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Sources of the Long-Term Fiscal GapPublished: May 24, 2004 || Availability: The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders. © TAX ANALYSTS. Reprinted with permission. Note: This report is available in its entirety in the Portable Document Format (PDF). Several previous studies have concluded that the United States faces a substantial long-term fiscal imbalance (CBO 2003, OMB 2004, GAO 2003, Auerbach, Gale, Orszag, and Potter 2003, Gokhale and Smetters 2003). This article extends previous work in two directions. First, we provide updated estimates of the fiscal gap using projections from the most recent Social Security and Medicare Trustee reports and new CBO projections for Medicaid and other spending. We find that the fiscal gap increased significantly in the past year. Over a permanent horizon, the gap is now in excess of 7 percent of GDP under the CBO baseline and above 10 percent of GDP under an adjusted baseline. This compares to estimates of about 7.5 percent of GDP under the adjusted baseline just a year ago (Auerbach, Gale, and Orszag 2003). About half of the increase in the gap in the past year is due to Medicare changes, with roughly one-fifth due to changes in revenue projections and one-fourth due to higher discretionary spending estimates.1 Second, we explore ways to address the question, "What is the source of the fiscal gap?" In a literal sense, the source is simply that projected revenues fall short of projected expenditures. The overall fiscal imbalance is a meaningful concept: It signals that an adjustment of either revenue or expenditure is necessary to avoid an explosion of government debt over the long term. Recent policy discussions, however, have generated interest in allocating the fiscal gap into components. Therefore, we develop and implement alternative frameworks that may be used to evaluate the source of the gap by expenditure category or tax level, and to provide perspectives on informal statements that suggest that the fiscal gap is "due" to one program or another, or to tax cuts. The task is more complicated than it may appear, and it raises serious questions about the value of any attempt to allocate the fiscal gap by budget category. Consider first the relatively straightforward question of how the gap should be allocated across expenditure categories. Most government programs are intended to be financed by general revenue and are not fully financed by dedicated revenue streams. Allocating the overall fiscal gap by program therefore requires some assumption, either implicit or explicit, about how future general revenue is to be allocated by budget category. We show that reasonable variations in the assumptions regarding the allocation of future general revenue generate substantially different distributions of programmatic contributions to the fiscal gap, underscoring the inherent ambiguities in attempts to allocate the fiscal gap by programmatic category. For example, if future general revenues are allocated based on the expected present value of spending in each program, then discretionary spending "accounts for" one-third of the long-term fiscal gap, and entitlements two-thirds. If however, future general revenues are allocated based on current spending in each program, entitlements account for more than 100 percent of the shortfall. (If general revenues are not allocated at all, the results are nonsensical.) The second concern is that allocating the fiscal gap across expenditure programs obscures the role of tax policy. The existence of a fiscal gap in a specific budget category does not necessarily mean that spending on that program is excessive; it merely means that projected future revenue (allocated according to some rule) is insufficient to finance projected future expenditures, and some adjustment to revenues, spending, or both, is therefore required. The concern over how programmatic fiscal gap measures could be misinterpreted arises in particular because a tax cut would be fully reflected in higher fiscal gaps within various expenditure programs under both approaches above (although in different proportions across the programs). That point provides another perspective on the problems with allocating the fiscal gap by program: Although an overall fiscal gap signals the need for a reduction in total expenditure or an increase in total revenue, a programmatic fiscal gap does not necessarily signal the need for changes within that program. Instead, it could signal the need for broader revenue or outlay changes that may be unrelated to the program itself but that would reduce the programmatic fiscal gap. Despite the possibility that the effect of tax policy changes on programmatic fiscal gaps could be misinterpreted, it is straightforward to calculate the increase in the overall fiscal gap attributable to a change in tax policy. We show that the 2001, 2002, and 2003 tax cuts, plus the cost of making the 2001 and 2003 tax cuts permanent, would widen the fiscal gap by 2.2 percent of GDP. How that increase is allocated across spending programs depends crucially on how projected general revenues are allocated to spending programs. One strong implication of our analysis is that policymakers should be wary of simplistic attempts to claim that the fiscal gap arises solely or mainly because of one or two programs. The logic of the budget constraint and the fact that general revenue is fungible make those statements highly conditional, and our results show how sensitive the pattern of allocating the fiscal gap across programs is to reasonable variations in the assumptions employed. Section I reports updated fiscal gap calculations. Section II reports projected future expenditures by program. Section III develops two ways of allocating revenues across expenditure programs, and reports the resulting fiscal gaps "by program." Section IV focuses on the role of revenues in the fiscal gap. Section V provides concluding remarks. Notes from this section 1. The fiscal gap is often expressed in present-value dollars. Our estimated fiscal gap is currently $86 trillion in present value under the adjusted baseline, up from $60 trillion last year (Auerbach, Gale, and Orszag 2003). The gap expressed in present-value dollars is significantly more sensitive to variations in assumptions than is the gap expressed as a share of GDP. Note: This report is available in its entirety in the Portable Document Format (PDF). |
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