Practical Economics

Congress to Weigh Options for Reducing Federal Debt

Hard choices on Social Security, Medicare, defense and taxes can’t be avoided much longer.

By Richard DeKaser, Contributing Economist, The Kiplinger Letter

July 30, 2010

Is Washington serious about tackling the federal debt?
Maybe not quite yet, but we think policymakers are getting there. There’s no chance that lawmakers will take any action this year. There are just too many competing priorities -- plus the fall elections. But soon Washington will have no choice but to dig in.

The key is Obama’s debt commission. Its short-term mission is to balance the budget by 2015 -- not counting interest on the swelling national debt. That would slash the annual deficits by two-thirds, to about $500 billion. The long-term goal: Achieve fiscal sustainability, which is generally seen as holding debt at something under the equivalent of 65% of gross domestic product (GDP).

To get there would mean reducing the yearly deficit to about 2.5% of GDP and holding it there. The deficit now is about 9.5%, with spending around 23% of GDP and federal revenues only about 14%. For comparison, consider 1983, when spending was 23.5% of GDP and taxes, 17.5%. That yielded an annual deficit equal to 6% of GDP.

The commission may never endorse a plan, which requires the assent of 14 of its 18 members. But by Dec. 1, it will lay out a series of policy options for Congress and Obama to use as a basis for discussion.

Recommendations in four areas are likely:

• Social Security. Once regarded as the untouchable third rail of politics, savings in the Social Security program is now seen as low-hanging fruit, easy to get to. Gradually raising the retirement age to 68, calculating benefits using the Consumer Price Index instead of wage inflation and shaving a half point from annual cost-of-living increases would knock $548 billion off the deficit in 2040, for example. Another possibility is to raise the cap on earnings subject to payroll taxes, perhaps to 90% of earnings for everyone. That would juice up incoming revenue.
• Health care. Commission members say there’s no way to balance the budget without taking more steps to rein in costs. They’ll recommend applying a means test for Medicare and revising the recently passed health care law, which they say won’t cut costs enough. And Obama may go along with changes in the hard-won legislation, if he gets concessions on other matters important to his agenda.
• Other government spending. There’ll be proposals for belt-tightening all around, but the big savings are in defense, and that’s where the focus will be. A full-scale review is already under way, including plans to forgo or scale back big weapons systems -- the F-35 Joint Strike Fighter, the C-17 transport and more. More base closings, especially abroad, are also possible.
• Taxes. While a one-year extension of the Bush tax cuts is likely -- maybe even for high incomers -- rates will surely be raised at some point. Holding them steady for a year -- for all but high incomers -- costs $95 billion. For 10 years, the tab climbs to $2.46 trillion. Other tax options on the table include limiting itemized deductions and imposing a value-added tax.

All of the options are extremely painful, and lawmakers’ instincts will be to balk and refuse to budge.

The politicians won’t bite the bullet until no action becomes even more painful than making some unpopular choices. The question is how long it will take for them to come to that realization.

Senior Associate Editor Richard Sammon contributed to this report.

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