The Bottom Line

August 26, 2013

On Friday, we discussed the President's recent speeches on his policy proposals for higher education. With most K-12 schools and university funding coming from state and local governments, it's easy to forget the role the federal government has in supporting education. In addition to many federal programs that supplement or support primary and secondary education, the federal government plays a central role in providing aid and financing for higher education. In this post, we will take a broad look at the federal budgetary commitment to education, some of the major policy changes that have affected the education budget, and a preview of what lies ahead.

A Breakdown of the Education Budget

The Department of Education received appropriations of $68.0 billion for FY 2013, but mandatory programs and student loans complicate matters somewhat. The Pell Grant program is the largest at a total of $30 billion, funded through an annual $22 billion discretionary appropriation and also a mandatory fund. The majority of the remaining $42.9 billion of discretionary funding goes to K-12 education programs, special education programs, and education programs for the disadvantaged. The Department of Education has six grant programs for higher education, 14 programs to support K-12 teachers, five student loan programs, and dozens of other programs to support disadvantaged populations and special education (more information can be found here).

Note that included in the remaining discretionary and mandatory total in the chart below are student loans, which in 2013 will count as a over $40 billion net gain for the government under the Federal Credit Reform Act (FCRA) accounting method. But this gain from student loans is a result of extraordinarily low interest-rates and will not last when the economy returns to full capacity. Using fair-value estimates, student loans would be a $10 billion cost to the federal government at normal interest rates.

But looking at only the Education Department would far understate the federal government's budgetary support of education. Some programs related to education are managed by other departments; the early childhood education program Head Start is managed by the Department of Health and Human Services and the National School Lunch and School Breakfast programs are part of the Department of Agriculture.

We've also said before that tax expenditures can be better thought of as spending through the tax code. When thought of this way, provisions related to education will cost $46 billion in 2013. In fact, the 17 tax expenditures related to higher education rival the Pell Grant program in size. We've said before that many of these tax provisions are poorly targeted, often delivering a windfall to wealthier families. The largest tax provision, the American Opportunity Tax Credit (AOTC) will direct a quarter of its total benefits to families making over $100,000. 

Federal Support for Education


Source: Joint Committee on Taxation and Department Congressional Justifications
Note: Department of Education Funding Includes Student Loans

Recent Policy Changes in the Education Budget

Since President Obama took office, a number of significant policy changes have been made that affect education spending. The stimulus bill included the creation of the AOTC, which expanded the existing Hope Credit and made it fully refundable. The AOTC was due to expire at the end of 2012 but was extended for five years as part of the American Taxpayer Relief Act. In addition, Pell Grants awards were increased and temporary funding for some provisions and state relief were also included as a part of the 2009 stimulus. While some of the smaller provisions have since expired, the Pell Grant and AOTC expansions appear to be permanent but will add to the deficit unless offsets are found.

There have also been changes made to the income-based repayment (IBR) formula for student loans. In 2010, Congress passed the Health Care and Education Reconciliation Act of 2010, which reduced the rate of repayment for student loans from 15 percent of AGI to 10 percent and allowed forgiveness of the loan after 20 years in repayment (previously 25). In 2011, the President applied the new formula to student loans that had been issued since 2008. Some critics of the program have argued that its aid is poorly targeted and suggested the funds be reallocated to better targeted programs like Pell Grants.

Since the President took office, some provisions which save money in student loans have also been enacted. The largest change to education in the Budget Control Act, of course, was the creation of overall discretionary caps. But the BCA also eliminated the in-school subsidy for graduate students and applied the savings toward the Pell Grant program. The most recent change was the passage of the student loan bill, which linked rates to ten-year Treasury rates. The bill will only save $715 million over ten-years, but could potentially save more in the long-run as interest rates return to their historical averages.

What Lies Ahead for the Education Budget

The student loan bill resolved the most urgent temporary policy in the education budget, but many other issues will need to be addressed in the next few years. For next year, lawmakers still need to decide what to do with sequestration, which is creating a substantial gap between the House and Senate on funding levels for the Education Department. The House Appropriations bill would provide $121.8 billion for Labor-HHS-Education, while the Senate would provide $164.3 billion. Post-sequester funding for Labor-HHS-Education was $149.6 billion. With the FY 2013 continuing resolution due to expire at the end of September, lawmakers will need to make a decision in the next month.

Also unaddressed is a near $50 billion Pell Grant shortfall between projected award grants and funding levels. The Bipartisan Path Forward used a variety of policies to achieve savings, including eliminating the in-school interest subsidy to shore up the Pell Grant shortfall. The President's Budget and the New America Foundation's Education Policy Program have also proposed reforms that would address the shortfall, with the latter going further to redirect education resources from poorly targeted tax provisions to the more effective Pell Grant program.

As mentioned previously, lawmakers will need to decide whether to allow the AOTC to expire or to find a permanent expansion when the refundable credit expansion ends in 2018. If lawmakers decide that the AOTC expansion should be continued, they will need to find savings to offset those costs.

*****

While the majority of funding for education is handled by state and local governments, the federal government support for education is still a significant matter, particularly for higher education. Whether the Congress decides to move forward with the President's policies or not, some decisions will need to be made over the next few years.

August 26, 2013

Late last week, the Washington Post's David Fahrenthold published a piece claiming that "big government is mostly unchanged" since 2010, when lawmakers turned their attention towards fiscal issues and Republicans took control of the House. One of the facts Fahrenthold used is the nominal dollar level of spending, which is roughly the same in 2013 as it was in 2010 ($3.455 trillion versus $3.457 trillion, respectively). Some commentators took issue with using this measure to show that there was little change in the size of government, since it does not account for inflation or express figures against the size of the economy (although it does say that the inflation-adjusted decline in spending is about 5 percent). Using those measures would show federal spending shrinking in the past three years. In this blog, we'll take a close look at these numbers and provide additional context.

Meaningfully comparing numbers from recent years can be difficult due to the effects of the Great Recession and the resulting policy response. A number of temporary factors can greatly affect the numbers when removed. For example, the graph below shows outlays in billions of dollars and outlays excluding "automatic stabilizers" which are automatic policy responses to the business cycle, the 2009 stimulus, TARP, Fannie Mae and Freddie Mac support, and extensions of unemployment insurance. The numbers are presented both in nominal dollars and inflation-adjusted 2013 dollars. As you can see, the lines tell different stories, with a smoother growth rate of federal spending when the financial and fiscal response to the Great Recession is removed.

Source: CBO

It is true that the more common way to compare budget numbers across different years is as a percentage of GDP (adjusting numbers for inflation is another way). In that case, spending has declined by 2.6 percentage points, from 24.1 percent of GDP in 2010 to 21.5 percent in 2013. This decline has occurred in both discretionary and mandatory spending, although 70 percent of the decline is concentrated in the discretionary portion. Interest spending as a percent of GDP has remained roughly stable as lower interest rates have offset the increase in debt. 

Source: CBO

If we were to examine the nominal dollar calculations, though, there are a few things to consider. One thing, which we have pointed out before, is that financial-type spending, particularly for TARP and the FDIC, may distort some of these totals. In 2010, TARP recorded a huge negative outlay of $110 billion as the CBO drastically adjusted their cost estimate of the program downward. In addition, the FDIC required that member banks prepay premiums for the next three years, a timing shift which showed up in FY 2010. These temporary factors resulted in a $140 billion swing which essentially deflates 2010 spending relative to 2013.

