The Bottom Line

February 26, 2014

In a widely anticipated move in the tax world, House Ways and Means Chairman Dave Camp (R-MI) has released a comprehensive tax reform discussion draft after both tax-writing committees had released a number of discussion drafts dealing with specific sections of the tax code. There is a lot to analyze in the bill: a quick summary of the bill's major reforms is below, and a more detailed analysis will follow later in the week.

In an editorial published in the Wall Street Journal preceding the discussion draft's release, Camp said: "If Congress doesn't take action, the U.S. risks falling further behind. The tax code should make it easier for American companies to bring back profits earned overseas so they can be invested here. It should not hinder small businesses from growing into large businesses. And the individual income tax needs to be simpler, fairer and flatter for everyone." Chairman Camp addressed both the corporate and individual tax systems in his discussion draft released today.

The reform reduces individual tax rates and consolidates tax brackets from seven to three: 10, 25, and 35 percent. These tax brackets – and other income thresholds – will be indexed to chained CPI. The 10 percent bracket also phases out for higher earners, and the top bracket does not apply to business income.

Meanwhile, personal and dependent exemptions are eliminated in favor of a larger standard deduction and child tax credit, both of which phase out for the highest earners. Capital gains and dividends are taxed as ordinary income with a 40 percent exclusion, leading to effective rates of 6, 15, and 21 percent before counting the 3.8 surtax currently in place.

These changes would be paid for in a number of ways. The state and local tax deduction would be eliminated, the mortgage interest deduction limited to $500,000 of debt (down from $1 million), and the charitable deduction subject to a 2-percent-of-AGI floor. A number of other tax preferences would be reduced or repealed, and many of those remaining – including the employer health exclusion, mortgage interest deduction, and exclusion of municipal bond interest – would be limited in value to the 25 percent bracket.

Comparison of Tax Reform Act of 2014 with Current Law
Area Current Law Tax Reform Act of 2014
Individual Income Tax  
Tax Rates 10% | 15% | 25% | 28% |33% | 35% | 39.6% 10% | 25% | 35%
(10% rate phases out at high incomes)
Standard Deduction $6.2k/$12.4k $11k/$22k (phases out at high income)
Personal Exemptions $3,900, phased out at higher incomes Eliminated
AMT Alternative tax w/ 26% and 28% rates Eliminated
Child Tax Credit $1,000/child not indexed for inflation - phased out at higher incomes; more refundable through 2017 Credit increased to $1,500 and indexed for inflation, refundability rate increased; phased out at higher incomes
Earned Income Tax Credit $500-$6,000 credit, phased out at higher incomes; higher for families with 3 children through 2017 Reduced credit rates to $100-$4,000, phase-outs begin at higher income levels; marriage penalties lessened
Mortgage Interest Deduction Available to itemizers for up to $1 million of debt Available to itemizers up to $500,000 of debt; value limited to 25% bracket
Charitable Deduction Available to all itemizers Subject to 2% of AGI floor
Health Insurance Exclusion Available w/ 40% tax on high-cost plans Value limited to 25% bracket; 40% tax on high-cost plans
State & Local Tax Deduction Available to all itemizers Eliminated
Municipal Bond Exclusion Available for public and private bonds Value limited to 25% bracket; exclusion eliminated for certain private activity bonds
401(k) Retirement Accounts Up to $17,500 of employee contributions on a tax-deferred or Roth-style basis Contributions above $8,750 allowed only in Roth-style accounts
Capital Gains and Dividends Taxed at 0%, 15%, 20% with 3.8% surtax for income above $250K Taxed as ordinary income w/ 40% exclusion (effective rates of 6%, 15%, and 21%); 3.8% surtax retained
College Tax Credit $2,500 American Opportunity Tax Credit through 2017 ($1,000 is refundable); additional tax benefits available AOTC extended permanently, refundability increased to $1,500, income eligibility range reduced; other benefits eliminated
Other Tax Provisions Various credits, deductions, exclusions, and other preferences available Dozens of preferences repealed or reformed. Numerous loopholes closed.
Corporate Income Tax  
Rates Top Rate of 35% Flat Rate of 25%
Accelerated Depreciation Accelerated Depreciation (MACRS) Economic depreciation, basis adjusted to account for inflation
Advertising Deduction Costs fully expensed Half of costs amortized over 10 years
Domestic Production Deduction 9% of income deduction generally available Deduction phased out by 2017
Research & Experimentation Costs fully expensed Costs amortized over 5 years
Inventory Accounting Last-in-First-Out Accounting allowed Last-in-First-Out Accounting phased out
R&E Credits 4 credits, all expired in 2013 Alternative simplified credit reformed and permanently extended, others repealed
International Tax Worldwide w/ deferral Territorial w/ base erosion protections and one-time transition tax
Other Tax Provisions Various credits, deductions, exclusions, and other preferences available Dozens of preferences repealed or reformed.
Excise Taxes  
Medical Device Tax 2.3% tax on sale of certain medical devices Tax repealed
Bank Tax N/A .035% quarterly tax on assets over $500 billion

 Source: JCT

On the business side, the corporate income tax rate would be reduced from 35 to 25 percent. This reduction would be paid for by repealing accelerated depreciation, moving away from Last in First Out (LIFO) accounting, requiring partial amortization of advertising and research and experimentation, phasing out the domestic production activities deduction, and making numerous other changes. The draft also calls for moving to a territorial tax system with base erosion protections and a temporary repatriation tax.

