US political stalemate stifles action on reducing debt and deficit

The US appears trapped in a dangerous economic stalemate, writes Martin Feldstein, chairman of former president Ronald Reagan's council of economic advisers.

Lucy Horwitz joins hundreds of anti-Wall Street protestors camped on the grounds of the Los Angeles city hall as part of the Occupy LA movement. Mike Nelson / EPA

The US appears trapped in a dangerous economic stalemate. The refusal by Republicans and Democrats to give ground on the budget is preventing the government from dealing with its huge fiscal deficit and rapidly rising national debt.

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The congressional budget office projects the national debt could increase to 82 per cent of GDP over the next 10 years - more than double the debt ratio as recently as 2008.

That forecast, moreover, is based on quite optimistic assumptions of strong economic growth and low interest rates. With slower growth and more normal interest rates, the debt ratio could easily rise to more than 100 per cent in 2021, and exceed 150 per cent by 2030.

A major reason for the accelerating growth in government debt is the US's rapidly ageing population and the resulting increase in the cost of the universal pension and healthcare programmes - social security and Medicare. Most experts believe limiting the rise in debt will require slowing the growth of these "entitlement" programmes and increasing taxes as a share of GDP.

But Barack Obama, the US president, and the congressional Democrats oppose any reduction in future entitlement programmes, while the Republican presidential candidates and their party's congressional delegation oppose any increase in tax revenues. The result is the current stalemate in reducing the fiscal deficit and reversing the growth of the national debt.

Republicans argue that the national debt's growth should be limited only by cutting government spending. Although some cuts in traditional outlays should be part of efforts to rein in spending, this approach should be supplemented by reducing "tax expenditures" - the special features of the tax code that subsidise health care, mortgage borrowing and local-government taxes among other things. Limiting tax expenditures could reduce the annual deficit by as much as 2 per cent of GDP, thereby reducing the debt-to-GDP ratio in 2021 by more than 25 percentage points.

Republicans generally reject this form of spending reduction, because it results in additional tax revenue. While this method does increase total revenue, the economic effect of limiting tax expenditures is the same as it is under any other method of cutting spending on those programmes. But the Republicans' opposition to anything that raises revenue means this method of breaking the budget stalemate will not be implemented.

The budget cost of social security pensions could be gradually reduced by substituting annuities generated by investment-based personal retirement accounts for part of the current tax-financed benefits. But even though such a reform could maintain income levels for retirees, Democrats oppose it, because it lowers traditional government benefits. This reinforces the stalemate. The two parties' hardline stances anticipate the general election next year.

Neither side wants any ambiguity in its message before the election, thus ruling out the possibility of any immediate changes in tax expenditures or future social security pensions. But, for the same reason, I am optimistic that the stalemate will end after the election. At that point, Republicans and Democrats will be able to accept reforms they must reject now.

Another post-election route to deficit reduction would be to lower marginal tax rates and balance that revenue loss with cuts in tax expenditures. Official analyses downplay the effect of lower marginal tax rates on taxable income, but experience shows that taxable income rises substantially as taxpayers respond to lower marginal rates by working more, taking more of their compensation in taxable cash than in fringe benefits, and reducing their tax-deductible consumption.

I may be too optimistic, but I think there is good reason to believe that the budget stalemate reflects election posturing, and that the US political system will make progress on fiscal consolidation once the election is past.

Martin Feldstein, a professor of economics at Harvard, was chairman of the US president Ronald Reagan's council of economic advisers and is a former president of the National Bureau for Economic Research.

* Project Sydicate