There are also factors which have the opposite effect, mostly related to stimulus spending and the recession. Some temporary discretionary stimulus spending would show up in 2010, but would have mostly been spent by 2013. Some other programs, in particular unemployment insurance and Medicaid, have a lower nominal level of spending since 2010 as temporary stimulus spending has expired or economic conditions have resulted in lower outlays.

There have been many other non-stimulus/recession-related factors which come into play as well. The spending caps and sequester adopted in 2011 have been reducing discretionary spending. In addition, war spending has continued to decrease, with that effect also showing up in the discretionary budget. Social Security and Medicare spending have continued to increase, although the pace of the growth of the latter has slowed in recent years. It remains to be seen whether the Affordable Care Act, as it takes effect, or other structural health care changes will play an even greater role in slowing the growth of health spending.

Note: All spending-to-GDP ratios use old GDP numbers since CBO has not officially released budget data for 2013 with the new GDP numbers.

August 26, 2013

The National Association for Business Economics (NABE) conducted its semi-annual survey recently, surveying 220 economists on questions of fiscal, monetary, and regulatory policy. On fiscal policy, they showed remarkable consensus that the long-term deficit, rather than the short-term deficit, is the government's primary fiscal challenge.

In the survey, only 6 percent of economists thought that there was no fiscal challenge facing the federal government, and only 12 percent thought that the current deficit was the primary challenge. Meanwhile 37 percent of economists thought that ten-year deficits were the main issue, and 43 percent thought that deficits beyond this decade were the primary concern.

Source: NABE

In terms of addressing the longer-term deficit, a plurality (39 percent) favored a mix of tax increases and spending cuts, while 32 percent favored mostly spending cuts, and 20 percent favored policies to encourage economic growth. In terms of what specifically should be done, 43 percent of economists favored targeting federal health care spending while 19 percent offered up defense and 18 percent wanted to tackle other entitlement programs. Of course, those surveyed could have also favored addressing multiple areas. In terms of taxes, 42 percent favored broadening the individual and corporate tax bases, while smaller groups favored a carbon tax or a value-added tax.

Perhaps the most salient result of the survey is that more than two-thirds of economists thought that uncertainty over fiscal policy was holding back the economic recover. Given the events coming up in the fall, that issue will be brought to the forefront once again. But judging by the results of the survey, at least a plurality of economists favor easing up on the deficit reduction pedal (i.e. the sequester) in the short term and making changes to entitlement programs and the tax code to make the long-term fiscal picture sustainable.

August 26, 2013

Update: A new note from the Office of the Chief Actuary of the Social Security Administration finds that allowance rates actually fell during the Great Recession. The Coe and Rutledge brief appears to have been removed from the website for the time being. This blog includes an extra paragraph discussing the SSA's findings.

Recently, Norma Coe and Matthew Rutledge from the Center for Retirement Research at Boston College published a brief that examined the Social Security Disability Insurance program and how it was affected by the Great Recession. One concern of those advocating on behalf of the DI program is that it could create a disincentive to work and serve as a more costly version of unemployment assistance.

Coe and Rutledge explain that economic conditions can affect individuals' decisions to apply for disability insurance. During a recession, applying for disability insurance benefits becomes more attractive as individuals are more likely to be unemployed. Unemployed individuals' health is likely to worsen, which can increase the likelihood of receiving disability insurance. The brief cites other studies which have found that individuals with borderline health problems are less to apply during good economic times and more likely to apply during recessions.

Source: CRR

Consistent with expectations, applications for Social Security Disability Insurance rose by around 33 percent from 2007 to 2010. However, allowance rates, the rate of applications that are granted disability benefits, also rose during this period from 42 percent to 50 percent. This is surprising, as traditional thinking suggests that as relatively healthier people enter the applicant pool due to economic distress, the rate of payout will decrease.

Source: CRR

Coe and Rutledge did not find a correlation between education level and allowance rate that was significantly different from the allowance rate during an economic expansion, and were unable to identify the cause of the growth in allowance rates.

Notably, the Social Security Administration's Chief Actuary found results to the contrary. According to their data, allowance rates fell from 58 percent in 2008 to 54 percent in 2011 (based on preliminary data). According to their data set, the 2011 allowance rate would be the lowest since 1995, when it was 53 percent. They also found that allowance rates were lower than would be expected given two different models of the relationship between unemployment rates and allowance rates.

The Social Security Disability Insurance trust fund is due to be exhausted by 2016, according to the latest Trustee's Report. At that point, benefits will either need to be cut by 20 percent or funds will need to be transferred from the Old-Age Fund, which has its own solvency problems. With many possible reforms that could improve the program as well as make it solvent, it does not make sense to wait three more years before giving DI needed attention.

August 23, 2013

The slowdown in health care spending growth in recent years has been a hotly debated topic, as experts try to figure out the source of the slowdown. Some have theorized that it is due mostly to the weak economy, while others have argued that changes in the delivery of care or other factors, perhaps in anticipation of the implementation of the Affordable Care Act, have been the main drivers. Now, CBO has jumped into the action, estimating the specific sources of the slowdown in fee-for-service Medicare in a new working paper. The study of Medicare in particular is interesting because the nature of the program and its beneficiaries should theoretically make it less effected by cyclical economic factors than other forms of insurance.

In particular, CBO compares the 2000 to 2005 period and the 2007 to 2010 period to see why growth in Parts A and B was slower in the latter period; specifically, per-beneficiary spending growth was 3.2 percentage points lower. Unfortunately, they were only able to identify reasons for one-quarter (0.8 percentage points) of the slowdown.

While the 2007 to 2010 period covers the Great Recession, CBO found that the economic downturn had no meaningful effect on spending growth. They found that differences in payment rates accounted for 0.2 percentage points of slower growth, although the periods studied were before provider payment cuts in the Affordable Care Act were implemented in 2011, so that may be a higher contributor going forward. Changes in the health status of beneficiaries, in part due to the average age of the Medicare population declining, contributed 0.3 percentage points to the slowdown. The share of beneficiaries enrolled only in Part A of Medicare also rose during the 2007-2010 period, causing a 0.2 percentage point slowdown. Growth in the use of prescription drugs, which may sometimes discourage the consumption of other medical care, caused 0.1 percentage point of the slowdown. Changes in supplemental coverage like Medigap had no effect.

The authors note that economy-wide inflation was lower in the 2007-2010 period than the 2000-2005 period but that even after accounting for that, there was still a significant slowdown. One thing they did not appear to account for are spillover effects from non-Medicare health care affecting costs.

Based on this data, the authors concluded the following:

In sum, our understanding of the causes of the slowdown in Medicare spending growth between 2000 and 2010, as well as the likelihood of those factors’ persistence, remains incomplete. Nevertheless, we can say that the slowdown appears to have been driven in substantial part by factors that were not related to the economic recession’s effect on beneficiaries’ demand for services; some of the other influences on Medicare spending that could have contributed to the slowdown, such as changes in how care is delivered to beneficiaries, might hold down spending growth for many years.

Obviously, the paper leaves a lot of question marks about the source of the slowdown but indicates that at least some of it may be hear to stay. But it's encouraging to see that CBO has found evidence for more structural and, hopefully, longer-lasting explanations for the recent slowdown in health care cost growth. If this leads CBO to alter some of their long-term budget forecasts for the better, it will be very welcomed news. As we have said many times before, it is better to be prudent and not simply assume that the problem is solved. We have seen seemingly permanent shifts in health care be illusory, particularly in the late 1990s. It would be better to be proactive and make health care spending sustainable considering how central it is to the fiscal outlook.

