Perspectives

Also see our Economic Commentary which supplements the Laufenberg Economic Quarterly and primarily focuses on more recent economic developments.

This page is designed to offer you my perspective on economic fundamentals, ranging from business cycles to yield curves. It will provide more detailed economic analysis than is generally available in the Quarterly. For the most part, the essays provided here will attempt to discuss timely fundamental issues related to the forecast but are expected to have a longer shelf life than the content on either the Quarterly or Commentary pages. I hope that over time you will consider the information on this page as a source of reference when debating economic issues in the future.

Daniel E. Laufenberg, Ph.D.
LaufenbergQuarterly.com

Health Care Legislation: Essay No. 3-Budget deficits will continue and they do matter!

[April 13, 2010. This is the third in a series of four essays discussing various aspects of the health care legislation enacted recently. The first discusses the expanded benefits and their impact on the future cost of health care, both in terms of price and quantity. The second essay will discuss the revenue provisions in the legislation and their impact on economic activity. The third essay will discuss the impact of the new legislation on federal deficits and debt, and what it implies for the long-run health of the economy. The final essay will try to summary the various features of the legislation and assess their net impact on the economy in the short-term, as well as in the longer-term.]

The Congressional Budget Office (CBO) estimates that over the next ten years the broadly defined revenue provisions of the Patient Protection and Affordability Care Act and the Health Care and Education Affordability Reconciliation Act of 2010 (health care legislation) enacted in March 2010 will more than pay for the added outlays associated with the expanded coverage provided by the legislation. As a result, the CBO estimates that budget deficits during the period 2010-2019 will be $148 billion smaller than they would have been without the legislation; that is, the legislation will increase outlays by $411 billion and revenues by $525 billion over the next 10 years. Most economists, even CBO Director Douglas Elmendorf, question the accuracy of these estimates.1 In particular, he reminds us that it is extremely difficult to estimate the cost of a new entitlement program because it is unclear to what extent the program will be used. The likelihood is that it will be used far more extensively than currently projected. Also, the bulk of the revenues expected to help pay for the new program are savings from existing entitlement programs or savings based on the perception that the government has the ability to effectively bargain on price. In both cases, the savings projections are most likely grossly overstated.

As a result, the debt-to-income ratio is likely to rise over the next few decades, possibly to levels that could prove to be problematic for the U.S. economy if nothing is done about it. That is, at some point, the burden of servicing the Treasury debt outstanding consumes an oversized share of total tax revenue, making it impossible to maintain government outlays without defaulting on Treasury debt. I am not forecasting such an outcome because I am confident steps will be taken before then to avoid such a crisis. The implication is that either spending must slow or taxes must increase. Expanding government-sponsored health care is not an option without corresponding tax increases. Effectively, the government has mandated that the economy will spend more on health care. Revenue to support such a government mandate must come from somewhere. Of course, care must be taken not to push taxes above the level at which they reduce total tax receipts. For that reason, policymakers must be respectful of just how much government assistance and income redistribution we can afford economically.

That being said, it is important to note that budget deficits are not always a problem—there are times when financing activity with debt is quite appropriate. For example, when the economy is in a recession or when the country is engaged in a war, budget deficits are not unexpected or undesirable. Deficits become a problem if they are large and persist even after the economy has returned to full employment. Once this point is reached, the deficit is considered structural, which means that it will require difficult tax and spending decisions to correct.

There is little doubt that serious reduction in future structural deficits has to start with health care. In fiscal year 2009, federal government expenditures on health care totaled $750 billion or roughly 23 percent of all federal outlays. More importantly for future budgets, health care is already projected by CBO to be the fastest growing segment of outlays. An interesting feature of the recent report from the National Commission on Fiscal Responsibility and Reform was that it basically deferred any discussion of cost cutting on health care to the budget analysis associated with health care legislation enacted earlier.2 The problem is that most everyone questions the accuracy of those projections, even some of the government officials responsible for them.

