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After the recent “fiscal cliff” theatrics in Washington, it is clear that the vast majority of Americans believes the real crisis is our government’s failure to act responsibly. Long before the fiscal cliff, we went over a “political cliff” when unwillingness to make practical economic decisions came to define the culture in Washington.
The political cliff is not the only reason we faced the so-called fiscal cliff, which was itself just the first drop-off in a more dangerous fiscal cascade. The true fiscal crisis remains to be averted, and we can’t count on the politicians to come up with a workable plan. They illustrated why with the recent “compromise” tax solution, which made our fiscal situation worse – it added $4 trillion to the forecast debt over the next decade, a 25% increase from today.
Cliff-dwelling politicians are sending our country toward insolvency. Averting this crisis requires unconventional yet bold thinking. I propose such a plan.
Before I explain my plan to restore fiscal solvency and sanity, however, let’s look at the depth of the current crisis.
The true fiscal challenge
The current trajectory of debt growth is unsustainable and, if unchecked, its future cost will become unbearable in just a couple of decades, during most of our lifetimes. We may see today a glimpse of our future in Greece, suffering with over 25% unemployment, radically increased costs of medical care, years of economic contraction, the collapse of their ability to borrow on the open market, the rise of racist and extremist political movements, and the ignominy of foreign oversight of its national finances.
The US national debt, which was about 33% of GDP in the post-war era through 1980, now stands at about 70% of GDP, and it is forecast to hit about 300% of GDP within 75 years. Unfunded future benefit promises (i.e., Medicare and Social Security) are variously estimated to range from 3- to 15-times the size of the national debt. Interest payments on the national debt are forecast to increase tenfold, from 1.5% of GDP in 2011 to 16% in 2086. The Medicare and Social Security trust funds are on track to be depleted in about 13 and 20 years, respectively; thereafter, benefits would be cut drastically (by about 25%) from today’s levels.
The Treasury Department’s latest Financial Report of the US Government states that “the continuous rise of the debt-to-GDP ratio illustrates that current policy is unsustainable.” The Treasury estimates that preventing the debt-to-GDP ratio from rising unsustainably over the next 75 years would require running primary surpluses (revenues less expenses, excluding debt service) of 1.1% of GDP. This compares to an average primary deficit of 0.7% of GDP today. The difference – the “75-year fiscal gap” – is 1.8% of GDP, and must be closed by some combination of expenditure reductions and revenue increases.
The Treasury’s report, released last year, also emphasized that these “base case” projections assumed that the Bush-era tax cuts would expire and end on December 31, 2012. Because they were made permanent by the fiscal-cliff compromise, the fiscal gap now resembles the Treasury’s “alternative” case estimate, which is about 8.3% of GDP on average over the next 75 years. The GAO estimates that, in that alternative scenario, “by 2040 more than half of all federal revenue will go to net interest payments” and waiting 10 years to address the issue “would increase the fiscal gap to nearly 10% of GDP.”
In US budgetary terms, this gap could be closed if projected levels of revenues and spending improved about 40-50% from currently planned levels.
These are the numbers that define our true fiscal challenge.
A plan to step away from the cliff’s edge
Yet our political cliff means that the real challenge is effectively ignored by politicians, who prefer to fight partisan battles.
Voters, meanwhile, don’t realistically understand the challenge. A recent Pew Center poll found that “when faced with the tradeoff of taking steps to reduce the budget deficit or keeping Social Security and Medicare benefits as they are now, the public favors keeping benefits as they are now by a margin of 56% to 32%.” Nouriel Roubini, a leading macroeconomist, recently summed up the situation, saying: “America has yet to wake up to the full extent of its fiscal nightmare.”
To address the debt crisis, we must set aside policy disagreements and special interests’ demands and focus on the relevant numbers – stated in clear and quantifiable terms – that will get us to a practical financial framework.
Such a plan must be equitable, practical and comprehensible. Planned levels of expenditures and taxes should leave unchanged the policy choices currently reflected in law.
To that end, below are elements of an equitable, comprehensible and workable plan to resolve the fiscal challenge:
- A fixed-percentage surtax would be added to all federal income tax until fiscal balance is restored. Therefore, all taxpayers would pay more in equal proportion.
- A fixed-percentage spending cut would apply to all federal government expenditures until fiscal balance is restored. Therefore, all government programs would receive less, in equal proportion.
- The surtax and spending cut percentages would be equal. Therefore, tax increases and spending cuts would be proportionately equal.