August 23, 2013
Our National Debt is Real and Growing

When Congress returns from recess in early September, they will have to address two major upcoming challenges: pass appropriations for next year before October 1, and raise the debt limit before the nation bumps up against our legal cap on borrowing, which could happen as early as October. An inherent part of this debate is the fate of the sequester--whether Congress will keep the reduced spending levels created by across-the-board cuts, or replace them with a credible long-term plan to replace the deficit.

Former Representative Jim McCrery (R-LA), a member of Fix the Debt's steering committee, explains the recent improvement in short-term deficits. McCrery served as as Ranking Member to the House Ways and Means Committtee, which oversees both taxes and many entitlement programs.

At the heart of both of these issues is a fundamental disagreement among Republicans and Democrats, conservatives and liberals, about federal spending, budget priorities and deficits, and the national debt. Some appear satisfied that the deficit appears on track to narrow substantially for the first time in a long while. So far this year, the government has “only” run a deficit of $607 billion, compared to the $974 billion deficit accrued in the same 10 months of fiscal year 2012.

In addition to the two immediate concerns about the FY 2014 budget and the debt limit, McCrery argues that Congress has not done enough to tackle our nation's long-term debt problems:

The reality is Washington has yet to enact a plan to slow the growth in debt over the long term and promote long-term economic growth. If this inaction continues, our country faces rising interest rates, slow rates of economic growth, less budgetary flexibility in times of national emergencies, an increasingly destructive burden on our children and grandchildren, and a greatly heightened risk of a tragic fiscal crisis.

 Therefore, America needs a bipartisan compromise, inclusive of comprehensive tax and entitlement reform, not some poorly conceived stop-gap measure like sequestration. When our Senators and Congressmen return to Washington in September, our budget and fiscal situation should be their top priority.

Read the full post here.

"My Views" are works published by members of the Committee for a Responsible Federal Budget, but they do not necessarily reflect the views of all members of the committee.

August 23, 2013

As part of an ongoing series of economic speeches entitled A Better Bargain for the Middle Class, President Obama spoke yesterday at the University of Buffalo on higher education, with additional speeches today at Binghamton University and Lackawanna College. Like his previous speeches on housing, the President laid out a series of policies to make higher education more affordable, some of which were included in his 2014 budget, others that are new.

Recent passage of the student loan bill created a permanent solution for student loan rates; by linking them to Treasury rates, they will remain low temporarily until the economy has recovered without adding to the deficit (the bill saved a modest $715 million over ten years, with greater long-term savings in theory). With this budget issue resolved the President has turned to proposing measures that could help foster competition, tie federal funds to performance for students and colleges, and reduce the burden of student debt.

Pay for Performance Measures: Many of these proposals are new, and the budgetary impact is unclear. The President proposes developing a college rating system based on "access, affordability, and outcome" and tying federal financial aid to those rankings. In particular, the White House suggests offering a bonus to colleges with greater numbers of Pell graduates. By itself, the proposal would increase the deficit, but offsets could be found in other areas, such as reducing payments to low Pell Grant schools. Low performing schools would also be required to disburse Pell Grant funding over the course of the semester, instead of in a lump sum, to prevent funding to go to those who drop out. Individual accountability would be enforced by requiring completion of a certain number of class or other progress measure before receiving next semester's Pell Grant. Included in this section is a request for an additional $1 billion in Race to the Top funding for state-based higher education reforms, also proposed in his FY 2014 budget.

Promote Innovation and Competition: Many of these measures will not have a budgetary impact, including greater use of online and "hybrid" courses, incorporating technology, recognizing dual-enrollment and other policies.

Student Debt Proposals: The President's main proposal, also included in his FY2014 budget, would expand Pay-As-You-Earn (PAYE) to all borrowers. PAYE modified income-based repayment plans by limiting federal loan payments to 10 percent of a borrower's income, with a maximum of 20 years of repayment. Currently, those who took out loans before 2008 or have not borrowed since 2011 are not eligible for PAYE, and the proposal would expand the program at a cost of $4 billion over ten years. The New America Foundation's Education Policy Project has previously argued that the IBR changes may be giving a windfall to some wealthier borrowers and suggests a number of reforms that could better target resources.

Unfortunately, missing from the speech and supporting resources was any discussion of the nearly $50 billion funding shortfall that the Pell Grant program faces over the next ten years. The President's Budget allocated $12 billion in mandatory funding to supplement discretionary spending. The Bipartisan Path Forward and the New America Foundation's Education Policy Program also have addressed Pell Grant funding without increasing the deficit by finding other education savings. In order to maintain this program, the funding gap must be addressed.

August 22, 2013

Last week, we noted that it was the 78th birthday of the Social Security program, but cautioned that reform was needed before we could count on another 78 years of sustainability. According to the latest Trustees Report, Social Security's trust fund is due to become insolvent by 2033, well within the lifetime of many of today's workers, and a 23 percent cut would need to be leveled on all beneficiaries for spending to match revenues. But compared to the decisions that need to be made on sequestration, the expiring government funding bill, and the debt ceiling, one might ask: Why is it important to do this now?

Today, CRFB has released a new report that shows the significant costs of waiting. While there are many options that could be combined to ensure 75-year solvency (try our Social Security Reformer to see), the longer policymakers wait to make reforms, the greater the costs. The report presents four main reasons why lawmakers cannot afford to wait with quantitative analysis for each.

  • Waiting to Act Places a Greater Burden on Fewer People
  • Waiting to Act Reduces the Accumulation of Interest in the Trust Fund:
  • Waiting to Act Makes Cuts to Real Benefits Harder to Avoid
  • Waiting to Act Gives Workers Less Time to Plan and Adjust

For instance, the percent benefit cut needed to close achive 75-year solvency is one of many examples that we use in the paper to show the advantages of starting early.

Achieving solvency for the program will require tough choices, which lawmakers may wish to avoid, but the challenge will only become more daunting the longer we delay. As we conclude in our paper: The right time to act to reform Social Security was two decades ago. The next best time is now.

Click here to read the full report.

Click here to try our Social Security Reformer.

August 22, 2013

This is the second post in a new CRFB blog series The Tax Break-Down, which discusses tax breaks under discussion as part of tax reform.

Last-in, first-out accounting, or LIFO, is a preferential method of measuring profits from inventory sales and is one of the ten largest tax breaks in the corporate code. LIFO accounting has been part of the U.S. tax code since 1939, but it is a uniquely American invention; it is not permitted under International Financial Reporting Standards.

To determine taxable profit, a company must subtract costs from gross revenues. LIFO accounting allows companies to sell inventory and calculate the purchase cost of that inventory -- which determines the deduction they may take -- as if the most recent product sold was the most recent bought and stored as inventory.

By contrast, for normal accounting, most companies use first-in, first-out (FIFO) accounting, which assumes that the item sitting on the shelf for the longest is sold first. Since prices tend to rise over time, being able to sell the last product first often allows companies to claim they paid the highest price and therefore achieved the lowest amount of profit for tax purposes.

For many retail industries, where goods are bought and sold quickly, there is little difference between the accounting methods. However, in industries where inventories move slowly and prices change quickly (like industrial equipment or petroleum), the difference can be significant. This difference is most pronounced for companies that bought their first inventories decades ago.