Under current law, CBO projects that budget deficits will drop markedly over the next few years—to $1.1 trillion in 2012, $704 billion in 2013, and $533 billion in 2014. 3 Relative to the size of the economy, those deficits represent 7.0 percent of GDP in 2012, 4.3 percent in 2013, and 3.1 percent in 2014 based on CBO’s economic forecast. “From 2015 through 2021, the deficits in the baseline projections range from 2.9 percent to 3.4 percent of GDP. The projected deficits that will accumulate under current law will push federal debt held by the public to significantly higher levels. Just two years ago, debt held by the public was less than $6 trillion, or about 40 percent of GDP; at the end of fiscal year 2010, such debt was roughly $9 trillion, or 62 percent of GDP, and by the end of 2021, it is projected to climb to $18 trillion, or 77 percent of GDP.” 4 With such a large increase in debt, plus an expected increase in interest rates as the economic recovery strengthens, interest payments on the debt are poised to skyrocket over the next decade. “CBO projects that the government’s annual spending on net interest will more than double between 2011 and 2021 as a share of GDP, increasing from 1.5 percent to 3.3 percent." 5

CBO’s baseline projections are not intended to be a forecast of future budgetary outcomes; rather, they serve as a neutral benchmark that legislators can use to assess the potential effects of policy decisions. Consequently, they incorporate the assumption that current laws governing taxes and spending will remain unchanged. In particular, the CBO’s most recent baseline projections are based on the following assumptions:

  • Sharp reductions in Medicare’s payment rates for physicians’ services take effect as scheduled at the end of 2011;

  • Extensions of unemployment compensation, the one-year reduction in the payroll tax, and the two-year extension of provisions designed to limit the reach of the alternative minimum tax all expire as scheduled at the end of 2011;

  • Other provisions of the 2010 tax act, including extensions of lower tax rates and expanded credits and deductions originally enacted in the Economic Growth and Tax Relief Reconciliation Act of 2001, the Jobs and Growth Tax Relief Reconciliation Act of 2003, and ARRA, expire as scheduled at the end of 2012; and

  • Funding for discretionary spending increases with inflation rather than at the considerably faster pace seen over the dozen years leading up to the recent recession. 6

As shown in Chart 1, the surge in budget deficits in recent years was due to the combination of more outlays and less revenue. Federal outlays as a percent of GDP jumped to over 24 percent in fiscal 2009, well above its historical average, and remained elevated in fiscal 2010. In contrast, federal revenues as a percent of GDP plunged below 15 percent in fiscal 2009 and remained at that depressed level in fiscal 2010. This resulted in budget deficits for fiscal years 2009 and 2010 that were a whopping 10 percent and 8.9 percent of GDP, respectively.

The projected deficits from CBO over the latter part of the coming decade are much smaller relative to GDP than is the current deficit, mostly because, under the assumptions listed above and with a continuing economic expansion, revenues as a share of GDP are projected to rise steadily—from about 15 percent of GDP in 2011 to 21 percent by 2021. As a result, the baseline projections understate the budget deficits that would arise if many policies currently in place were extended rather than allowed to expire as scheduled under current law. “For example, if most of the provisions in the 2010 tax act that were originally enacted in 2001, 2003, and 2009 or that modified estate and gift taxation were extended (rather than allowed to expire on December 31, 2012), and the alternative minimum tax was indexed for inflation, annual revenues would average about 18 percent of GDP through 2021 (which is equal to their 40-year average) rather than the 19.9 percent shown in CBO’s baseline projections.” 7

If Medicare’s payment rates for physicians’ services were held constant as well, then deficits from 2012 through 2021 would average about 6 percent of GDP, compared with 3.6 percent in the baseline. Indeed, a significant reduction in Medicare’s payment rates to physicians is at the heart of any improvement in the debt-to-income ratio over the next decade. Unfortunately, such a reduction in payments to physicians is inconsistent with the idea that there will be more physicians available to satisfy the increased demand for health care likely over the same period. “By 2021, the budget deficit would be about double the baseline projection, and with cumulative deficits totaling nearly $12 trillion over the 2012–2021 period, debt held by the public would reach 97 percent of GDP, the highest level since 1946.” 8