Finally, the legislation calls for repealing the medical device tax and imposing a new .035 percent quarterly tax on assets over $500 billion in large financial institutions.

Budget Impact of the Tax Reform Act of 2014
Provision 2014-2018 2014-2023
Individual Reforms  
Reduce rates to 10%, 25%, and 35%, limit certain tax preferences to 25% bracket, phase out 10% rate, and index brackets to chained CPI -$232 billion -$544 billion
Tax Capital Gains/Dividends with 40% Exclusion $15 billion $45 billion
Consolidate, reform, and extend personal exemptions, standard deduction, CTC, and EITC $18 billion -$16 billion
Modify various itemized deductions $309 billion $858 billion
Require 401(k) contributions above half of current limit be placed in Roth-style accounts $56 billion $144 billion
Reform education tax preferences $27 billion $19 billion
Enact other changes $76 billion $237 billion
Repeal Alternative Minimum Tax -$443 billion -$1,332 billion
Subtotal, Individual Reforms* -$174 billion
 -$589 billion
Business Reforms  
Reduce corporate rate to 25% and repeal AMT -$234 billion -$791 billion
Reform accelerated depreciation schedules $59 billion $270 billion
Modify net operating loss deduction $30 billion $71 billion
Amortize R&E and advertising expenses $152 billion $362 billion
Phase out domestic production deduction $44 billion $116 billion
Repeal LIFO accounting rules $6 billion $79 billion
Reform international tax system $20 billion $68 billion
Enact other changes $103 billion $359 billion
Subtotal, Business Reforms* $180 billion $533 billion
Excise Taxes  
Impose .035% tax on large banks $30 billion $86 billion
Repeal medical device tax and other changes -$12 billion -$28 billion
Subtotal, Excise Taxes $18 billion $58 billion
Total Budgetary Impact $24 billion $3 billion
Addendum #1: Total impact w/ economic growth Unknown $50 to $700 billion

 Source: JCT
* For pass-throughs, the rate reductions are captured in individual reforms while base-broadening is captured in business reforms.
Other corporate tax changes include revenue from tax-exempt entities and tax administration and compliance.

As shown above, Chairman Camp's discussion draft would be roughly revenue neutral over the decade. However, because several of the bill's revenue sources represent one-time gains or revenue shifted from the far future into the near future, we are concerned that the legislation would add to the deficit in future decades. We will continue to analyze the legislation and provide further information in the coming days.

* * *

Overall, Chairman Camp deserves a lot of credit for producing a full tax reform proposal; the first such proposal to come out of a Congressional committee in recent years. The plan identifies the trade-offs needed in order in lower tax rates and broadening the tax base while also bringing in new revenue sources. Making many hard choices, as this plan does, is praiseworthy, and the draft represents a starting point for a bipartisan tax reform deal. However, there is concern that the reform would add to the deficit over the long run, when we will need to raise revenue from tax reform to meet the nation's fiscal challenges. Still, the draft is one that lawmakers can build on and use along with entitlement reform to put debt on a downward path.

February 26, 2014

In a somewhat atypical move, Defense Secretary Chuck Hagel previewed in a speech yesterday the Department of Defense's (DoD's) budget request for FY2015, which will be a part of the President's Budget submitted to Congress next week. The budget shows the types of cuts necessary to comply with congressionally mandated budget cuts that transition DoD from an era of wars in Iraq and Afghanistan and real growth in the defense budget to a new era of discretionary spending restraint.

According to the Bipartisan Budget Act, defense spending next year is set to rise by $1 billion to $521 billion, which is lower than either party called for in their original budget proposals last year and represents $75 billion in cuts over this year and next compared to pre-sequester levels agreed to in the Budget Control Act.

While the President's Budget will abide by the agreed-upon spending levels for 2015, the President will propose five-year spending for the Defense Department that is $115 billion more than sequester levels. The budget will also propose an additional $26 billion of defense funding to be offset by cutting other spending and closing tax loopholes. Secretary Hagel argued that the increase strikes a balance between protecting national security and a realistic assessment of future fiscal levels, warning that "[s]equestration requires cuts so deep, so abrupt, so quickly, that we cannot shrink the size of our military fast enough."

Looking into the future, defense spending over the 2015-2024 period has been reduced by hundreds of billions of dollars as a result of several measures adopted over the past few years, including spending freezes, the Budget Control Act spending caps, and sequestration. As a result, defense spending will continue to fall as a share of the economy.

However, when looking at inflation-adjusted spending since World War II, defense spending will remain at historically elevated levels even after falling gradually over the next few years. 

