NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

In the Long Term, the U.S. Still Faces Deficits



"Medicare and Medicaid spending will rise from 4 percent of gross domestic product (GDP) today to 12 percent by 2070."

The Clinton Administration has recently proposed a balanced budget for fiscal year 1999, the first such budget in decades. This follows an impressive downward trend in recent years: the $22.6 billion deficit in fiscal year 1997, which ended September 30, was indeed a welcome and hard-won change from the huge deficits which peaked at $290 billion in 1992. But when Baby Boomers begin to retire around 2010 and draw trillions of dollars in Social Security and Medicare benefits, federal accounts could spin out of control and drag the economy down.

Huge deficits pose at least two major threats. Rising government debts lead to rising interest payments, which feed higher debts. Further, the more the government borrows from capital markets to cover its spending, the less money remains for private investment. Paychecks and corporate earnings will grow more slowly, which in turn will slow the growth in government revenues needed to keep deficits in check.

NBER Research Associate Alan Auerbach says "The long-run problem is still extremely severe and much larger than most people realize." In Quantifying the Current U.S. Fiscal Imbalance (NBER Working Paper No. 6119) Auerbach analyzes long-term projections from the Congressional Budget Office (CBO), which show Medicare and Medicaid spending will rise from 4 percent of gross domestic product (GDP) today to 12 percent by 2070 -- admittedly a long way off, but within the lifetime of many of today's children. Add in Social Security spending growth and the government's "primary deficit" (which excludes interest expenses) could rise to more than 7 percent of GDP by then. Government borrowing at that level would sink private investment and quite possibly undercut international confidence in the dollar.

To achieve long-term fiscal balance, even with a balanced budget in the year 2002, Auerbach calculates that the federal government would have to engineer a combination of permanent spending cuts and tax increases equal to 3.6 percent of GDP -- starting today. That means aiming not just for a balanced budget, but for an additional surplus on the order of $300 billion annually. Running surpluses for the next decade or two would pare the national debt, making the subsequent rise in deficits more manageable during the peak years of the retirement of Baby Boomers. Recent CBO projections of a small surplus by 2002 put only a small dent in this total. But these projections assume no recession between now and 2002; one modest downturn could sap revenues and send deficits rising again.

Despite recent focus on saving the Social Security system, Auerbach calculates that most of the problem lies elsewhere: eliminating the current imbalance, as measured by the Social Security Trustees, would reduce the imbalance only by one-fourth -- to 2.7 percent of GDP. The remainder is attributable to rising government health care expenditures. Indeed, this remaining gap would be even higher were it not for a projected continuation of the sharp decline (as a share of GDP) in all other government spending. While modest policies, such as reducing cost-of-living adjustments for retirees and increasing the normal retirement age, would help deal with the Social Security imbalance, Auerbach suggests that it will be much more difficult to address the overall fiscal problem without very large changes in the Medicare and Medicaid systems. Given the magnitude of changes involved even if this problem is addressed immediately, a policy of dealing with it "only when it arises" -- that is, when Baby Boomers begin to retire -- may leave future policymakers with a very daunting task.


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