Tag Archives: fiscal deficit

The Rate of Economic Growth and the Budget Gap: Returning to the Long-Term Average Growth Rate Would Eliminate It

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Long Run US GDP per Capita Growth (1870-2088) in logarithms

Larry Summers published an op-ed yesterday (appearing in Reuters, the Financial Times, the Washington Post, and probably elsewhere) in which he makes the important point that the current budget impasse is focussed on the wrong issues.  The discussion, at least as publicly expressed, has focussed on what is seen as needed to deal with the fiscal deficit and the resulting public debt.  Even the Republican attempt to end ObamaCare was ostensibly about cutting the government deficit (even though the CBO concluded that the opposite would happen, as they found that the ObamaCare reforms will reduce the deficit, rather than increase it).

Yet this focus on near term and projected budget deficits is misguided.  As Summers notes, under current policies the public debt to GDP ratio is falling, and is projected to continue to fall into the 2020s.  The recently issued Long-Term CBO budget projections indicate that while the debt ratio would then start to rise (primarily driven by expected higher health care costs), there is a good deal of uncertainty in those projections.

Specifically the CBO figures show that it would not take much, in terms of either higher revenues or lower spending, to keep the public debt to GDP ratio flat.  Higher revenues or lower spending or some combination of the two, of 0.8% of GDP over the next 25 years or 1.7% of GDP over the next 75 years, would suffice.  This is consistent with an earlier post on this blog, which showed that if the Bush tax cuts had not been extended for almost all households, the projected debt to GDP ratio in the CBO numbers would fall rapidly.

But projections of revenues or of spending are highly uncertain.  Projected health care spending has been coming down steadily in recent years, for example, in part due to the slow economy, but also in part as a result of the efficiency gains and cost reductions that the ObamaCare reforms are leading to.  With these lower costs, the CBO has been steadily reducing the projected costs to the government budget from Medicare, Medicaid, and other such health programs.  In the recent CBO report, for example, the projections of government spending on health care programs in the 2030s were reduced by 0.5% of GDP from what the CBO had projected just one year earlier.  Going back further, the CBO projections for government spending on health care in 2035 were over 1% of GDP lower in the projections recently issued than in the projections published in June 2010.

This should not be interpreted as a criticism of CBO.  Their projections are probably the best available.  Rather, the point is that these projections are inherently hard to do, and the uncertainty surrounding them should not be ignored.  Yet the politicians often ignore precisely that.

Furthermore and perhaps most importantly, the projected budget deficits and resulting public debt to GDP ratios depend critically on the rate of growth of the economy.  The CBO uses a fairly detailed and reasonable model to project this (based on projected labor force growth, investment in capital, and productivity growth).  However, it is probably even more difficult to project GDP than to project future spending levels and tax revenues for any given level of future GDP.  But Summers notes the critical sensitivity of the projected future deficits to the projected growth in GDP.  He states “Data from the CBO imply that an increase of just 0.2 percent in annual growth would entirely eliminate the projected long-term budget gap”.

One can calculate from the data made available with the CBO report their projected growth of real per capita GDP.  For 2013 to 2088, it comes to 1.60%  year.  A previous post on this blog noted the remarkable constancy of the rate of growth of real per capita GDP since at least 1870 of 1.9% a year (or 1.87% a year at two digit precision).  That earlier post noted that real per capita GDP in the US, despite large annual variations and even decade long deviations (such as during the Great Depression, and then during World War II), has always returned to a path of 1.87% growth since at least 1870.  That path even did not shift when there were even substantial deviations, such as during the Great Depression.  Rather, the economy always returned to the same, previous, path, and not one shifted up or down.

This is truly remarkable, and no one really knows the reason.  The path can be seen as a trend growth of capacity (based on labor available and capital invested, coupled with the technology of the time), but why this should path should have grown at 1.87% a year in the late 1800s; in the early, mid and late 1900s; and all the way into the 21st century, is not known.