Hagel's speech illustrates the types of choices that DoD is making to simultaneously live within smaller future budgets and to modernize its force to fight more advanced adversaries.

The largest cost reductions proposed are in the growing area of personnel costs, which currently make up roughly 50 percent of DoD's budget. Hagel said, "Given the steps already taken to reduce civilian personnel costs – including a three-year pay freeze – no realistic effort to find further significant savings can avoid dealing with military compensation. That includes pay and benefits for active and retired troops, both direct and in-kind." (emphasis added) As shown recently by CBO, military personnel indeed does make up a large portion of DoD's budget and shows no signs of abating down the road.

The budget will propose a 13 percent reduction in the size of the active duty force and a 5 percent reduction in the size of National Guard and reserve units, while the number of Special Operations forces would increase by 6 percent.

Hagel stressed the need for holistic changes, and proposed reductions beyond trimming troop numbers. Civilian and military personnel will be limited to a 1 percent pay raise this year, while pay for generals and other top officers will be frozen. Servicemembers will gradually be asked to pay for 5 percent of their housing, rather than 0 percent today. The Defense Department will stop reimbursing for renters' insurance, and trim the direct subsidies given to military commissaries by $1 billion (over 70 percent).

Similar to last year, this year's budget recommends modernizing TRICARE, so servicemembers use the most affordable means of care, such as using generic drugs. The budget asks servicemembers to pay a little more in copays and deductibles, but Hagel assures servicemembers that "benefits will remain affordable and generous…as they should be."

However, the FY2015 budget does not recommend any changes to the military retirement system, which has been debated recently in Congress. (In December, Congress approved a 1 percentage point reduction in annual cost-of-living increases for working-age retirees. It undid the change for current servicemembers two months later.) No recommendations will be made until the Military Compensation and Retirement Modernization Commission completes its work, due to be presented in February 2015.

Hagel also called for several other reforms, including eliminating an entire class of Air Force attack jets that were scheduled to be replaced within a decade, as well as eliminating the U-2 spy plane. He called for a new round of base closures under the BRAC Commission (even though Congress has not agreed to BRAC requests for the last two years) and will announce cuts to bases in Europe, where BRAC authority is not needed. In the navy, Hagel will reduce the number of the new Littoral Combat Ships constructed from 52 to 32.

Hagel closed his discussion of military compensation by noting the necessity of reform:

"Although these recommendations do not cut anyone’s pay, I realize they will be controversial. Congress has taken some important steps in recent years to control the growth in compensation spending, but we must do more...Our proposals were carefully crafted to reform military compensation in a fair, responsible, and sustainable way. We recognize that no one serving our nation in uniform today is overpaid for what they do for our country. But if we continue on the current course without making these modest adjustments now, the choices will only grow more difficult and painful down the road. We will inevitably have to either cut into compensation even more deeply and abruptly, or we will have to deprive our men and women of the training and equipment they need to succeed in battle. But, either way, we would be breaking faith with our people.  And the President and I will not allow that to happen."

February 26, 2014

In a new and informative series on Reforming the Budget, the Brookings Institution looked at challenges facing the budget process and proposed strategies to improve its shortfalls. Given the frequent breakdown and tardiness in the process and the limitations of federal budget data, there are a number of ways to improve budget process and accounting in order to facilitate better decision making.

The Brookings series presents articles from a number of budget community experts. Our recent blog covered the first two pieces in the series by Phillip Wallach and Elaine Kamarack. Picking up where the first left off, this blog covers the final five installments in the series. Overall, the experts clearly send the message that budget reform is badly needed to incorporate a review of all parts of the federal budget and to become a more manageable process. Bipartisan cooperation will be integral to the success of any reform effort.

* * *

Former CBO director and CRFB board member Alice Rivlin presents her ideas for reforming the currently broken budget process in 'How to Fix the Congressional Budget Process'. She makes a number of points about what an ideal budget process would look like -- noting that it should contain three central elements. First, the process should consider all spending and revenues. Currently, tax expenditures and mandatory spending are not given proper annual consideration like discretionary spending. Secondly, the process should be easy to understand and complete on time. Rivlin writes that since the Budget Reform Act of 1974, it has been too elaborate to be workable and its numerous demanding deadlines are regularly missed. Lastly, Rivlin proposes turning the budget into a law passed by Congress and signed by the president (it is currently a resolution passed by Congress, not signed by the president, and does not have the force of law). Additionally, she proposes that the membership of the Budget Committees include Congressional leadership and chairs of the program and revenue committees.

Linda Bilmes' article, Four Steps to Restore Fiscal Discipline, states that the current budgeting system is broken. For one thing, it consumes far too much time. Each year across the government, thousands of officials prepare their agencies' budgets, but increasingly often, Congress ignores these proposals and estimates. Rather, Congress has fallen into a pattern of enacting budgets based on the previous year's spending levels, not based on current need. To improve the budgeting system, Bilmes suggests four reforms: transitioning to biennial budgeting to lessen the time burden, adopting managerial cost accounting and capital budgeting, rewarding managers for efficiency gains, and simplifying the budget process.

