Record Deficits

We’re running deficits not seen since World War II, except the wars we’re fighting aren’t the main cause — deep recession, costly stimulus, and runaway health costs are. After running surpluses for four years FY98-FY01, we ran deficits averaging 2.5% of GDP through FY08, 10.0% in FY09, and 8.9% in FY10 just ended. See Table F-2 on p. 127 of the CBO Budget and Economic Outlook. As the economy recovers weakly, the deficit will drop to 5% or 6% of GDP as revenues recover automatically and stimulus spending stops, assuming the Bush tax cuts, AMT relief, and the Doc Fix are extended permanently. That would leave us with a rapidly growing public debt and a weak economy that would be vulnerable to outside shocks, e.g. rising interest rates to finance the public debt and/or inflation, particularly for energy prices, which will rise as the dollar falls. Therefore, it is very important that we lower our deficits to the point where they are sustainable, where they aren’t growing as a share of GDP. That would be about 3% of GDP.

So how should we shave the deficit by 2% or 3% of GDP? When I was doing deficit reduction on Capitol Hill in the 1980’s and early 1990’s, the unwritten rule for most deficit reduction bills was half revenue increases and half spending cuts. I’m still comfortable with that, but I’m open to arguments. I would note that discretionary spending has declined since then as more spending gets done through the Tax Code. Nonetheless, there are plenty of places to cut spending, particularly in entitlements, which have burgeoned.

Long run budget balance would be nice, but that isn’t in the cards for at least five years. Besides, as evidenced by the President’s Fiscal Responsibility and Reform Commission, there’s little agreement on where spending and revenues should meet. Co-Chair Erskine Bowls reportedly tried to get his members to agree on 21% of GDP, but quickly found that there was no agreement at any level of GDP. Democrats insisted on higher spending, and Republicans insisted on lower revenues. When we last had budget balance, spending varied from 19.1% to 18.2% of GDP, and revenues varied from 20.6% to 19.5% of GDP (See Table F-6 on p.131), so how about reaching balance around 19% or 20% of GDP within the next decade?

Finally, how soon should we undertake substantial deficit reduction? I wouldn’t wait past next summer, HOWEVER, I would delay the effective dates until 2012 or 2013 to get the market benefit of the anticipation of deficit reduction without endangering our fragile recovery.

No matter where you increase taxes or cut spending, the political battles will be ferocious. If we don’t take responsibility for balancing the budget, our kids will.

About Pete Davis 99 Articles

Affiliation: Davis Capital Investment Ideas

Pete Davis advises Wall Street money managers on Washington policy developments that affect the financial markets. President of his own consulting firm since 1992, Davis Capital Investment Ideas, he draws on 11 years of experience as a Capitol Hill economist with the Joint Committee on Taxation (1974-1981), the Senate Budget Committee (1981-1983), and Senator Robert C. Byrd (1992). He worked in the House and Senate, and for Republicans and Democrats.

Davis brought the first computer policy model, the Treasury Individual Income Tax Model, to Capitol Hill in early 1974, when he became a revenue estimator on the Joint Committee on Taxation. He formulated the 1975 rebate, the earned income tax credit, the 1976 estate tax rates, the 1978 marginal tax rates, and the Roth-Kemp tax cut. He left Capitol Hill in 1983 for the Washington Research Office of Prudential-Bache Securities, where he advised investors for seven years.

Davis has long written a newsletter on the Washington-Wall Street connection for his clients; Capital Gains and Games is his first foray into the blogosphere.

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