Since we do not know why the economy has always returned to this one path, we need to be careful in looking forward.  Still, it is noteworthy that the CBO projections imply that the economy will now slow, to just 1.60% real per capita GDP growth over the next 75 years.  This CBO path is substantially lower than the path of 1.87% growth that has ruled for the last 140 years in the US.

The graph at the top of this post shows the path of GDP per capita projected by the CBO (which one should note is a year by year projection, which just averages out to 1.60% per year over the full period), along with an extension of the 1.87% path that has ruled since at least the 1870s.   The graph is adapted from my earlier post (although now converted to prices of 2005 whereas the earlier one was in prices of 1990; this does not affect the rates of growth).  It is expressed in logarithms, since in logarithms a constant rate of growth is a straight line.

It is not clear why there should be this deceleration to 1.60% from the 1.87% rate of growth the economy has followed over the last 140 years.  Mechanically, one can ascribe the deceleration to what the CBO assumes for the rate of growth of technological progress.  But projecting growth in technology over a 75 year period is basically impossible, as the CBO notes.

The deceleration over the next 75 years has a very important implication, however.  The CBO found in its sensitivity analysis that a rate of growth that is just 0.2% faster will suffice to close the budgetary gap, even if one does not take any new measures to raise revenues or cut government spending.  Hence a return to the previous historical growth path of 1.87% a year from the 1.60% rate the CBO projects, or a difference of 0.27%, will more than suffice to close the budgetary gap.

The policy implication is that with such sensitivity to the growth in GDP, we should be focussed on measures to raise growth, rather than short term budgetary measures that will act to reduce growth.  The economy has suffered from government austerity since 2010, which has held back growth.  Government has been cutting spending, thus undermining demand in an economy with high unemployment and close to zero interest rates, where more labor is not employed and more is not produced because the resulting products could not then be sold due to the lack of demand.  As an earlier post on this blog noted, if government spending had been allowed to grow simply at the historic average rate (and even more so if it had been allowed to grow as it had under Reagan), the US would by now be back at full employment.

Over the medium term, Summers notes that both conservatives and liberals agree that growth should be raised, and on the types of measures which should help this.  More investment, both public and private, is required rather than less.  Research and development, both public and private, is important.  More effective education is also required.

I would agree with all of these.  But to be honest, since we do not really understand why the economy always returned to the 1.87% growth path over the last 140 years, it would not be correct to say we can be sure such measures will be effective.  However, what we can say with confidence is that measures that hinder the recovery of the economy, as the government spending cuts have been doing, will certainly hurt.

We Have a Revenue Problem: Government Debt to GDP Would Fall Without the Bush Tax Cuts

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Debt to GDP Ratio, FY1790 to 2038, no Bush Tax Cuts

A.  Debt to GDP Would Fall Without the Bush Tax Cuts

If the Bush tax cuts had not been extended at the start of this year for almost all households, the public debt to GDP ratio would be falling rapidly.  Even though health care costs are rising and Social Security payments will need to increase as baby boomers retire, the US would be generating more than sufficient tax revenues to cover such costs, if we simply had reverted to the tax rates that held prior to the Bush tax cuts.

The figures on this can be calculated from numbers provided by the Congressional Budget Office with its annual Long-Term Budget Outlook, which was published earlier this week.  Most of the attention paid to the report focussed on the base case projection by the CBO of the public debt to GDP ratio if nothing changes in current policy.   The ratio had risen sharply as a consequence of the economic collapse of 2008, in the last year of the Bush administration, and subsequent weak recovery.  But with the economy recovering and with other measures taken, the ratio is now projected to stabilize and indeed fall modestly for several years.  However, the ratio would then start to grow again in fiscal year 2019, and especially after 2023.  As the graph above shows, the CBO projects that, under current policy, the debt to GDP ratio would rise to 100% of GDP by fiscal 2038, reaching levels last seen at the end of World War II.

This has been interpreted by Republicans as a runaway spending problem, and have asserted this calls for further sharp cuts.  But the data issued by the CBO with its report allows one also to work out what the consequences were of allowing most of the Bush tax cuts (primarily – there were also some other tax measures) to be extended from January 1, 2013.  The Bush tax cuts had been scheduled to expire on that date.  They were instead extended and made permanent for all but the extremely rich (those households earning more than $450,000 a year, the richest 0.7% of the population).

