## May 29, 2003

### The Fiscal Crisis of the State

The Financial Times, which seems to be trying to capture the coveted Marxist banker demographic, is reporting that the US Treasury Department buried a study indicating that current federal fiscal policies are out of whack by \$44 trillion, and helpfully provides the PDF of the report. Somewhat misleadingly, the FT describes this deficits totaling \$44 trillion in current dollars. The truth is, arguably, worse. The authors --- Jagadeesh Gokhale and Kent Smetters --- argue that deficits and debts matter less than what they call "fiscal imbalance".

[A]dopting short-term measures or arbitrarily truncating the projection horizon understates significantly the prospective financial shortfall that the federal government faces under today's fiscal policies. As a consequence, the degree to which current policy is unsustainable remains hidden from policymakers and introduces a bias in favor of current debt minimization at the expense of policies that would be fiscally sounder from a long-term perspective.

This Pamphlet proposes a pair of new measures called Fiscal Imbalance (FI).... The FI measure for the federal government equals current federal debt held by the public plus the present value of all future federal non-interest spending minus the present value of all future federal receipts. The FI measure indicates how much fiscal policy must be changed in order to be sustainable; a sustainable fiscal policy requires FI to be zero.... [Attending to FI would] render policy decisions free of the aforementioned bias and allow comparisons of alternative policies on a neutral footing.

Now, why do they think FI is the right thing to look at?

The federal government provides a myriad public goods and services.... The continued operation of these programs through the indefinite future at current levels of service or benefit provision per capita will depend upon the availability of resources for financing them. All federal purchases and debt service payments must ultimately be financed out of future federal revenues.... Although the government can borrow for temporary periods of time, the additional debt must also be serviced out of future tax receipts. Hence, current (net) debt held by the public plus the government's future non-interest spending must be balanced over time by its future receipts.

The government's overall fiscal policy may be called balanced if today's outstanding debt held by the public plus the present value of projected future non-interest spending equals the present value of projected future government receipts, where projections are made under today's fiscal policies. By present value, we mean that dollars paid or received throughout the future are discounted by the government's long-term interest rate in order to reflect their value today. A fiscal policy that is balanced can be sustained without future policy changes in either federal outlays or in the various sources of federal revenues. Hence, the Fiscal Imbalance measure as of the end of year t is defined as
FI(t) = PVE(t) - PVR(t) - A(t)
This definition is simply understood as the excess of total expenditures over available resources in present value. Here, PVE(t) stands for the present value of projected expenditures under current policies at the end of period t, PVR(t) stands for the present value of projected receipts under current policies, and A(t) represents assets in hand at the end of period t. Note that if the program for which FI is being calculated has debt outstanding, A(t) would be negative and would increase FI.

I think this is sound; you can run a debt forever, if you have the revenue to service it, and this isn't really a fiscal problem. You can spend more in the short run, if you have long-run revenues to cover it, and people are willing to lend to you on the strength of them (which is generally the case when your name is Uncle Sam). But if you don't have the money coming in, you're in trouble.

How much trouble? Well, I'm not about to double-check Gokhale and Smetter's arithmetic or projections; they could be wrong or exaggerating, for all I know. But assuming they did a competent job, things are pretty bad.

Taking present values as of fiscal-year-end 2002 and interpreting the policies in the federal budget for fiscal year 2004 as "current policies," the federal government's total Fiscal Imbalance is equal to \$44.2 trillion. By "present value," we mean that all future spending and revenue are not only reduced for inflation but are additionally discounted by the government's (inflation-adjusted) long-term borrowing rate. This calculation allows us to determine how much money the government must come up with immediately to put fiscal policy on a sustainable course. Since, of course, the government does not have an extra \$44.2 trillion today it must make cuts or increase revenue in future years so that, when discounted to today, the present value total of those cuts and extra revenue equals \$44.2 trillion. Of course, for their discounted value to equal \$44.2 trillion, the cumulative dollar value of future spending cuts and revenue increases must be more than \$44.2 trillion.... Our estimate of federal Fiscal Imbalance is more than 10 times as large as today's debt held by the public. Hence, implementing policy changes that only eliminate debt held by the public would still leave the federal government far from being financially solvent. Moreover, the FI grows by about \$1.6 trillion per year to about \$54.0 trillion by just 2008 unless corrective policies are implemented before then. This rapid annual increment is also around 10 times as large as the official annual deficit reported for 2002. How large must spending cuts or revenue increases be to eliminate the current \$44.2 trillion FI? We estimate that to achieve fiscal sustainability, an additional 16.6 percent of annual payrolls would have to be taxed away forever beginning today. Alternatively, income tax revenues would have to be hiked permanently by another two-thirds beginning immediately. Yet another alternative would be to permanently eliminate all future federal discretionary outlays. Moreover, the size of corrective policies will grow larger the longer their adoption is postponed. For example, waiting until just 2008 before initiating corrective policies would require a permanent increase in wage taxes by 18.2 percentage points rather than 16.6 percentage points beginning today.

Now, as I said, I haven't checked the math, and I'm not about to. There are important assumptions in there about the growth of social security and Medicare expenses which are beyond my ability to judge. (These are crucial to their attempt to work out the "generational imbalance" of fiscal policy, about which I won't say anything.) It seems like generally honest work, but it is from the American Enterprise Institute (and so they feel compelled to plug privatizing Social Security). It'd be nice if some people with actual knowledge of tax and fiscal policy would weigh in. It might be that most of the imbalance would vanish if we could just undo the tax code to where it was in January 2001; or it might be that the US government, and with it the global political economy, is deeply, deeply screwed. Now that I think about it, those are not mutually exclusive alternatives.