To take an extreme example, assume a company purchased a barrel of oil for $1 in 1939, when LIFO was first adopted, and then purchased an additional barrel each year with the hopes of selling that oil starting in 2013. Under standard accounting "FIFO" rules, the first barrel of oil the company sold would generate about $100 of revenue at a $1 cost, leaving a $99 taxable profit. By comparison, LIFO rules would allow the company to subtract last year’s cost of about $90 and pay taxes on only $10 of profit – allowing a 90 percent reduction in the company’s tax burden.

Though the above example rarely occurs so starkly, many companies keep some inventory indefinitely, leading to a permanent deferral of some of their tax liability.

Below, we answer other questions about LIFO accounting rules.

How Much Does It Cost?

According to Joint Committee on Taxation, the cost of the LIFO tax break is about $5 billion in 2013, which we estimate at $60 to $65 billion over a decade. Most (85 to 90 percent) of the value of LIFO accrues to C-Corporations paying the corporate income tax, while the remainder accrues to pass-through entities which pay through the individual tax. Another related tax expenditure called lower-of-cost-or-market (LCM), which allows companies to deduct losses if inventory costs at market prices are below the purchase price, costs an additional $8 billion or so over a decade.

Because the transition from LIFO to FIFO would lead to the reclassification of current inventory, the revenue raised from repealing LIFO would be more than the value of the tax expenditure in the short run. According to our Corporate Tax Calculator, repealing LIFO on its own would raise enough revenue over ten years to reduce the corporate tax rate by 0.6 percentage points. Importantly, the corresponding rate reduction would be much less significant over the long-run.

Who Does It Affect?

LIFO is used primarily by a select group of companies who have had time to accumulate old inventories. A "LIFO reserve" is the cumulative total of the profit difference between using LIFO and if the company had been using FIFO in that year. It does not represent available cash, but the amount that past profits would be higher under a different accounting system. According to CFO Magazine, energy companies hold over one-third of LIFO reserves, and manufacturers about one-sixth. This chart only measures publicly traded companies ranked by Moody’s, as only publicly traded companies must disclose their LIFO reserve.

Inventory and LIFO Reserve by Industry (millions)
Industry Inventory LIFO Reserve Percent of Total
Automobile $3,236 $387 1%
Chemicals $23,905 $3,797 9%
Consumer Products $15,738 $2,198 5%
Energy $228,974 $14,960 37%
Forest Products $7,672 $884 2%
Manufacturing $48,842 $7,724 19%
Metals and Mining $8,876 $4,100 10%
Retail $30,238 $3,341 8%
Other $48,031 $2,868 7%
Total $415,512 $40,259 100%

Source: Moody's Investors Service

What are the Arguments For and Against LIFO?

Repeal proponents argue that LIFO has no value as an accounting system and is only used to reduce tax liability. Put even more bluntly, critics have described LIFO as a "massive tax holiday for a select group of taxpayers." Repeal would end a system where taxpayers can permanently defer taxes on gains from rising prices. In addition, they argue that LIFO encourages an economically inefficient accumulation of inventory. In their view, LIFO is "the equivalent of a deduction for a cost that is never incurred" because of the tax deferral it represents.

Proponents of retaining LIFO, on the other hand, argue that LIFO encourages economically-valuable inventory investment and keeps inventory on comparable footing with other investments like machinery and buildings that benefit from accelerated depreciation. LIFO proponents also argue that LIFO accounting offsets what would otherwise be a tax on inflation, since inventory value may increase simply because prices do. Finally, they argue that repealing LIFO would mean taxing past decisions – as far back as 70 years ago – and claim "the extent of this retroactive reach by the government appears to be unprecedented in the history of the Internal Revenue Code."

What are the Options for Reform and What Plans Have Other Plans Done?

Most comprehensive tax reform plans would repeal LIFO accounting, including the President’s Business Tax Reform Framework, the Simpson-Bowles tax reform plan, the Domenici-Rivlin tax reform plan, and even the 2007 tax reform bill introduced by Charlie Rangel. The Wyden-Gregg bill from 2010 does not repeal LIFO, though it does propose a one-time adjustment for large oil companies which reduces the benefit of LIFO by re-valuing their inventory.

When it comes to repealing LIFO, however, there are a number of questions which have to be answered. For example, what accounting mechanism is it replaced with? And is the repeal accompanied with a repeal of lower-of-cost-or-market rules?

Furthermore, immediately repealing LIFO and replacing it with FIFO would cause companies to claim large one-time profits from their historic inventories, which would be a massive one-time tax increase. Most proposals to repeal LIFO would space out back taxes over a number of years. As a result, revenue estimates will vary based on reform plan – though they will always be substantially larger over the first decade than over the long-run. For instance, CBO estimates that repealing LIFO and spreading the profits over 4 years will raise about $100 billion over that per, but only 

Parameters and Revenue from Different LIFO Options
Policy Savings
Plan
Re-valuate LIFO inventories for large integrated oil companies; repeal LCM $12 billion (2011-2020) Wyden-Gregg
Replace LIFO and lower-of-cost-or-market (LCM) with FIFO or specific identification method, phased in over 4 years $112 billion (2014-2023) CBO Budget Option
Replace LIFO with FIFO, phased in over 10 years $78 billion (2014-2023) President's Budget
Replace LIFO with FIFO, phased in over 8 years $107 billion (2008-2017) Rangel Bill (HR 3970)
Repeal lower-of-cost-or-market (LCM) method, phased in over 4 years $5 billion (2014-2023) President's Budget

Where Can I Read More?

* * * *

Repealing LIFO for inventory accounting would bring the United States in line with international accounting standards while eliminating a major source of tax deferral for businesses. At the same time, LIFO can adjust for gains due solely to inflation and maintain tax neutrality between inventory and other types of capital. With that said, retaining LIFO would take a sizeable amount of revenue off the table, even if more of that revenue is one-time, upfront revenue rather than a long-term permanent gain. But dealing with LIFO isn't just a matter of repeal or retain--policymakers must decide which accounting method works best to determine how inventory is counted in a business's taxable income.

Click here to read more entries in The Tax Break-Down.

August 21, 2013

With President Obama set to give a speech in the coming weeks on retirement security, the Center for American Progress (CAP) has released a report describing a new retirement account that intends to improve on current 401(k)-type plans. Their report discusses their Secure, Accessible, Flexible, and Efficient Retirement Plan (SAFE), and focuses primarily on the potential merits of collective defined-contribution (CDC) plans, as compared to traditional defined-contribution or defined-benefit plans. The report analyzes how such plans would outperform traditional 401(k)s and thus benefit retirees.

CAP first describes some of the shortcomings of current defined-contribution plans and how CDCs would address them. In short, current 401(k)s put the financial risk on the workers and rely on those individuals to make investment decisions. CAP argues that the latter point often results in adverse economic decisions, generally as a result of participants not weighting the riskiness of their portfolio in the optimal way. In addition, individual 401(k)s have higher management fees than would be the case under a CDC plan.

CAP's SAFE Retirement Plan would instead pool contributions to spread risk around, in addition to having the plan be professionally managed so as to take advantage of better investment strategies than may be the case if individual investors were managing it. In addition, the fund would manage risk by having a flexible reserve fund; one added to when returns exceed a certain amount and depleted when returns are negative.

