Implications of the Looming Budget Adjustments for Macroeconomic Activity

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Implications of the Looming Budget Adjustments
for Macroeconomic Activity

• Alan J. Auerbach
• University of California, Berkeley
• December 2, 2005

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Outline

• What We Face
• Policy Changes to Expect
• The Impact of These Changes
• How We Could Do Better

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What We Face

• Huge Long-Run Imbalance
• Using CBO 10-year baseline
• 4.6 of GDP through 2080
• 7.9 of GDP permanently
• Using Adjusted 10-year baseline
• 7.3 through 2080
• 10.6 permanently

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What We Face

• Long-run gap substantially larger than five years
  ago
• January 2001 3.3 - 4.1
• Now 7.9 - 10.6
• What happened?
• Spending growth
• Tax cuts
• The end is near(er)
• The economy (very little over long run)

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Policy Changes to Expect

• Three places to look (in decreasing order of
  importance)
• Health Care (Medicare, Medicaid)
• General Revenue (i.e., not dedicated) Taxes
• Social Security

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Policy Changes to Expect

• Primary focus has been on potential effects of
  current deficits (crowding out, interest rates,
  current account, etc.).
• But what about effects of necessary policy
  adjustments?
• What will happen to the economy when the music
  stops?or when people realize that it will stop?

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Coming Policy Changes Taxes

• Taxes as a share of GDP lower than at any time
  since the 1950s
• The current share is even lower if one excludes
  payroll taxes, which have risen as a share of GDP
  along with Social Security and Medicare, to which
  they are dedicated

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Coming Policy Changes Taxes

• Taxes as a share of GDP lower than at any time
  since the 1960s
• The current share is even lower if one excludes
  payroll taxes, which have risen as a share of GDP
  along with Social Security and Medicare, to which
  they are dedicated
• Given history and current gap, an eventual tax
  increase of 4 of GDP plausible

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How Would Taxes Change?

• Likely a mix of base broadening and marginal tax
  rate increases
• Base broadening look at recent tax reform panel
  report
• housing
• state and local taxes
• So, expect shifts in spending patterns from these
  sectors

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What Would Tax Changes Do?

• Sectoral shifts aside, what effects should we
  expect from higher tax burdens and higher
  marginal tax rates?
• Higher future tax burdens ?
• higher private saving
• higher labor supply
• Higher future marginal tax rates ?
• lower private saving
• higher labor supply

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What Would Tax Changes Do?

• Overall effects of impending tax changes
• sectoral shifts away from activities currently
  tax-favored
• increases in labor supply (employment/hours)
• uncertain impact on private saving

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Coming Policy Changes Entitlements

• Consider recent responses to Social Security and
  Medicare problems
• Medicare in face of huge long-run gap, increase
  long-run cost by 1/3 with unfunded prescription
  drug benefit
• Social Security no progress at addressing this
  easy problem
• Implication nothing will happen without a crisis

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Coming Policy Changes Entitlements

• A crisis will be characterized by the need for
  immediate action
• gap too big to be closed by increased payroll
  taxes alone
• but sizable benefit cuts unlikely for less
  affluent retirees, so
• Means testing of entitlements is in our future

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What Would Means Testing Do?

• Mixed incentives to accumulate retirement wealth
• positive, if benefits reduced
• negative, if reducing assets wards off benefit
  cuts
• In first scenario, increased incentive to work
  and save in second scenario, the opposite save
  less, and therefore need to work less

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What Would Means Testing Do?

• Overall effects of impending entitlement changes
  unclear

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Further Effects Trade

• Adjustment will eventually involve trade
  surpluses, to service accumulating international
  obligations
• Should lead to relative growth in trade-sensitive
  industries

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Further Effects Uncertainty

• Until we know what will happen, there should be a
  higher equity premium
• once we realize that something must happen

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Summary

• Policies outlined are costly to economic
  well-being
• sharp marginal tax rate increases
• means-testing and its disincentives
• uncertainty about future policy
• Costs could be reduced by more gradual,
  systematic plans, but recent policy actions not
  promising