U.S. Fiscal Policy: A Tough Balancing Act

IMF Blog, July 30, 2013

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The federal government budget deficit has fallen sharply from almost 12 percent of GDP in 2009 to less than 7 percent in 2012.
Recent budget reports show that the deficit is shrinking faster than expected only a few months ago, to a projected 4½ percent of GDP for the current fiscal year, which ends September 30.
Health care cost growth has slowed down dramatically since the Great Recession, alleviating pressure on public health care programs at least temporarily.
Despite improvements, if policy choices and timing are not right, deficit reduction may be "too much in the short run—stunting the economic recovery—and not enough in the long run."

Around this time last year there was concern that temporary tax cuts would fully expire and the sequester would kick in on January 1, 2013, creating a "fiscal cliff."
Congress partly averted the fiscal cliff: tax cuts were permanently extended for taxpayers below a certain income threshold, the sequester was delayed temporarily and allowed to take effect on March 1, 2013.
The sequester imposes indiscriminate budget cuts, affecting education, science, and infrastructure, at a time when the recovery is still fragile.
IMF estimates suggest that if the sequester did not happen, real GDP growth in 2013 would have been half a percentage point higher.

The longer-run fiscal outlook is not as intimidating as projected a few years ago.
In 2010, the IMF projected an unsustainable trajectory for public debt—federal government debt ratio could reach levels close to 100 percent of GDP.
Subsequent legislation has improved projections: the federal debt in 2020 is now anticipated to be about 20 percentage points below what it was projected to be back in 2010.
Nevertheless, long-term challenges persist because of population aging, rapid growth in health care costs, and anticipated increases in interest rates.
Spending on Social Security and major health care programs, even considering the recent slowdown, is expected to increase by close to 2 percentage points of GDP over the next decade.
A similar increase is projected for net interest outlays as interest rates gradually normalize.
With no further actions to raise revenues and reduce entitlement spending, the public debt ratio would start rising again from a relatively high starting point.

Implement a deficit reduction plan to curb pressure that emerges around mid-decade, when the recovery is complete, interest rates return to historical norms, and demographic pressures kick in.
The plan should:
- Protect the fragile recovery―the bulk of deficit reduction should begin when the economy is firmly back on its feet and before the public debt ratio starts rising again.
- Entail lower growth in entitlement spending and higher revenues―savings from entitlement reform accrue at a very gradual pace, so early legislative action is crucial to be able to reap the benefits later. Early action would also help contain the rise in long-term interest rates, thus promoting growth, and reduce the risk of turmoil in the Treasury market.
- Replace the sequester with better-targeted cuts and new revenues―these automatic cuts fail to address the real problem (spending on entitlement programs), hurt growth in the short term, and could damage medium-term potential growth if the reductions in education, science, and infrastructure spending are maintained.

Considerable disagreements exist across the political spectrum on what a deficit reduction plan should look like—hence, the continuing lack of a comprehensive plan.
Negotiations so far have shown that there is common ground that can form the basis for a bipartisan blueprint.
The overarching message: explore options to replace the sequester and fine-tune the pace of fiscal adjustment so that no harm is done to economic growth, and enact laws today that will address the medium-term threats to fiscal sustainability.

Source: U.S. Fiscal Policy: A Tough Balancing Act, Deniz Igan, July 30, 2013