the upper incomes are excluded—with much smaller negative effects (around 0.3 percent losses) than do the permanent extensions.

Then, on October 1, the IMF published its latest world economic outlook. Chapter 3 of this report examines the macroeconomic effect of deficit-reduction plans (“fiscal consolidation”) in 33 advanced economies. The key finding: While deficit reduction typically reduces GDP and job growth in the short-term, it boosts them in the long-term. A fiscal consolidation plan equal to 1 percent of GDP reduces GDP by about 0.5 percent within two years and raises the unemployment rate by 0.3 percentage point while domestic demand—consumption and investment—falls by about 1 percent. In the long-term, however, the IMF study finds that “for every 10 percentage point fall in the debt-to-GDP ratio, output rises by about 1.4 percent in the long term.”

Granted, these reports are not uncontroversial. The IMF’s claim that fiscal consolidation is contractionary in the short term is contested by scholars such as Alberto Alesina and Silvia Ardagna who find the opposite, using a different methodology. And some staunch Keynesians do not believe that there is a significant relation between debt-to-GDP ratios and economic growth, at least during the next decade. Still, it is suggestive that these two high-quality reports point in the same direction.

Consistent with the thrust of both the CBO and IMF reports, Maya MacGuineas and I have just issued a 10-year budget outline that reduces the debt to GDP ratio in 2020 from a projected 90 percent to 60 percent while maintaining a broadly stimulative policy between now and 2012. We do this with a 50/50 mix of program spending cuts and revenue increases, phased in over time so that the impact on the deficit is backloaded. If the IMF estimates are right, this would boost America’s GDP by about $900 billion in 2020—almost $3,000 per person—without undermining an economic recovery now proceeding painfully slowly.

These findings have an obvious bearing on the issues that American policymakers will soon be forced to engage. Between now and the end of the year, two blue-ribbon fiscal commissions will issue their recommendations. By next February, the president will offer his 2012 budget proposals to a new Congress, whose political balance will differ significantly from its predecessor.

Most pundits predict little except gridlock over the next two years, and they may be right. Between now and the next presidential election, we will find out whether two political parties who disagree sharply about the proper role of government can come together to promote the long-term national interest. But the rest of the world won’t be standing still just because we are, and every year of inaction imposes a cost on our future.