Paul Posner, Steven Redburn, and Jonathan Breul address the absence and relative invisibility of tax expenditures in the budget process in their article, The Mysterious Case of Tax Expenditures. They argue tax expenditure consideration should be added to the budget process for multiple reasons. First, their relative lack of transparency and accountability means other parts of the budget assume disproportionate shares of deficit reduction. Second, to hold revenues constant, tax rates have to be higher to cover the costs of subsidies provided through the tax code. Finally, tax provisions often subsidize activities taxpayers would undertake anyway, so they are not efficient. We have repeatedly called for tax reform and emphasized the great need for a close examination of tax expenditures.

Philip A. Wallach, in his article The Still-Useless Debt Ceiling, calls for the repeal of the debt ceiling and replacement with another measure aimed at fiscal restraint. His reasons are that the debt ceiling incited budget standoffs of recent years have been economically damaging. He links to a previous post of his suggesting a few ways to replace the debt ceiling, including with counter-cyclical spending controls or a "No Budget Agreement, No Pay" type provision.

In Thomas E. Mann's article, Budget Process Blues, he blames Congressional hostility and failure to make timely and reasoned decisions as a fatal impediment to the budget process. He states budget process reforms such as biennial budgeting and instituting caps on spending and revenue are an ill-suited match for Congress' recent failures.

* * *

We agree with several of the authors that the budget process contains plenty of room for improvement. The current system is flawed and does not adequately serve the public. However, budget process reforms alone cannot solve our nation’s fiscal challenges. Still, they can help make budget decisions be made more efficiently and perhaps pave the way for a major budget deal. The Peterson-Pew Commission has provided extensive in-depth analysis of options for budget process reform. Take a look at our analysis of the Commission's work.

February 25, 2014

Tomorrow, House Ways and Means Chairman Dave Camp (R-MI) is expected to release his comprehensive tax reform proposal after a series of discussion drafts. The tax code is in significant need of an overhaul, and reform can to improve fairness and simplicity, make U.S. businesses more competitive, and reduce the deficit. Over the years, CRFB has produced extensive analysis of previous proposals and the need for tax reform.

Click Here to Visit Our Tax Resource Page

To get a better idea of how Chairman Camp's proposal would compare to previous reform efforts, take a look at this chart summarizing several bipartisan tax reform plans from recent years.

Comparison of Bipartisan Tax Reform Plans

Area Simpson-Bowles Illustrative Plan Domenici-Rivlin 2005 Tax Panel Growth and Investment Plan Wyden-Coats
Individual Income Tax    
Tax Rates 12% | 22% | 28% 15% | 28% 15% | 25% | 30% 15% | 25% | 35%
Standard Deduction Increased 10% Replaced with work and family credits Replaced with work and family credits Roughly Tripled
Personal Exemptions Retained Retained
Child Tax Credit & EITC Retained Retained
AMT Repealed Repealed Repealed Repealed
Mortgage Interest Deduction Converted to 12% credit; capped at $500K mortgage Converted to 15% credit; limited to $25K of interest Converted to 15% credit; limited to average price of housing No change
Charitable Deduction Converted to 12% credit; 2% of AGI floor Converted to 15% credit Retained with 1% of income floor No change
Employer Sponsored Insurance Exclusion Capped, phased out from 2018 to 2038 Capped, phased out from 2015 to 2025 Capped at average premium Cafeteria Plans Preference Eliminated
State & Local Tax Deduction Eliminated Eliminated Eliminated No change
Misc. Itemized Deductions Eliminated Floor increased to 5% of AGI Unspecified Eliminated
Muni Bond Exclusion Phased out for new bonds Private Activity bonds repealed Retained Replaced with a credit
Retirement Savings Consolidated and capped at $20K or 20% of AGI Consolidated, replaced with 15% credit up to $20K or 20% of AGI Replaced with “Save for Retirement” accounts with $10K limit Consolidated into new Retirement Savings Accounts and Lifetime Savings Accounts
Capital Gains and Dividends Taxed as ordinary income (top rate 28%) Taxed as ordinary income (top rate 28%) Taxed at 15% top rate Taxed as ordinary income with 35% exclusion (top rate 22.75%)
Step-up Basis for Capital Gains Eliminated Eliminated Retained No change
Other Tax Expenditures Most other tax expenditures eliminated Most other tax expenditures eliminated Most other tax expenditures modified or repealed Several dozen tax expenditures eliminated, including various exclusions for employee benefit
Corporate Income Tax    
Rates 28% 28% 30% (consumption base) 24%
Depreciation Economic depreciation No change Full expensing Alternative Depreciation Schedule
Domestic Production Deduction Eliminated Eliminated Unspecified Eliminated
Inventory Accounting LIFO eliminated No change All purchases immediately deductible LIFO and LCM eliminated
Other Tax Expenditures Eliminated Mostly eliminated Mostly eliminated Mostly eliminated
Interest Deduction No change No change Disallowed; interest income is not taxed Deduction in excess of inflation disallowed
International Tax Territorial No change Destination-based Worldwide

 Visit Our Tax Resource Page for More Information

Check back tomorrow and later this week for more analysis of Camp's tax reform draft.

