Obama’s Budget Battle

The new administration in Washington faces unprecedented economic challenges. President Barack Obama held a fiscal responsibility summit on Monday, gave an address to Congress and the nation on Tuesday and then followed up with an outline of his first budget today.

The backdrop to these events is the plan to spend close to $2tn on repairing the US economy and plug an enormous long-term hole in the nation’s finances, while simultaneously searching for ways to restrain spending or raise revenues. The long-term problem was serious before the recession hit – and it has now gone from very bad to much worse. A new Brookings analysis by my colleague William Gale shows that even under optimistic assumptions, the federal deficit will average about $1tn a year over the coming decade.

How can the administration deal with this challenge? First, it must get healthcare spending under control. Rising healthcare costs are causing federally funded spending to skyrocket. At the moment, no one knows how to rein in the problem, short of rationing care. Even efforts to introduce electronic medical records, to fund serious research on the effectiveness of different treatments and to start to base reimbursements on the evidence are controversial. Everyone is in favour of providing coverage for the currently uninsured but this will cost more, not less, than the current system. So it’s hard to see a solution emerging any time soon.

Second, the public pension system, Social Security, while not as big a problem as the public health programmes, needs to be put on a sound fiscal basis. Solvency of the system could easily be achieved if people were willing to work a little longer, if future benefits for more affluent seniors were dialled back and if payroll taxes were increased for those making more than $100,000 a year.

Spending in other areas could be reduced as well, but the big pension and healthcare programmes are where the real problem lies. Without tackling them, other budget cuts are likely to save dimes not dollars.

Finally, revenues will have to be raised. The president has promised to raise the tax rate for those making more than $250,000 to tax the income thrown off by private equity investments more heavily, along with dividends and capital gains. The stimulus package, however, contains a working-family tax credit and a reduction in the alternative minimum tax that go in the opposite direction. All in all, these revenue measures are not going to make a serious dent in the problem.

The administration seems to at least recognise the difficulties and admits that it will be impossible to do more than reduce the deficit by half over the president’s term. Even that modest goal will be impossible to achieve unless the economy cooperates, the administration foregoes any expensive new initiatives in other areas and there is a peace dividend as the wars in Iraq and Afghanistan wind down.

There is no political appetite to do any of the above – but without these and other measures, the US may be courting a fiscal disaster down the road. In the meantime, we are leaving an enormous burden of debt to the next generation and keeping our fingers crossed that foreign investors, including many in the UK, continue to lend us money on reasonably favourable terms.

On top of everything else, as a result of these fiscal constraints, the world’s biggest economy may also be hobbled in its ability to help the rest of the world recover from a deep and long recession. The problem is not a lack of resources – the problem is a lack of political will to make the sacrifices that our current predicament requires. But at least we have started the conversation.