December 3, 2013

Budget Conference 2013: Principles For A Credible Deal

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A credible budget conference agreement would take a first step toward improving the nation’s dire fiscal outlook and achieve the following:

  1. maintain sequester spending levels in addition to—not in exchange for—other spending reductions;
  2. begin structural reform of the largest and least sustainable entitlement programs—the key drivers of future spending and debt; and
  3. avoid attempts to solve the spending problem by raising taxes.

Regrettably, the goal of this year’s budget negotiations appears to have shifted from improving the nation’s finances to eliminating the modest spending sequester to which both sides have already agreed. This would be a mistake with lasting repercussions.

Below, Mercatus Center scholars review the principles for a credible deal for the fiscal year 2014 budget.

Maintain the Sequester

Sequestration was implemented as the consequence of the Budget Control Act of 2011, which raised the federal government’s debt ceiling (or the borrowing authority) by approximately $2 trillion. Relative to the nation’s fiscal imbalance, the sequester’s spending cuts are admittedly tiny. But it is not the size of the sequester that is most important; it is Congress’ commitment to its implementation.

Maintaining sequester spending levels is a critical marker of Congress’ will to gain control of federal spending. It signals that Congress can honor its agreements, and—in following through on this small effort—has the potential to meet the far greater challenge of correcting the nation’s longer-term spending and debt crisis.

Despite Washington rhetoric, the sequester’s spending reductions are far from “draconian cuts”; the sequester does not even reduce overall spending levels. Rather, the sequester slightly slows the projected growth in overall spending between 2013 and 2023.

  • Even with the sequester, federal spending will grow by $1.8 trillion—more than 50 percent—between 2013 and 2021, the period during which spending cuts from sequestration will take place.
  • Total federal spending still increases under sequestration because any spending cuts are up front and fall mostly on the discretionary side of the budget; the main drivers of future spending and debt—entitlement programs—are largely untouched.

Begin Credible Entitlement Reform

  • Maintaining sequester spending levels is the absolute least Congress must do. The long-term fiscal imbalance is driven primarily by growth in the costs of Medicare, Medicaid, Social Security, and the new health-insurance exchanges established as part of the 2010 Affordable Care Act. Left unchecked, the unsustainable cost growth of these programs will result in considerable tax increases, reduced economic growth, fewer resources for every other federal program, severe benefit cuts in the entitlement programs themselves, or—most likely—some combination of these things.
  • Structural and cost-reducing reforms to the largest entitlement programs need to begin immediately. Any strategy that fails to reform these entitlement programs will inevitably fail to correct the federal government’s fiscal imbalance; merely tweaking these programs for short-term political gain only slightly forestalls their inevitable insolvency.

Don’t Attempt to Tax Away the Spending Problem

Some in Washington claim the federal spending and deficit problem is solved. While the deficit has been cut in half (from a record-high of $1.4 trillion in FY09 to $680 billion in FY13), this reduction can be attributed to several singular events, such as the end of the payroll tax “holiday” and higher receipts from Fannie Mae and Freddie Mac. Over the longer term, deficits and debt are projected to continue increasing.

Attempting to fix the unsustainable federal spending growth through tax increases would wreak havoc on the economy, as taxes would have to more than double just to fund entitlement spending. Further, expansive academic research shows the “balanced approach” does not work.

  • The general consensus in the academic literature is that fiscal adjustments based more on spending cuts were much more likely to achieve successful and lasting reductions in debt-to-GDP ratio than tax-base adjustments. This is particularly true of spending-based adjustments that reform entitlements and public pay.
  • Data from Greece, Italy, and Japan show that tax increases don’t effectively reduce debt levels; evidence from Canada, Germany, and Finland show that cutting spending and implementing structural reforms are the most successful policies.
  • Sweden’s experience indicates that significantly cutting government spending without an equivalent increase in taxes can provide a path to fiscal sustainability.

· Sweden successfully reduced welfare spending and pursued economic stimulus through a permanent reduction in the country’s taxes, including a 20-point reduction in the top marginal income tax rate.

· Sweden’s recent economic growth has trumped that of every other European country.

  • Data from past fiscal adjustments show that while spending cuts will effectively reduce a country’s debt, they do not necessarily hurt the economy in the short-term.

∙ Evidence shows that if an economic slowdown follows the spending-cut based adjustment, it is generally mild and short lived. Conversely, tax-based adjustments result in significant economic slowdowns.

∙ A leading paper in the austerity debate by International Monetary Fund economists shows that while spending cuts can hurt the economy in the short run, they probably don’t hurt the economy as much as tax increases do.