EconomistMom.com

My Friday post on Warren Buffett’s growing “economic pie,” as measured in CBO’s long-term outlook report, concluded that:

A 40 percent larger economic pie for my kids, in my opinion, isn’t big enough, and isn’t “fair.”  Not given past history [of more like 100% growth], and not given how big it could be [such as 60% growth under baseline policies] if we just stopped sneaking some of our kids’ pie for ourselves.

But it turns out, that’s not the half of it–quite literally.  You see, that 40 percent growth in per capita real GDP under CBO’s “alternative fiscal scenario” contains at least a bit of a free lunch.  The macroeconomic effects come from a growing budget deficit–a fiscal gap that reaches 2.8% of GDP over 25 years, 5.2% over 50 years, and 6.9% over 75 years (see Box 1-1 on page 6 of the CBO report).  The bit of a free lunch, however, is that there’s no recognition that eventually that gap will have to be closed (or the economy will “blow up”–at least in a simulation sense), and that eventually that involves a tax increase and/or a spending cut that would further cut into any measure of economic well being.

CBO’s report in fact includes a section (on pages 15-17, right after the one from which I drew the macroeconomic effects of higher budget deficits) called “What Are the Costs of Delaying Action on the Budget?”  In that section CBO examines how much of a tax increase or spending cut would be needed to close the fiscal gap under the “alternative fiscal scenario” depending on when that action was eventually taken.  CBO does not do this analysis for the “extended-baseline scenario” because it doesn’t have to, for as CBO explains, the extended-baseline scenario already has built into it a way of closing the fiscal gap over the next 25-50 years–letting revenues/GDP come up:

Under the extended-baseline scenario, projected revenue increases would be sufficient to avoid serious budgetary and economic troubles until after 2050, but those increases would result in federal revenues that were much higher, as a percentage of GDP, than the nation has been accustomed to. Under the alternative fiscal scenario, such troubles would begin in the next couple of decades, and the longer that policy action on the budget was put off, the more costly and difficult it would be to resolve those expected long-term budgetary imbalances.

As the report goes on to explain, delaying action allows us to temporarily enjoy a higher level of government spending and/or more tax cuts, and a higher GDP, but just postpones the eventually higher cost–which on net leaves us worse off because economic growth isn’t able to keep up fully with the compounded interest: 

CBO’s simulations indicate that under the alternative fiscal scenario, delaying action could substantially increase the size of the policy adjustments needed to put the budget on a sustainable path. The impact of delaying changes in policy would be large even before accounting for potential macroeconomic feedback effects. If policymakers wanted to close the fiscal gap in 2020 by altering spending (and economic feedbacks were not part of the calculation), they would have to reduce noninterest outlays permanently by 9 percent of GDP (see Figure 1-3). If they delayed action on the budget until 2040, to close the fiscal gap in that year, they would have to reduce noninterest outlays permanently by 15 percent of GDP. Waiting until 2040 to close the fiscal gap would allow spending to grow significantly before that year; however, the reductions required in spending in 2040 and in subsequent years would have to be substantial—and much larger than would have been necessary if action had been taken earlier (see Figure 1-4).

In other words, the 39 percent growth in per capita, real GDP that I cited on Friday is only before the bill comes due.  If we assume that we proceed with the “stay the course” alternative fiscal policy scenario, with tax cuts extended without paying for them as we go along, then we enlarge the deficit and hence increase the drag on our economy due to interest payments and reduced national saving.  But if on top of that, we imagine that our kids might finally wise up before the economy collapses, and would take action to close the fiscal gap by 2040 (to “clean up the mess” we’ve left for them), they’d have to pay higher taxes and/or put up with lower spending starting in 2040.  How much would those higher taxes (or reduced benefits) cut into that already-too-low 39 percent real growth in their per capita (average) incomes? 

So I translated the GDP growth figures I provided on Friday into the actual constant-2000-dollar per capita amounts, and then combined these numbers with CBO’s “cost of delaying action” analysis.  CBO’s Figure 1-3 on page 16 of the report shows that under the alternative fiscal scenario, to close the fiscal gap, tax revenues would have to come up (permanently) by 6.9% of GDP if action began in 2008, but by a much larger 15.2% of GDP if action wasn’t taken until 2040.  Interpreting these tax increases as shares of per capita income that would have to be “taxed away” eventually when the bill was paid, I get the following comparison, for the alternative fiscal scenario:

• Under alternative fiscal scenario (extended, deficit-financed tax cuts and higher Medicare spending) not paid for (or not paid for until sometime past 2040):  Real, per capita GDP in 2007:  $38,794; and in 2040:  $53,977 (39% growth over 33 years).  (It’s just that growth after 2040 would suffer.)
• Under alternative fiscal scenario (extended tax cuts and higher Medicare spending) “paid for” (by closing the fiscal gap) starting 2008:  Real, per capita GDP in 2007:  $36,116; and in 2040:  $50,253 (still 39% growth over 33 years, but no more postponed tax increases afterwards).
• Under alternative fiscal scenario (extended tax cuts and higher Medicare spending) “paid for” (by closing the fiscal gap) starting 2040:  Real, per capita GDP in 2007:  $38,794; and in 2040:  $45,772 –just 18% growth over 33 years.

So that’s what I mean about the 39% growth being “not the half of it”–because contrary to just cutting my kids’ generation’s economic growth to less than half of the growth my generation has enjoyed up to now (and less than a third of the growth my parents’ generation enjoyed), if we recognize that the bill must eventually be paid, and if our kids indeed end up paying it in 2040, that too-low economic growth is cut by more than half again (to 18%).

In contrast, if we instead manage to stick to the CBO, current-law baseline levels of taxes and spending, even without yet addressing the longer-term challenges facing our entitlement programs, CBO shows that the fiscal gap over 50 years would be close to zero (0.6% of GDP), and there would be no fiscal gap (in fact a surplus of 0.7% of GDP) over the next 25 years.  Under that scenario:

• Under the extended-baseline scenario (current-law, or pay-as-you-go revenue and spending levels):  Real, per capita GDP in 2007:  $38,794; and in 2040:  $60,000 to $62,000 –or 55-60% growth over 33 years.

That’s why I think the expiration of the Bush tax cuts (at the end of 2010) provides our first real opportunity to do the right (fiscal) thing for our children and grandchildren and their economic future–even before we consider entitlement reform.  We don’t necessarily have to let all the tax cuts expire, and we don’t necessarily have to raise marginal tax rates to pay for the tax cuts we choose to keep.  But whatever tax cuts we do want to keep, we ought to be willing to pay for them in ways that keep revenues at baseline levels (or make up the difference with spending cuts), and in ways that make economic sense–both for today’s economy and especially for our children’s economy.  Having the next Administration and the next Congress stick with (and maybe even strengthen) pay-as-you-go budget rules would be a great step toward making that happen.