February 24, 2014
Weekly Update on Budget and Fiscal Policy Developments and a Look Ahead

Closing the Ceremony – The Winter Olympics ended in Sochi, Russia on Sunday with the closing ceremony. The eye-catching spectacle put an exclamation point on two weeks of intense drama and competition. Another ceremonial closing occurred back in Washington as it was reported that the president’s forthcoming budget would not include any offers of compromise as last year’s budget did. Not only did the announcement put an end to some two years of jockeying to reach a broad fiscal deal, but it also effectively closed the door on any bipartisan action this year on any matter. The ritual of governing from crisis to crisis has been concluded, as has any pretense of finding agreement on a comprehensive deficit reduction plan. In this election year, there is little hope for substantive action on the critical issues facing the country. As Congress returns from its Presidents Day recess this week, don’t expect any golden moments for a while.

Budget Ends Hopes for Solutions —The president will unveil his Fiscal Year 2015 budget request on March 4, with more detailed numbers coming the following week. In previewing the budget, it was revealed that the proposal that was in last year’s budget submission to switch to a more accurate measure of inflation, the chained CPI, will not be included. The White House did say the offer remains on the table if Republicans agree to close some tax loopholes. Check out our Chained CPI Resource Page for more on chained CPI. The budget proposal will call for increased public investment to boost the economy that will be paid for by some tax and spending changes. But it is likely to be more of an election-year political statement than a feasible fiscal blueprint that can attract broad support in Congress. 

Mobilizing Defense Savings – On Monday, Defense Secretary Chuck Hagel unveiled a Pentagon budget proposal that would shrink the armed services to its smallest size since before World War II. The plan also calls for eliminating some costly weapons systems. Defense spending represents a considerable share of the overall federal budget, and there is growing pressure to cut back due to military action in Afghanistan winding down and spending caps.

The Never Ending Tax Reform Debate – Amid skepticism that fundamental reform of the tax code can be achieved this year, House Ways and Means Chairman Dave Camp (R-MI) plans to release a comprehensive tax reform discussion draft on Wednesday. Tax reform is critical to addressing our fiscal challenges. Our partners at the Campaign to Fix the Debt make the case for fundamental tax reform and offer some principles to guide the process. Check out our Tax Break-Down series for a look at areas of the tax code ripe for reform. Meanwhile, the G-20 nations agreed to strengthen international tax rules to clamp down on multinational firms using loopholes to avoid paying taxes.

Still Looking for Closure on Unemployment Insurance Extension – Work continues on extending emergency Unemployment Insurance benefits. Republican senators are reportedly working on an approach that would pay for the extension and could gain bipartisan support. Sticking to PAYGO principles is critical as policymakers consider new policies. We cannot afford to backslide on the deficit reduction achieved so far.

Doc Fix Still Open Ended – Lawmakers still aren’t able to seal the deal on permanently repealing the Sustainable Growth Rate (SGR) formula to prevent a sharp cut in payments to Medicare physicians. The main barrier to the “doc fix” remains finding a way to cover the estimated $150 billion price tag. Last week, a group of health experts offered a potential solution in Health Affairs that would offset the costs with some Medicare reforms. 

Budget Gimmicks Still a ConcernRoll Call warns that lawmakers are still eyeing gimmicks as they seek to avoid budget tradeoffs in considering new policies. We identify the key gimmicks to be on the lookout for in our chartbook.

 

Key Upcoming Dates (all times are ET)

 

February 28

  • Bureau of Economic Analysis releases second estimate of 4th quarter GDP growth.

 

March 4

  • White House releases topline numbers for Fiscal Year 2015 budget request.

 

March 7

  • Bureau of Labor Statistics releases February 2014 employment data.

 

March 18

  • Bureau of Labor Statistics releases February 2014 Consumer Price Index data.

 

March 27

  • Bureau of Economic Analysis releases third estimate of 4th quarter GDP growth.

 

March 31

  • "Doc fix" expires.

 

February 24, 2014

CBO's recent budget projections show a much deteriorated budget outlook, with debt now rising faster over the coming decade than previously anticipated. Their projections, of course, are based a number of assumptions, including assumptions about future policy. Were Congress to make different policy choices than CBO assumes, debt numbers could change significantly.

Typically, CRFB makes certain adjustments to CBO's current law baseline to establish the CRFB Realistic Baseline, but this year the CBO baseline may represent a reasonable approximation of that. Differences between "current law" and "current policy" have been narrowed dramatically as a result of the 2012/2013 fiscal cliff deal - which extended $4 trillion of expiring tax cuts - and the 2013 Ryan-Murray deal, which created a glide path to the sequester-level spending caps.