Specifically, the CBO provided in the projections it had made last year (in 2012) what public revenues would have been if the tax cuts had expired, as scheduled, at the start of 2013.  The new report provides those figures for comparison, updated to reflect the new methodology for GDP that the BEA adopted in July.  One can combine those revenue projections with CBO’s current projections of non-interest expenditures, along with a calculation of what interest would then be on the resulting (lower) debt, to estimate what the fiscal deficit and debt to GDP figures would then be.

The resulting path of federal government debt to GDP is shown as the green line in the graph above.  The debt to GDP ratio plummets.  Instead of reaching 100% of GDP in fiscal 2038, it instead would fall to just 37% of GDP in that year.  And a simple extrapolation of that line forward would bring the debt all the way to zero in a further 24 years.

The extension of the Bush tax cuts for most households can therefore, on its own, more than fully account for the projected rise in the public debt to GDP ratio.  With tax rates as they had been under Clinton, there would be no debt issue.

B.  A Longer Term Perspective

The CBO report also provides data on the federal government debt to GDP ratio going back to the founding of the republic in 1790.  I have put the projected paths on a graph with the history to put them in that context.  The fall in the debt ratio that would follow if the Bush tax cuts had not been extended is similar to the falls seen in that ratio in the periods following the Revolutionary War, the Civil War, World War I, World War II, and during the Clinton years following the run-up during the Reagan and first Bush presidencies.

Public debt reached a peak of 106% of GDP in fiscal year 1946, at the end of World War II.  The ratio then fell steadily in the 1950s and 1060s, and was just 25% in 1981, at the end of the Carter presidency.  It fell during this period not because there were large budget surpluses, but rather because of generally strong economic growth.  This also shows that strong growth is possible even if the debt ratio is as high as 106%, undermining the argument made by the economists Carmen Reinhart and Ken Rogoff in a 2010 paper, that debt in excess of 90% of GDP will lead to a sharp reduction in growth.  Republican politicians had quickly jumped on the Reinhart and Rogoff conclusion, arguing that this work supported their views.  But aside from numerous counterexamples, such as the US after World War II, researchers later discovered that there had been a coding error in the spreadsheet Reinhart and Rogoff used to assemble their data.  More fundamentally, researchers showed that to the extent there is a relationship between high debt and slow growth, it is that downturns and slow growth lead to a rise in the debt to GDP ratio (as we saw in the US after the 2008 collapse), rather than that a high debt ratio leads to slow growth.

The debt ratio then rose sharply during the Reagan and first Bush presidencies, rising from 25% of GDP in fiscal 1981 to 48% in fiscal 1993.  This was the first such rise in the debt ratio in American history, aside from the times when the country went into war or at the start of the Great Depression.  During the Great Depression the ratio rose during the Hoover years from 15% in fiscal 1929 to 39% in fiscal 1933, and then to 43% in fiscal 1934.  But it is interesting that during the Roosevelt presidency, and in stark contrast to the common view that the New Deal was characterized by big increases in government spending, the ratio then stayed in the range of 40% to 44% until 1942, following the entry of the US into World War II.

The debt ratio then fell during the Clinton presidency, from 48% in fiscal 1993 to 31% in fiscal 2001.  But with the Bush tax cuts and then the 2008 collapse, the ratio rose to 52% in  fiscal 2009, and to 73% this year.   As noted above, the ratio would now start to fall again if the Bush tax cuts had not been extended, reaching a projected 37% in fiscal 2038.  But with most of the Bush tax cuts made permanent, the ratio (with the same government spending levels) is instead projected to rise to 100% in that year.

C.  Conclusion

The first step in addressing some problem is to understand the cause.  The cause of the current fiscal problems, which if not addressed would lead to a public debt rising to 100% of GDP by fiscal 2038, is the Bush tax cuts.