The report's actuarial analysis shows that the CDC plan would hypothetically have provided a much higher replacement rate for retirees than a "real-world" 401(k) and a slightly higher replacement rate than a theoretical perfectly managed 401(k). They also show that the CDC plan would be less risky, showing that it would have much better protected workers who retired during the Great Recession.

The CAP report is a good reminder that while the three legs of retirement security -- Social Security, pensions, and individual savings -- are affected by different parts of the government, policymakers should keep in mind how the three could best work together when making changes to any individual one. Although the most important thing we can do for retirement security is to make Social Security solvent, it is important to consider all parts of the retirement system.

August 21, 2013
Neither The President Nor Congress Earned A Vacation This Summer

It's the dog days of August and with Congress in recess, we can do nothing but wait to resolve some of the upcoming fiscal challenges that lie ahead. We have made some progress, particularly in beginning to seriously discuss tax reform, but overall, there is a still a tremendous amount of work that remains to be done in the fall.

Today in Forbes, CRFB board member and former Congressman Bill Frenzel (R-MN) expresses his disappointment with the effort so far:

Just like in the stables, when the job is not done, work begins to pile up. The debt ceiling which reached its limit in May, has been postponed by clever manipulations at Treasury, but it will bite us sometime in the 4th quarter. No progress has been made there. Indeed, other than public statements of no concessions, the matter has hardly been discussed.

September 30 is the deadline for financing the government for Fiscal Year 2014. In its budget, the Senate dismissed the sequester. The House budget etched it in stone. There have been no real efforts to negotiate the differences yet.

No appropriations bills have been enacted, so another set of continuing resolutions will have to suffice, but the same budget differences  must be negotiated there. Perhaps the appropriators will be better negotiators than the budgeteers, but there is no evidence of that yet.

The sequester poses a similar, but slightly different, problem. Both parties, and nearly all the policy makers, believe it is a thoughtless way to cut expenses. There is general agreement that it must be modified, but no agreement as to how. The Senate insists on wishing it away. The House demands that the total spending reductions be maintained and that other cuts be substituted for the unwise “meat-axe” approach.

Frenzel goes as far to say that a small deal will be the best possible outcome this fall. That might be too pessimistic, as there have been some signs that the leadership in Washington still sees a grand bargain as a real possibility. And as we showed last week, even a "mini deal" would contain some long-term savings and thus be a better option than one year of sequestration if lawmakers should fall short. Still, our long-term problem demands tax and entitlement reform, which will only get harder the longer we wait. Washington should heed the wake up call from Frenzel.

Click here to read the full piece.

"My Views" are works published by members of the Committee for a Responsible Federal Budget, but they do not necessarily reflect the views of all members of the committee.

August 20, 2013

Frequent readers of this blog will be familiar with projections of long term debt. But the Peterson Foundation has found an interesting interactive way to present that informs the viewers about what the long-term outlook looks like and what the possibilities are going forward.

Peterson's presentation contains both a four minute video explaining the long-term projections and an interactive graph that allows users to look closer at the numbers. The projections appear to be based on CBO's Alternative Fiscal Scenario and show that even with the fiscal cliff deal, the sequester, and some slowing in projected health spending, debt as a percent of GDP would be on a sharply upward path over the long term. This is also true of the CRFB Realistic baseline, although the path is not quite as sharp.

In addition to showing what the status quo looks like, the graphic also shows what the five fiscal plans presented at the Foundation's "Solution Initiatives II" last November do to the debt. As we said last year, all of the plans at least stabilize the long-term debt and generally put it on a downward path. Each plan's label also links to a full description of the policies involved, so viewers can see how the plans got to where they are. The interactive also includes a sliding breakdown of spending and revenue projections over the next 40 years, convincingly showing the growth of entitlements.

The new presentation is a helpful resource for understanding the long-term projections and what some think tanks have proposed to change them. You can see the video and graphic here.

August 20, 2013

Even though Washington slows down in August, several think tanks are staking out positions in advance of this fall's pending fight over the debt limit and next year's budget. For example, today two organizations - Americans for Prosperity and Americans for Tax Fairness - have put forward two different approaches.

Americans for Prosperity, a conservative group, is encouraging legislators to maintain federal funding at reduced, post-sequester levels. In making their case, AFP highlights the fact that several appropriations bills that have stalled in the House over a seeming lack of Republican consensus regarding how to live within the existing, post-sequester caps. They express concern that if lawmakers remove the sequester without finding any offsetting savings, federal spending will be $1.2 trillion higher over the next 10 years. As the Financial Times reported,

AFP is raising its concern amid signs that a small number of Republican legislators are starting to balk at the tough austerity line the party has adopted since gaining the majority of the House of Representatives in 2010, including the budget mechanism known as "sequestration."

By contrast, Americans for Tax Fairness, a progressive group, released a report today comparing the price of certain corporate tax expenditures with the impact of various spending cuts under the sequester. Their plan suggests repealing certain corporate tax breaks and ending deferral of foreign-source income to raise revenue and offset some of the sequester's spending cuts. Their policy proposals include:

First, we've said before that the corporate tax code is in need of reform, and there are many options on the table for consideration, including those listed above. However, we believe reforming the corporate code should be done as part of comprehensive tax reform that addresses both the individual and corporate side in order to make our tax system more efficient, effective, fairer and contribute to deficit reduction.

Second, we've said the sequester is not a smart way to cut the deficit, and therefore policymakers must come together on a comprehensive debt reduction package that replaces part of the sequester with smarter cuts, coupled with meaningful entitlement and tax reforms. It is encouraging to see think tanks acknowledge that repealing the sequester without offsetting replacements would be costly, and that any replacement should be fully offset. But given the opportunity over the coming months, we hope lawmakers go even further than addressing the sequester, and an agree upon a comprehensive plan that includes entitlement and tax reform that meaningfully addresses our long-term debt problem.

August 20, 2013

This is the first post in a new CRFB blog series The Tax Break-Down, which will analyze and review tax breaks under discussion as part of tax reform.

The state and local tax deduction is one of the largest in the tax code and allows individual income taxpayers who itemize to deduct from their income the cost of certain taxes paid to state and local government. Specifically, it allows for three different types of taxes to be deducted from income: income taxes, property taxes, and sales taxes – though the sales tax deduction expires at the end of the year.

The deductions for state and local taxes have been in place since the income tax was created in 1913 – though the sales tax deduction was removed in the Tax Reform Act of 1986 before being added back on a temporary (but continued) basis in 2004. Most other countries have no equivalent deduction, in part because the federalist nature of the United States (with autonomous state governments) is relatively unique.

Below, we answer a number of questions about this tax break.

How Much Does It Cost?

The state and local tax deduction is the seventh largest tax expenditure in the tax code costing the federal government $77 billion of foregone revenue in 2013 according to JCT and CBO and $1.1 trillion over the next ten years. OMB estimates the cost at $64 billion in 2013. Based on CBO's numbers, this amount of revenue could be sufficient to reduce all individual taxes by about 5 percent (which translates into 2 points for the top rate) or reduce each rate uniformly by about 1.5 points.

About three-fifths of the deduction’s cost comes from the income tax deduction and the remainder from the property tax deduction.  A small portion – about 2% in 2011 – comes from the sales tax deduction which would cost $15-20 billion to extend over the next ten years.