With these changes in place, our view is that the CBO baseline represents a reasonable approximation of where the debt is currently headed (reasonable, but by no means definitive). After all, the CBO baseline assumes lawmakers continue to spend at current law levels on the wars abroad, allow doctors in Medicare to take an 25 percent payment cut, let a host of expired or expiring tax provisions disappear, and provide no additional sequester relief. 

For that reason, CRFB has contructed two alternatives to the CBO baseline. On the low end (the PAYGO Scenario), we assume that Congress fully abides by PAYGO rules (by fully offsetting any spending or tax cuts) while we draw down troop levels in Afghanistan from 38,000 to 30,000 by 2017, and that spending will decrease consistent with that plan.

On the high end (the No-Offset Scenario), we continue to assume the troop drawdown but also assume that lawmakers enact annual doc fixes, extend the refundable tax credit expansions after 2017, reinstate and continue the currently-expired "normal tax extenders," and repeal future sequestration cuts. Essentially, this is the scenario if lawmakers do not adhere to PAYGO at all. In both scenarios, we correct for some minor timing issues.

Bridge from Current Law to Alternate Scenarios (Billions of dollars)

Source: CBO, CRFB calculations
All numbers are rounded to the nearest $5 billion.

Not surprisingly, deficits and debt differ substantially depending on the assumptions made. Under CBO's baseline, debt will remain at about 72 percent of GDP through 2017, and then rise to 79 percent of GDP by 2024. After accounting for the war drawdown in our PAYGO Scenario, debt levels grow modestly slower -- reaching 77 percent of GDP by 2024 as opposed to 79 percent.

On the other hand, if policymakers choose the fiscally irresponsible route assumed in our No-Offset Scenario, debt would rise to 84 percent of GDP by 2024, and would be on a much faster upward path. 

The graph above illustrate that without real policy changes, debt will remain at its record high levels and begin to grow rapidly later in the decade. Yet, taking steps backward by failing to abide by pay-as-you-go rules will substantially worsen the fiscal situation.

In addition to the debt implications, the scenarios we laid out also have different implications for spending and revenues. The table below shows how other budget metrics fare under each scenario.

Budget Metrics (Percent of GDP)

Source: CBO, CRFB calculations

Clearly, the federal budget continues to be on an unsustainable path. Lawmakers should work on a bipartisan basis to take advantage of the upcoming Congressional and President's budget proposals to put forward responsible fiscal policies that reduce the debt as a share of the economy this decade and over the long term. At the very minimum, they should not be passing measures that make the situation worse, and should abide by PAYGO rules.

Click here or on either table for an Excel version of the tables.

February 21, 2014

Next week, House Ways & Means Chairman Dave Camp is set to release a draft of a bill to revamp the U.S. tax code, according to press reports. It was unclear whether Camp would release a tax reform draft at all, as House Republican leadership remains skeptical of tax reform, and Camp's Senate taxwriting counterpart Max Baucus was recently confirmed as Ambassador to China. While details about the bill are still scarce, Camp's decision to release a draft represents a positive step forward for the tax reform debate.

We applaud Chairman Camp's decision to release a draft. It is one thing to talk in generalities about the need to lower tax rates and make the tax code simpler, but the debate does not move forward until legislators get specific. Simplifying the tax code and reducing rates will require eliminating or significantly scaling back some popular tax breaks. For instance, making changes necessary to reduce the corporate tax rate (currently at 35 percent) below 30 percent without increasing the deficit almost requires changing accelerated depreciation and Section 199, which both provide significant tax breaks to manufacturers. On the individual side, reducing rates will require eliminating or scaling back popular deductions, such as the deductibility of state and local sales taxes which Camp held a hearing on last year. A serious effort to reform the tax code will require numerous tradeoffs, but if done properly, the economic and fiscal benefits of tax reform will justify the tough choices that will be necessary.

Tax reform has the potential to improve the fairness of the tax code, make U.S. business more competitive, and improve the deficit. Our partners at Fix the Debt summed up nicely the case for comprehensive tax reform, arguing that many of the $1.3 trillion of tax preferences are:

Many of these preferences are expensive, regressive, and economically distorting; they increase complexity, reduce fairness, and let the government pick winners and losers. The higher than necessary rates, narrow base, and sheer complexity in the tax code hurt economic growth by driving up compliance costs and reducing incentives to work, save, and invest.

Similar to the analyses we provided of the Baucus discussion drafts released last year, we will eagerly wait to see what is in Camp's tax reform draft and provide analysis of the draft when it is released. Although tax reform efforts may be temporarily stalled, Chairman Camp's has done a great deal of work on the nuts and bolts of tax reform in his four years as Chairman, and he can make a valuable contribution to the debate before he steps down as Ways & Means chairman at the end of this year by putting forward a comprehensive proposal based on that work.

* * * * *

Looking for more info? Check out Fix the Debt's case for comprehensive tax reform and our blog series "The Tax Break-down" that examines the tax breaks under discussion as part of reform and options for reforming them.

