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Friday, April 29, 2011

Reducing the Budget Deficit: Policy Issues

Marc Labonte
Specialist in Macroeconomic Policy

The budget deficit (the difference between outlays and revenues) each year from 2009 to 2011 has been the highest ever in dollar terms and significantly higher as a share of gross domestic product (GDP) than in any other year since World War II. The budget is not projected to be on a sustainable path under current policy, in the sense that it would cause the federal debt to continuously grow more quickly than GDP. While there has been no difficulty financing the deficit to date, at some point, investors could refuse to continue to finance deficits that they believed were unsustainable.

As one example of the policy changes that would return the budget to a sustainable path, CRS estimates that to stabilize debt as a share of GDP at its 2011 level would require budget deficits averaging no more than 2.5% to 3% of GDP over the next ten years. In dollar terms, this would amount to a deficit of about $400 billion in 2012, rising to about $550 billion in 2015. Under a current policy baseline, the deficit would decline from more than 9% of GDP in 2011 to 5% of GDP in 2014, and rise to 6% of GDP by 2019. To reduce the deficit to sustainable levels would require some combination of spending cuts and tax increases equivalent to roughly $700 billion in 2012 and $400 billion in 2015 compared to a projection of current policy.

The recent growth in deficits is the result of spending reaching its highest level as a share of GDP since 1945 and revenues reaching their lowest level as a share of GDP since 1950. Revenues are projected to be higher than their historical average from 2013 on if the “alternative minimum tax (AMT) patch” and “Bush tax cuts” expire as scheduled. Those tax provisions were extended through 2011 and 2012, respectively, by P.L. 111-312, which CBO projects increased the deficit by $374 billion in 2011 ($204 billion of which is attributable to expiring tax provisions). If these tax cuts are extended again, revenues are estimated to be reduced by about 2% of GDP each year from 2014 on, and will remain around their historical average from 2014 on.

Assigning the relative contribution of past policy decisions to the current deficit depends on one’s starting reference point. Compared to CBO’s 2001 baseline projection, legislative changes in 2009 and 2010 increased the 2010 deficit by $570 billion, while legislative changes from 2001 to 2008 increased the 2010 deficit by $947 billion. Changes to the economic projection increased the 2010 deficit by $135 billion.

Spending cuts in FY2011 are equivalent to less than 1% of the 2011 budget deficit. Under current projections, even if total discretionary spending (defense and non-defense combined) were reduced to zero in 2011, there would still be a budget deficit. Freezing total discretionary spending at 2011 levels (which would reduce spending in inflation-adjusted terms) would reduce the deficit by about 0.1% of GDP in 2012, gradually rising to a 1% of GDP reduction by 2018. If defense is not included in the freeze, the reduction in the deficit is less than half as large. Defense, Social Security, and Medicare account for more than half of total spending. Outside of those three programs and net interest, all other spending is about the same size as the budget deficit in 2011.

Growth in entitlement spending on the elderly drives long-term projections of large budget deficits—by mid-century, outlays on Social Security and health programs would exceed total revenues. Most proposals to reform entitlement programs for the elderly would generate significant budgetary savings in the long run, but little budgetary savings in the short run, partly because most proposals exempt current retirees from reform and partly because the savings from these changes would compound over time.

Date of Report: April 22, 2011
Number of Pages: 23
Order Number: R41778
Price: $29.95

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