For those just joining the deficit debate, the first thing to tease out is the difference between short-term deficits and long-term structural deficits. The former are necessary. The latter are pernicious. This year's projected $1.7 trillion short-term deficit has many parts, but the most important are (1) collapsing tax revenue from the recession and (2) growing public spending to reverse the death spiral of private sector thrift. In the next few years, some tax revenue will return and public spending will draw back. But it won't be enough.
The United States suffers from not only a temporary imbalance, but also a deeper rot. Congressional Budget Office Director Doug Elmendorf summed it up this way: "The country faces a fundamental disconnect between the services the people expect the government to provide, particularly in the form of benefits for older Americans, and the tax revenues that people are willing to send to the government to finance those services." Whereas the natural trajectory of rich countries is to support greater services for the elderly and poor with higher tax levels, the United States increasingly "supports" greater services for the elderly and poor with lower effective tax rates and higher borrowing. That is what a looming deficit crisis sounds like. This is what it looks like:
When you look at structural deficits, the thing to keep your eye on is not only the deficit number after the dollar sign, but its relation to GDP. Countries aren't like people. We can finance consistent deficits, but only if we grow fast enough to pay our creditors back. If our structural deficits exceed GDP growth for a prolonged period of time, we get into trouble because our debt grows faster than our ability to pay for it.
The White House's own projections are warning signs. The administration's budget anticipates that by 2020, the budget deficit will outpace GDP growth by about 2 percentage points. Many independent analysts are much more pessimistic. Economic forecasts are always cloudy, but the moral of the story is clear: at the dawn of the baby boomers' en masse retirement, our deficit will already be at a tipping point. Even Paul Krugman, who like me has been dovish on Obama's deficits, acknowledges that the baseline is unsustainable. We'll need to find at least an extra 2-4 percent of GDP in tax increases or cost savings (or economic Miracle Grow) by next decade.
Raising 2 to 3 percent of GDP through a VAT is theoretically achievable. As Bruce Bartlett has written, the experience of other countries with a VAT suggests we can tax about a third of GDP at a rate around 10 percent. That would do the trick, right? Not so fast. A VAT will take years to put in place. It would be whittled and carved out with special interest exemptions over time, just like the tax system we have today. Liberals will demand that we correct its regressivity through tax credits, which will eat away at revenue. Republicans will demand quid pro quo: a new consumption tax in exchange for reductions to corporate income or federal income tax rates. That will also eat away at revenue. The leftovers might amount to one percent of GDP. We will need something more: Social Security reform, Medicare reform, military drawback, tax expenditures out, carbon taxes in... The menu is long. But all of the meals are expensive and hard to swallow.
Paul Krugman is right that our deficit challenge is a political challenge. But significant deficit reduction has been political hemlock in modern American history. From Carter to Bush I to Clinton, the clearest lesson has been that Americans say they hate the disease of deficits, but ultimately they punish politicians for finding the cure. Today the biggest gap is not between our revenues and outlays. It is between the size of the looming crisis and the incentive for politicians to do something about it.
Chart: Washington Post