 

Importantly, the value of the state and local tax deduction interacts significantly with the Alternative Minimum Tax (AMT) which allows no deduction for these taxes. Repealing the AMT, as a number of tax reform plans propose, would noticeably increase the size of the state and local tax deduction. According to numbers published in 2010 by the Tax Policy Center, when taxpayers recalculate their income under the AMT, roughly two-thirds of the increase comes from denying state and local tax deductions.

Who Does It Affect?

As an itemized deduction, only 27 percent of taxpayers take advantage of the state and local tax deduction every year. According to the Congressional Budget Office (CBO), a full 80 percent of the value of the preference flows to the top 20 percent of the income spectrum. Three tenths of the value of the deduction, meanwhile, flows to the top 1 percent of the population. Whereas the deduction increases after-tax income for the average taxpayer by about 0.8 percent, it increases after-tax income for the top one percent by 2.2 percent.

 

Source: CBO

Yet the benefit of the tax deduction is skewed not just by income but by state. High-income, high-tax states like California and New York claim 17 and 13 percent, respectively, of the deduction, while residents in many low-tax states in the Midwest and Rocky Mountains see almost no benefit. As the Tax Policy Center points out, half the beneficiaries and over 60 percent of the amount deducted comes from just 10 states.

 
Source: CRFB calculations based on 2011 IRS Statistics of Income data. Mapping tool provided by the National Council of Teachers of Mathematics

Eight states have no state income tax, and get much more benefit from the sales tax deduction. If the sales tax deduction expires at the end of the year, states that depend on sales tax revenues rather than the income tax, like Washington, Texas, Florida, and Tennessee will lose most of the deduction’s benefits.

What are the Arguments For and Against the Deduction?

Proponents of keeping the state and local tax deduction argue that the deduction prevents double taxation, since a portion of the taxpayer's income that would otherwise be taxed by the federal government is already taxed at the state level. Proponents also argue that the state and local tax deduction is a form of financial assistance to the states, by reducing the tax burdens of their residents. In addition, it is important to remember that the state and local tax deduction – or at least the income tax deduction – reduces taxpayer’s effective marginal rates by blunting the impact of high state income tax rates.

Critics point out that that deduction is regressive and provides a back-door subsidy to high-tax states and localities. This provision unwittingly has residents in low-tax states subsidize budgets in states with larger governments. The deduction also favors some state revenue sources over others, for example license fees and severance taxes – which fund much of the government in Delaware and Alaska, respectively, are not deductible. Finally, critics argue the $1.1 trillion cost of the deduction could be better used for repealing the much-loathed Alternative Minimum Tax while reducing rates or deficits.

What are the Options for Reform?

A number of options exist to reduce the cost of the state and local tax deduction. One possibility would be to eliminate it in its entirety (possibly in part of a trade to repeal the AMT), or to eliminate either the property or income portion of the deduction.

Short of elimination, the deduction could be converted into a credit, limited to a certain rate (i.e., the 28 percent rate), capped as a percentage of income, or limited to a certain dollar amount. The most recent available score of full repeal was in 2011, when CBO estimated $862 billion in ten year savings. In today’s terms measured against the laws currently in place, this would likely be the equivalent of nearly $1.1 trillion. More modest options would result in smaller amounts of savings.

Options for Reforming the State and Local Tax Deduction
Option 2014-2023 Revenue
Repeal the S&L Tax Deduction $950 billion
Repeal the Income Tax Deduction Only ~$600 billion
Repeal the Property Tax Deduction Only ~$350 billion
Cap the Deduction at 2 percent of Income $720 billion
Cap the Deduction at $5,000 Per Person (indexed) $600 billion
Limit the Value of the Deduction to the 28% Bracket $150 billion
Replace the Deduction with a 15% Credit $240 billion

 

What Have Tax Reform Plans Done With The Deduction?

Unlike some of the other large tax expenditures, there appears to be substantial support among bipartisan plans for a full repeal of the state and local tax deduction. Since the 1984 Treasury paper that launched the 1986 tax reform effort called for its complete repeal (which was not achieved in 1986), a number of plans have followed in step.

President Bush's 2005 tax reform panel called for complete elimination, arguing that state and local taxes pay for public services and “should be treated like any other nondeductible personal expense, such as food or clothing, and that the cost of those services should be borne by those who want them – not by every taxpayer in the country.” The Fiscal Commission illustrative plan and the Domenici-Rivlin tax reform plan also fully repealed the deduction. 

To be sure, not all tax reform plans follow that model. The Center for American Progress, for example, replaces the state and local tax deduction with an 18% credit. And the Wyden-Coats Bipartisan Tax Fairness and Simplification Act leaves the deduction in its entirety (though it would likely be used less, because the standard deduction is tripled). It remains to be seen what the tax reform bills put forward by Chairmen Camp and Baucus do with the deduction.

Where Can I Read More?

*    *    *    *

The state and local tax deduction is expensive, regressive, targeted toward a small number of states, and is certainly ripe for reform. At the same time, any changes to the deduction, unaccompanied by other reforms, could modestly reduce work incentives, make some states less appealing to live in, and substantially increase the tax burden of some taxpayers.

How far policymakers are willing to go in modifying the state and local deduction may depend in large part on what they are able to achieve with regards to tax rates and the Alternative Minimum Tax. Even without the outright repeal recommended in a host of bipartisan tax plans, many options exist to trim the cost of this tax break.

See the other tax preferences discussed in The Tax Break-Down here.

August 19, 2013

Today, a piece in the Financial Times shows the unnecessary damage being done by the ongoing sequester -- in this case, sharp cuts to federal support for low-income housing. We've said before that the abrupt, across-the-board cuts would slow economic growth and reduce spending in vital areas, despite doing little to address our long-term debt problem. But the piece is a reminder that these cuts do have real world consequences. The FT tells of one single mother of two who found out that her government subsidized rent would be increasing by $1,000 a month:

"It was definitely shocking because the amount is not feasible for me," said Ms. Bearden, a 28-year-old single mother of two from San Jose, California. "Here I am with six weeks to move into a smaller unit in a less-fortunate part of town, or I can pay my entire month’s income to keep my son stable in his school."

Similar dilemmas are being faced by low-income families across the US as public housing programmes try to absorb the costs of sequestration – the across-the-board budget cuts in Washington, imposed amid political wrangling in Congress, that have slashed $930m from federal housing assistance programmes. The squeeze will affect 125,000 families.

We have argued before that sequester's method of blunt, indiscriminate cuts is not a smart way to achieve deficit reduction, and it will further cut discretionary spending, of which low income housing support is a component, despite that the majority of deficit reduction has been achieved through discretionary cuts. In fact, even if the sequester were repealed, as assumed in the CRFB Realistic Baseline, discretionary spending is projected to fall from 7.6 percent of GDP in 2013 to 5.4 percent in 2023. By contrast, combined spending on Social Security and health care will increase relative to the economy, from 9.8 percent of GDP to 11.7 over the same time period. The growth in those programs is especially notable in the second decade as the Baby Boom generation retires, rising to 13.8 percent of GDP by 2033 and 15.0 percent by 2043. 

Note: Projections based on CRFB Realistic Baseline

Yet while many would like to replace the sequester to prevent these cuts to vulnerable populations, many also feel certain reforms to entitlement programs, which are driving our debt problem, should be off the table. A recent article from The Nation takes a look at pushback received by Members of Congress during the August recess on one possible reform, switching a more accurate measure of inflation called the chained CPI. It highlights those who argue it should be off limits because of its impact on Social Security benefits. 