Beyond the 10-year projection period, further increases in federal debt relative to the nation’s output almost certainly lie ahead if current policies remain in place. The aging of the population and rising costs for health care will push federal spending as a percentage of GDP well above that in recent decades. More specifically according to the CBO, spending on the government’s major mandatory health care programs—Medicare, Medicaid, the Children’s Health Insurance Program, and health insurance subsidies to be provided through insurance exchanges—along with Social Security will increase from roughly 10 percent of GDP in 2011 to about 16 percent over the next 25 years. Of course, the budget and debt projections by CBO are very uncertain, and they know it. In its January budget document, the CBO noted that even if federal laws were unchanged for the next decade, actual budgetary outcomes would differ from their baseline projections because of unanticipated changes in economic conditions and in a host of other factors that affect federal spending and revenues. 9

If revenues stay close to their average share of GDP for the past 40 years, then the additional health care expenditures outlined above would lead to rapidly growing budget deficits and surging federal debt. To prevent debt from becoming unsupportable, policymakers will have to substantially restrain the growth of spending or raise revenues significantly above their historical share of GDP, or pursue some combination of those two approaches. I suspect that it will be the latter—some combination of reduced spending and higher taxes. If they do not, then the implication is that the living standards for future generations could be compromised. After all, it is not that future generations are expected to pay down the debt as much as it is the expectation that the cost of servicing that debt remain manageable. If the cost is too high, which is possible if the current budget deficit persists, it will make it more difficult for the economy to invest in the capacity it needs to produce goods and services in the future. If the capacity to produce goods and services is denied, then so too is the higher living standard to future generations that such goods and services would provide.

Also, according to the CBO, of the $9.0 trillion in federal debt held by the public at the end of fiscal 2010, domestic investors owned 53 percent and foreign investors held 47 percent. “The Federal Reserve System and individual households are the largest U.S. holders of Treasury debt, accounting for 12 percent and 9 percent of the total, respectively. Other investors in Treasury debt in the United States include pension and retirement funds, mutual funds, and state and local governments. Investors in China and Japan have the largest foreign holdings of Treasury securities. Together, central banks and private entities in those two countries hold about 20 percent of U.S. public debt.” 10

Indeed, one could argue that these two countries have already reached a saturation point with regard to their holdings of Treasury securities, which might mean that a very liquid part of the market may not be as actively buying future issues of Treasury debt. They still may add to their Treasury holdings, but may become increasingly reluctant to own much more than 20 percent of all Treasury debt held in the hands of the public. The implication is that just as the Treasury’s cost of borrowing over the last twenty years apparently came down more than economic fundamentals alone might suggest due to foreign buying, its cost of borrowing over the next twenty years could rise faster than economic fundamentals alone might suggest owing to the absence of foreign buyers. Such an outcome would put considerable upward pressure on bond yields after adjusting for inflation and, in turn, considerable downward pressure on U.S. business fixed investment.
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1 Douglas Elmendorf, “The Effects of Health Reform on the Federal Budget,” Congressional Budget Office Director’s Blog, Monday, April 12th, 2010.

2 The National Commission on Fiscal Responsibility and Reform, The Moment of Truth, December 2010, pp. 36-42.

3 Congress of the United States, Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2011 to 2021, January 2011, pp. 1-26.

4 One factor contributing to the rapid growth of debt held in the hands of the public is the unwinding of the Social Security Trust Fund starting this year as the front edge of the boomer population retires. Recall that this Trust Fund was established to help fund Social Security for boomers. The impact is that even without any new debt issuance, the outstanding debt shifts away from being held by the government in the Trust Fund to being held by the public. In this case, additional private buyers of Treasury securities are needed. The concern will be whether new buyers will step up at current low yields.

5 Congress of the United States, Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2011 to 2021, January 2011, pp. 1-26.

6 Ibid.

7 Ibid.

8 Ibid.

9 Ibid.

10 Ibid.

 

The views expressed here reflect the views of Daniel Laufenberg as of the date referenced. These views may change as economic fundamentals and market conditions change. This commentary is provided as a general source of information only and is not intended to provide investment advice for individual investor circumstances. Past performance does not guarantee future results.


Special Report: Health Care Legislation
Essay No.1 - Costs
Essay No.2 - Revenue
arrow Essay No.3 - Budget Deficits
Essay No.4 - Things to Watch

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