An earlier post on this blog looked at what the debt to GDP ratio would have been had the Bush tax cuts never been enacted (in 2001 and 2003) and the Afghan and Iraq wars had not been launched.  It found that even assuming the 2008 economic downturn would still have occurred, the public debt to GDP ratio would have risen only to about 35% by fiscal 2014, and would then start to fall.  That post also showed that even assuming the cost of the wars and with the Bush tax cuts in place from 2001 to 2013, phasing out the tax cuts starting in fiscal 2014 would have led the public debt to GDP ratio to fall until at least fiscal 2022 (the last year in the CBO figures then available).

The current post has made use of the CBO’s new long term projections, and finds that if the Bush tax cuts had not been extended at the beginning of 2013, the debt to GDP ratio would be on a sharp downward path to at least fiscal 2038.  The current conventional wisdom appears to be that rising health care costs and the increase in the number of retirees as the baby boom generation reaches 65 means that a rise in the debt to GDP ratio is inevitable, unless there are sharp cut-backs in Medicare and Social Security.

But that is not the case.  The debt ratio would be falling rapidly if it were not for the Bush tax cuts.

An Increase in Government Spending Can Reduce the Debt to GDP Ratio: Econ 101

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Most people realize that it is not the absolute value of the government debt that matters, but rather the ratio of that debt to GDP.  A larger economy can support a larger debt.  But most people will also think instinctively that an increase in government spending will necessarily lead to an increase in the government debt to GDP ratio.  It is not surprising that they should think so.  But it is wrong.

Whether the government debt to GDP ratio will rise or will fall when government spending increases will depend on economic conditions and other structural factors.  In conditions of high unemployment and where the Central Bank has driven the interest rates it can control essentially to zero, such as exist now in the US and Europe, an increase in government spending will increase the demand for goods and services, and hence will increase the demand for labor to produce those goods and services.

Employment and output will then rise. How much they will rise will depend on the multiplier, but as was discussed in a previous Econ 101 post on this site, in conditions of high unemployment and close to zero Central Bank controlled interest rates such as currently exist, the multiplier will be relatively high.  The higher incomes that then follow from the higher employment and output will also then lead to higher tax revenues, as a share of the higher incomes will be paid in taxes.

Hence the addition to the deficit and thus the public debt will be less than simply the increase in government spending, due to the higher tax revenues.  With GDP higher due to the greater demand and with the debt also possibly higher but not by as much, the debt to GDP ratio could fall.  And indeed, under conditions such as currently exist in the US and Europe, the debt ratio will almost certainly fall.

To see this, one can start with a simple numerical example.  Suppose one starts with a GDP equal to 100 units (it could be $100 billion), a public debt of 50 (or 50% of GDP, roughly where it was in the US in 2009), a multiplier equal to 2.0 (a reasonable estimate for the US in recent years), and a marginal tax rate on additional income of 30% (also a reasonable estimate for what it is for US federal government level revenues; it would be higher if one included state and local government revenues).

In these conditions, suppose government spending rises by 1 unit.  With a multiplier of two, GDP will then rise by 2 units.  Tax revenues will then rise by 0.6 units, when the marginal tax rate is 30% on the additional 2 units of GDP.  The government deficit, and hence the public debt, will rise by 0.4 units, equal to the extra 1 unit of government spending less the 0.6 units of additional tax revenue.  The resulting public debt will be 50.4, while GDP will then be 102, and the ratio of 50.4/102 is equal to 0.494.  Hence the debt ratio fell from 50% to 49.4% when government spending rose by 1.  Higher government spending led to a reduction in the debt to GDP ratio.  While the total debt rose, GDP rose by proportionately more, leading to a fall in the debt to GDP ratio.