As we've argued before, switching to chained CPI would grow benefits at the more accurate rate of inflation - on average, slightly slower than the current measure. Given that Social Security's trust fund faces insolvency in twenty years, chained CPI would be a much better option than the 23 percent benefit cut that would be required at that point.

Importantly, many entitlement reforms, including proposals to switch to chained CPI, include protections for the most vulnerable. The President's chained CPI proposal includes an old-age bump up that would help those who outlive their savings, as does The Bipartisan Path Forward. The same is true with many other entitlement reforms; we've previously identified $600 billion in health savings that, on whole, would help disadvantaged populations.

The sequester will negatively impact the most vulnerable, but so will continuing to kick the can down the road when it comes to addressing the core drivers of our debt challenges. Policymakers must come together on a comprehensive debt reduction package that replaces part of the sequester with smarter cuts, coupled with meaningful entitlement and tax reforms. And unlike the sequester, this can be done in ways that protect, and in some cases improve, the economic well-being of the most vulnerable.

August 19, 2013
Where CRFB Reviews the Many Tax Breaks Up for Discussion in Tax Reform

We've written many times before about the $1.3 trillion of tax breaks currently littering the code, urging policymakers to focus on paring back tax preferences in order to reform the tax code and reduce rates and deficits.

Encouragingly, the Blank Slate approach put forward by Senate Finance Committee Chairman Max Baucus and Ranking Member Orrin Hatch effectively puts all these tax expenditures on the table, requiring any that remain to be justified on economic, fairness, or policy grounds.

Our new blog series, The Tax Break-Downwill take a closer look at these tax breaks one at a time, showing their cost, describing who benefits from them, providing arguments for and against keeping them, and offering options to repeal or reform them. We’ve written in the past about more efficient ways to design the mortgage interest deduction, the charitable deduction, and the employer-provided health care exclusion and offered a list of options for reforming all three. This series will go beyond the most popular and well-known provisions to do a deeper dive on both the individual and corporate sides of the income tax.

Tax expenditures represent a large and often overlooked portion of government policy. Like programs in the regular budget, they provide support for housing, health care, philanthropy, infrastructure, research, education, retirement, domestic production, child care, work, aid to states, and a number of other functions. At $1.3 trillion in annual cost, they cost more than all discretionary spending and as much as Social Security and Medicare combined.


Many of these tax breaks serve important or desirable public policy purposes, though they do so with varying degrees of success. At the same time, many tax breaks complicate the code, reduce the progressivity of the code, and distort economic decision making. Every dollar spent on retaining a tax preference is a dollar which is unavailable for other purposes.

As Washington engages in the important debate on what tax reform should look like, we'll be offering information and analysis on the tax breaks under discussion. Tomorrow we will post our first Tax Break-Down, a discussion of the state and local tax deduction.

*****

Posts in the Tax Break-Down:

August 16, 2013

A New York Times piece today lays out a possible "mini-bargain" to move past the debt ceiling and expiration of government funding. The piece, "Puzzle Awaits the Capital: How to Solve 3 Fiscal Rifts," discusses the three upcoming fiscal disputes facing Washington: the debate over whether to fund "Obamacare" or risk a government shutdown, the question of how to address the 2014 sequester, and the need to raise the debt limit. The article argues that the first challenge appears to be resolving itself and the third challenge has a still-not-clear future, but it floats an idea for the second challenge.

In short, the article suggests policymakers might waive a portion of two years' worth of sequester cuts (remember, the sequester continues through 2021) in exchange for an equivalent amount of other deficit reduction over ten years. The article suggests that policymakers could first enact a temporary continuing resolution, and then negotiate the details:

The aim of negotiations after that would be to come up with new savings approaching $200 billion.

Part of the savings would come from entitlements, but programs like farm subsidies, rather than the more politically volatile Social Security and Medicare. Part would come from new revenues, but “user fees” tied to special government services, rather than broad-based tax increases.

That could allow both sides to tell key constituencies that they did not violate core principles. And it would be enough to replace cuts in military and domestic programs for about two years, without increasing the deficit.

This solution, of course, would be less than ideal. Ideally, policymakers would use the sequester as it was intended -- as an impetus to develop a comprehensive debt solution. If policymakers do undertake this approach, however, they must at minimum fully offset the cost of any sequester repreal with permanent savings that do not rely on budget gimmicks. There is no question that sequestration is bad policy, but repealing any part of it it without fully offsetting its costs would be unacceptable and undermine our fiscal credibility.

So what about this proposal to offset two years' worth of costs without really touching "entitlements" or directly increasing taxes? Using policies in the President's budget, we took a go at designing such a package. It is certainly possible to do so, though not easy.

By our math, repealing the sequester for two years would cost roughly $210 billion after accounting for various interactions. We assumed that one third of the sequester would be left in place, one third would be offset with what one might consider direct spending cuts, and the remaining third with user fees and revenue from minor changes. Of the direct spending cuts, we took about $15 billion from health care to pay for the health portion of the sequester and the rest from federal retirement contributions and farm subsidies. On the revenue side, we relied on as many user fees as possible -- some of which would technically be classified as "offsetting receipts" and others as revenue -- but we also had to assume about $20 billion in taxes from improving tax reporting and restoring the recently-expired unemployment insurance surtax. It is possible these savings could be replaced with other user fees from outside the President's budget.

Our illustrative deal did not address a number of other provisions that will expire at the end of the year such as the doc fix, expanded unemployment benefits, and the tax extenders. Although we are optimistic on the chances of a permanent doc fix this year, one could see a two year replacement -- costing about $30 to 40 billion -- being replaced with something like a reduction in payments for Medicare bad debts, a combination of a one-year freeze in post-acute care payments, and an extension of the freeze of income-related thresholds for premiums.

The package outlined above could certainly be seen as an improvement over current law. It would replace $140 billion of deficit reduction at a time when we don't particularly need it with an equivalent amount over the next decade and an additional $200 billion to $250 billion of further savings in the folllowing decade.

On the other hand, the package would do little to alter the trajectory of our debt since it would not address the drivers of our long-term debt problem -- the growing costs of entitlement programs -- nor would it do anything to improve the tax code.

Additionally, this package would virtually pick dry the remaining low-hanging fruit of deficit reduction. The same game could not be repeated to replace the next two years of sequester and the two years after that. There simply isn't enough money left from the small basket of user fees and other mandatory programs.

Ultimately, the only sources big enough to pay off the sequester and put our long-term debt on a sustainable are Social Security, Medicare, Medicaid, and the $1.3 trillion of tax breaks in the code. A "grand bargain," even a smaller grand bargain, would allow policymakers to address many of these issues together while also incorporating much of the "low-hanging fruit" and finding a permanent solution of the sequester.

Sooner or later, the available "hard choices" will be the only ones left, and policymakers will have wished they acted sooner to make them. Offsetting the sequester is certainly better than waiving it, but a permanent solution is likely to be the best answer for the short-term economy, the long-term economy, and the unsustainable long-term debt burden we face.

August 15, 2013

In his column in today's Wall Street Journal and an accompanying audio clip, David Wessel takes on the question before Washington: Is the budget deficit falling, or does it pose a serious threat to the nation's prosperity? His answer: Yes to both. On one hand, the budget deficit is shrinking, due in large part to the recovering economy but also due to some of the savings lawmakers have enacted over the past year. On the other hand, the federal debt remains a high level and will begin to rise as a share of the economy after 2018.