February 20, 2014

Today, the White House announced that the President will not propose adopting the “chained CPI” in the President’s Budget this year, as he did last year (though the White House commented today that they are open to the provision as part of a bipartisan deficit reduction deal).

We argued yesterday that this would be a mistake, explaining that the chained CPI is not only a much more accurate measure of inflation but would also result in several hundred billion dollars of savings in the first decade and more than $1 trillion in the second.

For those interested in learning more about the chained CPI, CRFB and its partner – the Moment of Truth Project – have published a large amount of material on the topic. Their paper, Measuring Up: The Case for the Chained CPI, explains the interaction between the inflation measure and the budget, makes the technical case for chained CPI, and shows the budgetary and distributional impact of adopting it.

In addition to this paper, we have published answers to frequently asked questions about the chained CPI, corrections to some common myths, explanations of the distributional impact, pushback on misleading claims, and dozens of blog posts discussing various facets of chained CPI.

Our chained CPI resource page compiles numerous resources on chained CPI from CRFB and from government agencies, think tanks, and economists from across the ideological spectrum. Our resources page also links to a brief summary of the issue, which can be viewed below:

As we’ve explained many times before, chained CPI is a common-sense proposal with broad bipartisan support that would not only improve the way we measure inflation but also raise additional revenue, slow the growth of government spending, and help to shore up Social Security.

Although we are glad the President remains open to the policy, we are disappointed he has removed it from his budget. As CRFB President Maya MacGuineas said today in a statement from our partner Fix the Debt:

We are incredibly disappointed to learn that the President has decided to drop his proposal to correct the way in which the federal government measures inflation…Reaching agreement on a comprehensive debt deal will require consideration of all policy options and compromises by both sides. While we welcome today’s statements from the administration indicating they remain open to supporting chained CPI in the context of a bipartisan deficit reduction agreement, the nation needs the President to lead on this issue. The clear pullback on his part is a disturbing sign that he will not.

To learn more about chained CPI, visit our chained CPI resource page here

February 19, 2014

At the beginning of the month, the Congressional Budget Office released its annual report on the federal budget, which showed that the deficit is expected to fall by $166 billion from last year to this year, but increase by $1.7 trillion over the next ten years compared to previous projections.

The next day, we released an analysis of the reasons why the deficit dropped since last year. Three-quarters of the drop, or $120 billion, could be attributed to "expected" changes that had been predicted in last year's report. Higher collections from Fannie Mae and particularly Freddie Mac also improved the deficit, while legislation increasing discretionary spending above sequestration amounts in exchange for cuts in future years increased the 2014 deficit. In this post, we look into the other changes to the 2014 deficit, those included as "expected" changes, particularly the automatic stabilizers that increase deficits when the economy is operating below potential.

There are several large factors which will reduce the deficit in 2014. Perhaps most fundamentally, government revenues increase along with the economy. As payrolls, personal incomes, and corporate profits increase, so does tax revenue. The economy is projected to grow by nearly 4 percent, and income tax revenue will grow by nearly 5 percent.

Yet revenues still have a long way to recover from the recession. During a recession, certain "economic stabilizers" automatically increase the deficit by lowering tax revenue and raising safety net spending. At their height in 2010, these stabilizers increased the deficit by $373 billion, nearly 30 percent of the total deficit.

The high deficits of the last few years are falling; however, the deficits from automatic stabilizers are projected to continue for several more years. The automatic stabilizers only fell by $16 billion between 2013 and 2014, a drop caused by $6 billion in higher revenues and $10 billion in lower safety net spending. In 2014, stabilizers will cost $261 billion, over half of this year's $514 billion deficit. The automatic stabilizers will continue to drop in future years, but are not expected to reach zero based on a change in how CBO projects future growth: they no longer expect the economy to reach full potential within ten years or the unemployment rate to fall to levels projected in past forecasts.

Other factors contributed to the changes to the deficit. The new taxes in the fiscal cliff deal, such as a new top rate of 39.6 percent and a 5 percent higher rate on capital gains and dividends, raised approximately $47 billion. While they were in effect for all of calendar year 2013, they did not apply to the entire fiscal year 2013, which includes 3 months of 2012, before the tax increases were enacted.

Other factors increase the deficit. The Affordable Care Act's new coverage provisions have begun, costing the federal government $41 billion in exchange subsidies and expanding health coverage to low-income populations. Finally, with every passing year, more of the population ages into retirement – Social Security outlays will increase by $38 billion and net Medicare spending is expected to increase by $13 billion. 

As Congress wrestles with how to achieve deficit reduction, they would be wise to consider the various factors pulling the deficit in different directions – particularly over the long term. The newest deficit projections were slightly rosier in the short-term, but that was largely as a result of factors outside their control. Later this decade and over the long term, there will almost surely be no conversations about why the deficit is falling. The focus will instead be on why the deficit is growing because of health care costs and an aging population. However, waiting until that happens before we take action will risk higher debt levels, forgoes time when reforms could be gradually phased in, and places a larger share of the population at risk by being either in or near retirement. Falling deficits this year should be an opportunity to create lower deficits in the future too.

