United States

Better economy no match for long-term fiscal threat

THE REAL ECONOMY  | 

If a combination of tax and entitlement reforms isn’t enacted, the United States will be headed toward another searing period of adjustment.

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Fiscal dynamics in the United States continue to improve, reducing near-term interest-rate risk linked to government spending. Growth in tax revenues and restraint in outlays have yielded a federal deficit of about 2.8 percent of gross domestic product (GDP) in 2014, with a small decline to 2.7 percent forecast for this fiscal year; both are below the 30-year average of 3.1 percent. Those improvements, however, driven by a modest increase in economic activity, mask the coming demographic and growth challenges that, if left unchecked, threaten to drive up the costs of policy changes necessary to prevent a budget crisis during the next decade.

If a combination of tax and entitlement reforms isn’t enacted, the United States will be headed toward another searing period of adjustment that will likely fall on the broad shoulders of the middle market, which comprises the bulk of the real economy. Moreover, if these tax and entitlement reforms aren’t implemented soon, additional layers of taxes, such as a value-added tax or a carbon tax, will likely be imposed. Either way, substantial change to the tax code is coming even with the temporary improvement in the fiscal condition of the economy.

For middle market firms, fiscal matters are of paramount concern. Expectations on taxes shape capital investment decisions during the medium to long term, and those decisions provide the foundation for increasing productivity and living standards in the economy. If middle market firms notice a drift in the fiscal direction toward no reform with additional layers of taxation looming on top of an already inefficient tax code, they will pull back on capital investment and expansion plans in a way that bodes ill for growth, productivity and better living standards.

Improvement in the near term fiscal picture masks the long-term structural challenges that will reappear as soon as 2016 to 2017. That’s when the Congressional Budget Office (CBO) estimates the Social Security Disability Insurance (SSDI) facility–comprised of the Old-Age and Survivors Insurance and Disability Insurance Fund–will exhaust its funds. At that point, the government will start shifting funds from the old age and survivors benefits–the other leg of social security–bringing forward the day it will, in turn, exhaust its funds.

MIDDLE MARKET INSIGHT: If middle market firms notice a drift in the fiscal direction toward no reform and pull back on capital investment and expansion plans, it will bode ill for economic growth.

During the next few years, policymakers should bring the primary budget deficit (the deficit excluding interest owed on past debt, which should be equal to about 2.2 percent of GDP on average during the next decade) to balance or to surplus. That would provide the necessary space to respond to any economic shock or earlier-than-anticipated test of the political system’s capacity to produce significant budget and taxation reform. Implementing policies that foster growth, along with substantial tax and entitlement reform, remains the key to putting the budget on a stable long-term path.


Source: RSM, CBO

From 1950 to 2007, the United States averaged 3.5 percent annual real growth. Since the end of the recession in 2009, growth has averaged just 2.3 percent. The Federal Reserve has reduced its long-run real growth forecast to 2.15 percent, which is in line with the CBO’s 2.3 percent projection during the next decade. Such a slow pace significantly challenges the support of entitlement obligations to future retirees.


The one percentage point lost in growth translates to around $1 trillion in output lost by 2025 and more than $3 trillion lost 20 years later. Assuming an average federal tax rate of about 21.7 percent (the average tax rate from 1990-2010) during the next decade, that suggests a net loss of about $230 billion in tax revenue to support demand for medical and retirement services.


To put that loss and the fiscal challenge unleashed by changing demographics into perspective, even if the United States experienced a period of above-trend growth near the 1945 to 2007 average, restoration of $200 billion in revenue would only cover 60 percent of the anticipated $375 billion shortfall in the SSDI program between 2015 and 2019. 


While the low-rate environment produced by Federal Reserve policy has provided an assist to the current financing of government debt, that will likely end this year. As rate normalization plays out, federal borrowing may drive capital away from private investment and thus generate lower productivity. As interest rates climb even further under conditions of non fiscal reform, higher taxes, lower spending on benefits, or both, may be the result. 


The first fiscal test will probably appear in 2016 or 2017 when the SSDI fund exhausts its trust. Soon thereafter, normalization of the term spectrum and demographic headwinds associated with the retirement of Baby Boomers will demand major tax and budget reform, whether Washington wants to or not.


The next and most serious test will begin in 2024 when the ratio of the population aged 65 and older to that aged 20-64 rises to 31 percent from 24 percent. During the succeeding 15 years, the tidal wave of retirees will increase, sending that ratio to 39 percent. In that time period, spending on Social Security will increase to 6.3 percent of GDP in 2039 from 4.9 percent. Without a credible and sustained period of reform that targets both fiscal and growth policy, once the demographic wave gathers momentum, policymakers will have fallen behind the curve. At that point, they will be forced to make choices in a crisis rather than making tough choices now about how to meet promised entitlements to retirees. 


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