As baby boomers retire and health care costs continue to grow, pressures on the debt will escalate leading to a dangerous upward trend, as the chart below shows, particularly in the second decade. 

 

Source: CRFB
Note: Based on CBO's old GDP numbers

As Wessel notes, debt is far beyond the historical average, which gives us far less flexibility until debt returns to more normal levels - a concept we refer to as fiscal space. In addition, deficit reducing policies have a greater chance of success if they are phased-in gradually. Without some lead time to allow taxpayers, agencies, and beneficiaries to adjust and slowly phase-in these policies, the needed changes could invoke unneccessary pain. With the long-term problem well established, Wessel argue that lawmakers need to be prudent and anticipate the coming problem. Writes Wessel:

Prudent politicians would be aiming to gradually reduce the debt burden, both by money-saving changes to benefit programs and money-raising tax policies and by doing what's necessary to quicken the long-run pace of economic growth.

It's natural to focus on next year's appropriations, but they are not related to the long-term problem. While recognizing the deficit reduction savings enacted to date, Wessel criticizes the focus on the discretionary portion of the budget which is neither large nor growing in comparison to the entitlements. We made this same point recently, arguing that our growing debt can be entirely attributed to growing entitlement costs as the population ages and health care costs continue to rise.

Prudent politicians would be making changes today that will reduce the share of the budget that goes to interest 10 years from now.

And then there are the immutable demographic facts. America is aging, which means more folks on Medicare. And health-care costs per person continue to rise faster than most everything else...Prudent politicians would be seeking ways to slow health-cost growth and temper the costs of the retirement of the baby boomers.

Unfortunately, until recently, Congress has not been taking Wessel's advice:

So what is Congress doing? Heading for a fiscal showdown this fall, and perhaps a government shutdown. But that fight isn't about any of the above issues. It's over how much to spend on the one-third of domestic and defense outlays that are appropriated annually, spending that is not driving deficits.

Thankfully, there are some signs that Washington may again be turning to a comprehensive deal that addresses our long-term problem. In the fiscal discussions ahead, we expect that the President and Congress will use the opportunities ahead to work out a bipartisan compromise on entitlement and tax reform. The debt problem may feel far off now, if lawmakers kick the can now and wait until the last minute to make changes, they will regret not taking on the issue earlier.

Click here to read the full editorial.

August 14, 2013

It's August 14 and that means it is Social Security's birthday! The program has been around for 78 years, providing retirement security to the elderly and support for the disabled. But the demographics have changed over the past 78 years and financial projections clearly show that reforms will be needed to ensure the program can continue to provide those benefits.

As we discussed in our analysis of the latest Social Security Trustees Report, the combined trust fund is due to become insolvent as early as 2033. At this time, benefits will need to be cut by 23 percent to match revenues. This year's projections were similar to last year's, with a 75-year actuarial shortfall now at 2.72 percent of payroll (0.98 percent of GDP) from the 2.67 percent of payroll (0.96 percent of GDP) mark in last year's report. However, another lost year gives us less time to slowly phase-in the changes need to restore solvency for the program. 

Source: Social Security Actuaries

While the gap needed to be made up is significant, there are many options that lawmakers could consider that could make the program solvent. CRFB has developed a useful tool, The Reformer, which allows users to select from a variety of revenue and benefit options will the goal making the program sustainably solvent, closing the gap between revenue and spending over 75 years and in the 75th year. We've even used the Reformer to show the effects of Social Security reform plans from Simpson-Bowles, Domenici-Rivlin, the National Academy of Social Insurance, Rep. Jason Chaffetz (R-UT), and Rep. Gwen Moore (D-WI).

Social Security is one of the most important programs in the federal government. But each passing year forfeits an opportunity to enact phased-in, gradual changes that allow beneficiaries and taxpayers time to adjust. With the Disability Insurance portion of the program due to become insolvent by 2016, Washington will need to make some decisions about the future of Social Security. Try The Reformer and develop your own plan to make the program sustainable for generations to come.

August 14, 2013

Yesterday, we noted the revisions that CBO has made to its historical budget data going back to 1973, in light of the Bureau of Economic Analysis's revisions to GDP numbers going back to 1929. Although the nominal dollar totals are unaffected, numbers that were estimated as a percentage of GDP have all been revised downward, as a result of the higher GDP. We pointed out that the revisions were noticeable but certainly not huge.

But even if the revisions to past data were not course-altering, budget wonks and lawmakers will be watching closely to see how budget projections will change as a result. In this post, we use the CRFB Realistic baseline to show how budget projections might change, with the caveat that these are, of course, not official numbers and may not fully represent the changes that would be made to either budget or economic projections as a result of the GDP revisions. In particular, we have used the new GDP levels but assume the same growth rates CBO has in its projections.

First, there is spending and revenue, which have been revised down compared to the old GDP numbers by about half a percentage point each year. Spending and revenue in 2023 equal 22 percent of GDP and 18.5 percent, respectively, whereas they had previously been 22.7 percent and 19.1 percent. The ten-year average of spending and revenue is revised down from 22.1 percent and 18.9 percent, respectively, to 21.3 and 18.3 percent.

Source: CBO, BEA, CRFB

The new GDP numbers lower yearly deficits as a share of GDP by about one-tenth of one percentage point annually, only a small difference. For debt, the new GDP levels lower debt-to-GDP by about 2.5 percentage points annually. Under current Realistic projections, debt will rise to 76.5 percent of GDP in 2014, fall to a low of 71.9 percent in 2018, and then rise to 75.5 percent by 2023. After incorporating the new numbers, debt would rise to 74 percent by 2014, fall to a low of 69.5 percent by 2018, and then rise to 73 percent by 2023. Note that while the levels of debt have fallen, the trajectory is very similar.

Source: CBO, BEA, CRFB

In addition, we have used the new GDP numbers to re-estimate debt-to-GDP in the budget plans from the President, the House, the Senate, and the Bipartisan Path Forward. Again, the debt trajectories remain the same, but the level of debt in 2023 is about 2 to 3 percentage points lower than previously estimated. 2023 debt in the House and Senate budgets (adjusted for changes in CBO's May baseline) are revised down from 52 percent and 67 percent, respectively, to 64.4 percent and 50 percent. Debt in the President's budget in 2023 is revised down from 69.8 percent to 67.5 percent. And 2023 debt in the Bipartisan Path Forward is revised down from 66.2 percent to 63.8 percent.

Source: CBO, CRFB
Note: House, Senate, and BPF numbers have been adjusted from original reported numbers for changes in CBO's baseline.

Importantly, all of these re-estimates assume that projected GDP growth rates stay the same. However, BEA's revisions also bumped up the average GDP growth rate from 1929-2012 by 0.1 percentage points annually. If we assume that would hold true going forward, it would further lower numbers calculated as a percent of GDP, although not by as much as the changes in GDP levels. Incorporating the new growth would have spending and revenue in 2023 at 21.7 percent of GDP and 18.3 percent, respectively, while debt would be 72.2 percent of GDP in that year.

Ultimately, we will see how much has changed when CBO releases its long-term outlook in September. At that time, it will likely incorporate the new GDP numbers but will not change its ten-year budget projections (although its projections beyond 2023 will change). Based on what we have calculated, the GDP revisions will change the level of the budget metrics but not the trajectory, which we consider to be the most important.

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