Options to Close the Long-run Fiscal Gap

Mr. Chairman and other members of the Committee, thank you for the invitation to testify today on one of the most important issues facing our nation: the long-run budget deficit. I currently serve as Director of the Hamilton Project at the Brookings Institution, an initiative dedicated to developing policies that promote broad-based growth and opportunity. Restoring fiscal discipline plays a critical role in achieving these objectives. Note that none of the specific options I am discussing today have necessarily been endorsed by staff, officers, or trustees of The Brookings Institution, or the members of The Hamilton Project Advisory Council.

The Congressional Budget Office (CBO) projects that the unified deficit in fiscal year 2007 will be $198 billion. This amounts to 1.5 percent of Gross Domestic Project (GDP), which is less than the average over the last forty years. This may lull some into a false sense of complacency. It should not. The United States can do a lot better than a $198 billion unified deficit and the United States needs to do much better than a $388 billion non-Social Security deficit. This is especially true in a year when macroeconomic performance is strong and when we face large risks including the private saving rate at its lowest level since 1939, a current account deficit approaching 7 percent of GDP, and major fiscal challenges just around the corner.

Restoring fiscal balance will require three steps:

• Step one: To stem the flow of red ink, restore the PAYGO rules;
• Step two: Take simpler steps to reduce the deficit today;
• Step three: Address Social Security, Medicare, Medicaid and tax reform to bring the government’s books into balance over the longer term.

The deficit represents a major economic challenge. It drives down national savings, leading to less investment or more foreign borrowing. In either case, future national income will be lower, either because we will have a smaller capital stock or because more of our capital stock will be devoted to producing income to repay our foreign creditors. This effect is slow and gradual but relentless and inevitable. In addition, the budget deficit and the related large current account deficit increase the chances of a highly disruptive short-run financial crisis. If America finds itself suddenly unable to borrow 7 percent of GDP, the economy would need to rapidly reallocate a large fraction of the labor force from domestic production to export production. This adjustment process could be painful as millions of workers would be forced to find jobs in new industries in short order.

Even setting aside the economic effects, current tax and spending policies are literally unsustainable. The sooner we act the better for three reasons. First, the sooner we increase revenues or reduce spending, the smaller the eventual adjustments will have to be because we will not accumulate as much debt and thus will save a lot on interest payments. Second, if addressing our long-run fiscal challenge entails altering currently-scheduled benefits for future retirees, more notice about such adjustments will improve workers’ ability to prepare. Finally, even if much of the actual revenue or spending changes themselves do not occur for decades, scheduling them sooner may be politically easier than waiting until the necessary changes are imminent.

I will first briefly review the sources of our long-run deficit and then discuss the three steps we should take to address it.