Further numerical examples will help give a feel to what is going on:

Impact on Debt/GDP Ratio from a One Unit Increase in Government Spending
        Scenario: (a) (b) (c) (d) (e)
GDP: Y 100 100 100 100 100
Public Debt: D 50 70 30 50 50
multiplier: m 2.0 2.0 2.0 0.5 3.5
marginal tax rate: t 0.3 0.3 0.3 0.3 0.3
pre-change D/Y 0.500 0.700 0.300 0.500 0.500
Change in G 1 1 1 1 1
Change in Y 2 2 2 0.5 3.5
Change in D 0.4 0.4 0.4 0.85 -0.05
Resulting D/Y 0.494 0.690 0.298 0.506 0.483

Scenario (a) is the case just discussed.  With an initial public debt ratio of 50%, a multiplier of 2, and a marginal tax rate of 30%, a unit increase in government spending will lead the debt to GDP ratio to fall to 49.4%.  This is robust to different initial debt to GDP ratios:  The debt to GDP ratio will fall with higher government spending with an initial debt ratio of 70% (scenario (b), with the debt ratio where it was in FY2012) or at 30% (scenario (c), almost what the debt ratio had fallen to at the end of the Clinton administration, before the Bush tax cuts).

Under conditions where the economy is close to full employment, so that the multiplier will be relatively small, the debt ratio could rise with the higher government spending.  GDP will not rise by much, if at all, if the economy is already producing at or close to full employment levels.  The denominator in the ratio hence will not rise by much, if at all, while the numerator (the level of debt) will rise by the level of extra government spending, with only limited or no extra tax revenues to offset this since GDP has not increased by much.   Scenario (d) provides an example, with a multiplier of 0.5.  The debt ratio will rise from 50% to 50.6% in this example, when government spending rises by 1.

At the other extreme, a very high multiplier may lead to such a large increase in GDP that the extra tax revenues thus generated are greater than the increase in government spending, leading to an actual decrease in the deficit and hence the debt.  Scenario (e) presents an example, with a multiplier of 3.5.  Debt actually falls from 50 units to 49.95 units, despite the increase in government spending by 1 unit, and the debt to GDP ratio falls from 50% to 48.3%.

One will also get this result if the extra tax revenues generated for a given increase in GDP is sufficiently high.  The above examples assume a marginal tax rate of 30%.  More generally, if the marginal tax rate times the multiplier is greater than one (e.g. 30% times 3.5 = 1.05 in the example above), then the absolute value of the debt will fall with the higher government spending.

It may well be unlikely, however, that the multiplier will be as high as 3.5, even with the current high unemployment in the US and Europe.  Thus it is unlikely that the absolute value of the debt will fall with higher government spending, even in conditions of high unemployment.  But as was discussed above, with a reasonable estimate of the multiplier at around 2, one will see the debt to GDP ratio fall, under conditions such as now exist in the US and Europe.

For those with some mathematical expertise, it is straightforward to derive the specific conditions which will determine whether the debt to GDP ratio will rise or fall with an increase in government spending.  This requires some elementary differential calculus, and I will not go through the derivation here.  But the final result is that the debt to GDP ratio will fall if:

(t + D/Y) – (1/m) > 0

and the debt ratio will fall if the sum on the left is less than zero.  That is, the debt to GDP ratio will fall if the marginal tax rate (t), plus the initial debt to GDP ratio (D/Y), minus the inverse of the multiplier (m), is greater than zero (and will rise if the sum is less than zero). Thus if t=30%, D/Y=50%, and m=2 (so 1/m=0.5), with a sum then of 0.3 + 0.5 – 0.5 = 0.3, which is greater than zero, the debt to GDP ratio will fall.

The material above is straightforward.  There is nothing deep or complex.  It also just examines the immediate impact on the public debt to GDP ratio from an increase in government spending.  For a more elaborate look at the long-term impact, see the paper of Brad DeLong and Larry Summers published in 2012.  They show there that higher government spending will not only spur GDP in the short run under conditions such as exist now, but also that such spending will likely pay for itself in the long run through its long term positive impact on growth.

But this post simply focuses on the short term, and shows that counter to what many people might at first believe, higher government spending can lead to a fall in the public debt to GDP ratio.  All this result requires is the recognition that under conditions such as exist now, when unemployment is high and Central Bank controlled interest rates are close to zero, there will be a significant multiplier effect from an increase in government spending.  The resulting increase in GDP along with the extra tax revenues thus generated could very well then lead to a fall in the debt to GDP ratio.  Indeed, with the conditions and parameters such as now exist in the US and Europe, one should expect this result.