- The tax and spending percentages would start at 2% and increase 2% each year until fiscal balance is restored. This would gradually restore fiscal balance in about 10 years.
- Until fiscal balance is restored, all remaining federal deficits would be financed with Treasury bonds funded by the Federal Reserve. This would immediately halt the debt explosion. It would not add to the net cost of financing our debt, because the interest we would pay on new debt to the Federal Reserve would be paid back to the government as income. Essentially, we would be funding our deficits with newly printed money, which may have an inflationary impact; that inflation may be viewed as another potential tax, one which would be also widely shared.
Taking these actions would do roughly the following: (See here, table 1.3, for the supporting data.)
- Forecast revenues would increase from the current level of about 15.8% of GDP to 19.3% of GDP over a decade, a 3.5% of GDP improvement.
- Forecast expenditures would decrease from the current level of about 24.3% of GDP to 19.9% of GDP over a decade, a 4.4% of GDP improvement.
- These improvements would total 7.9% of GDP over the decade. That amount is roughly equal to the 8.3% of GDP improvement from the current Treasury plan, described above, and would put the national budget on a sustainable course which closes the fiscal gap.
- Deficits would shrink from the current 8.5% of GDP to 0.6% of GDP over the decade.
- The funding of those deficits would increase the national debt; however, because the Fed would permanently hold and roll over all of that new debt, the net debt service cost would be zero. (While this may sound a bit like the $1 Trillion coin proposal that the administration recently rejected, it is not intended to be a shortcut around the coming debt-ceiling debate. This overall strategy would require a much bigger change in our approach to the debt.)
- The amount of debt issued in this manner would amount to approximately 40% of GDP. Debate about the likely inflationary impact of such a policy would be vigorous but inconclusive; until and unless this idea was put into practice, its effects are unknown. Those who believe it would be inflationary must be reminded that the Fed expanded the monetary base over the past five years by approximately 12% of GDP with no perceptible impact on inflation.
My proposal is unconventional, but it is clear that conventional policy measures – driven by our political-cliff culture – have failed and will continue to fail. The question we must answer is whether it is preferable to continue along the current, deteriorating path toward a precipice. Doing so will not produce any realistic plan, let alone a better plan than mine, in the foreseeable future.
My plan would immediately set the US on a reasonable course to fiscal solvency. In the future, more thoughtful changes remain desirable and possible. Meanwhile, my plan would make such changes easier to achieve by defining clearly the realistic fiscal goal.
Appendix 1 – Numerical Illustration
|
Year
|
Base
(current )
|
2013
|
2014
|
2015
|
2016
|
2017
|
2018
|
2019
|
2020
|
2021
|
2022
|
|
Policy changes (% GDP)
|
2%
|
2%
|
2%
|
2%
|
2%
|
2%
|
2%
|
2%
|
2%
|
2%
|
|
Revenue base reset to (% GDP)
|
15.8%
|
16.1%
|
16.4%
|
16.8%
|
17.1%
|
17.4%
|
17.8%
|
18.1%
|
18.5%
|
18.9%
|
19.3%
|
|
Revenue base as % of current base
|
102%
|
104%
|
106%
|
108%
|
110%
|
113%
|
115%
|
117%
|
120%
|
122%
|
|
Expenditures base reset (% GDP)
|
24.3%
|
23.8%
|
23.3%
|
22.9%
|
22.4%
|
22.0%
|
21.5%
|
21.1%
|
20.7%
|
20.3%
|
19.9%
|
|
Expenditures base as % current base
|
98%
|
96%
|
94%
|
92%
|
90%
|
89%
|
87%
|
85%
|
83%
|
82%
|
|
Base fiscal balance (% GDP)
|
-8.5%
|
-7.7%
|
-6.9%
|
-6.1%
|
-5.3%
|
-4.5%
|
-3.7%
|
-2.9%
|
-2.2%
|
-1.4%
|
-0.6%
|
|
Cumulative debt change (% GDP)
|
-7.7%
|
-14.6%
|
-20.7%
|
-26.0%
|
-30.5%
|
-34.3%
|
-37.2%
|
-39.4%
|
-40.8%
|
-41.3%
|
|
Improvement of fiscal balance trend
|
4%
|
8%
|
12%
|
16%
|
20%
|
24%
|
28%
|
32%
|
36%
|
40%
|
Lawrence Grossman (CFP®, MBA, AIF®, MA) is the founder and principal of Grossman Financial Management, a Benicia, CA-based fee-only registered investment advisory firm.
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