February 19, 2014

Last Friday, 16 Senate Democrats sent a letter to President Obama, but it wasn't for Valentine's Day. Rather, the letter warned the President against including cuts to Social Security, Medicare, or Medicaid benefits in his FY 2014 budget, due out in two weeks. Although it did not specifically mention any policies, it was clearly addressed at the inclusion of the chained CPI in last year's budget and certain modest Medicare cost-sharing reforms. Today, House Democrats sent a letter more specifically opposed to the chained CPI. There has been much speculation about what this budget will contain, particularly with regards to the chained CPI.

However, given the recent deterioration in budget projections, though, this is the wrong time to turn our back on entitlement reforms. With health care, there are significant savings that can be had from health care providers and drug companies -- and the President has those -- but beneficiaries will ultimately need to contribute as well. There are ways to achieve savings that will actually help beneficiaries and make the health care system more efficient, such as cost-sharing reforms. And on Social Security, the system's finances demand that we find solutions, or else beneficiaries will receive a one-quarter cut to benefits in 2033, according to the program's trustees.

As we have said many times before, the chained CPI is the most accurate measure of inflation and should be used where inflation calculations are relevant, whether that be in Social Security or other programs. Chained CPI achieves significant savings across the budget on both the spending and revenue side by more accurately implementing the policy of adjusting benefits and provisions in the tax code to reflect inflation. Overestimating inflation is not a targeted or wise way to increase benefits; other ways exist to boost benefits, particularly for the most vulnerable.

Switching to chained CPI has been a key element of comprehensive deficit reduction plans such as Simpson-Bowles, Domenici-Rivlin and the President's budget and backing away from chained CPI now will make it harder to reach an agreement in the future which puts the debt on a sustainable path while replacing sequester with smarter savings. But chained CPI could also be part of smaller packages such as the proposal put forward by CRFB President Maya Macguineas to use the non-Social Security savings from chained CPI to offset the costs of temporary spending for unemployment benefits and job creation measures, with savings in Social Security going to improve the program's solvency.

Another issue with taking entitlement reforms off the table is the squeeze unchecked growth of entitlement programs will put on the rest of the budget. Deficit reduction efforts on the spending side in recent years have focused almost entirely on discretionary spending, which contains defense spending and non-defense spending like education, infrastructure, and research. That category has fallen significantly in recent years and will continue to be constrained in future years if policymakers do not act to restrain the growth of mandatory spending. With mandatory programs contributing little to deficit reduction so far, discretionary spending has felt the brunt.

In short, we hope that President Obama not only maintains the reforms he proposed last year and in previous years but builds on them. The recent uptick in debt projections should bring a new focus on the drivers of the long-term debt.

February 18, 2014

Last week, the relevant Congressional committees released a bipartisan, bicameral proposal to replace the Sustainable Growth Rate (SGR) formula for Medicare physician payments, which has repeatedly been modified or delayed before taking effect since 2003. Despite this agreement, much less work has been done concerning how to pay for the cost of the replacement. To fill that void, Mark McClellan, Keith Fontenot, Alice Rivlin, and Erica Socker published a proposal in Health Affairs to offset the $130–$170 billion ten-year cost of a replacement system.

Their proposal aims to use this opportunity to create better incentives to provide and use care more efficiently through rewards for coordinated care and the use of cost-sharing changes, shared savings, and other means. Their package includes a mix of savings from both providers and beneficiaries, many of which have been highlighted in the Congressional Budget Office's (CBO's) Budget Options report. Many have also received support from the President's budget, Simpson-Bowles, Domenici-Rivlin, and the Medicare Payment Advisory Commission (MedPAC). They describe their list of policies as follows:

If Congress can come up with off-sets for physician payment reform that support improvements in care as well as lower costs, the whole package could have a more meaningful effect on beneficiary care than the physician payment reforms alone.  This could assure beneficiaries and other health care providers that these savings are not just payment cuts that must be absorbed, but steps to help reduce spending through reforms that improve care.

The reforms they propose would be sufficient to pay for the cost of a reasonable permanent doc fix.

McClellan-Table-1

This package is just one way lawmakers could choose to offset the cost of a doc fix. There are many options from CBO and others that would also do the trick while also encouraging higher-quality, higher-value care. Legislators working on the SGR replacement simply need to find the political will to agree on offsets.

February 18, 2014
Weekly Update on Budget and Fiscal Policy Developments and a Look Ahead

Cold Reality – The Winter Olympics are in full swing in Sochi, Russia, but Washington saw its own share of winter games before Congress adjourned for yet another break. Lawmakers played with the debt limit and considered virtually every idea under the sun before agreeing to put it off for another year. Legislators also fooled around with various budget gimmicks as they seek to game the system. There are a lot of issues that Americans want their representatives to tackle, but there isn’t much hope of that happening in this political climate. Avoiding debt ceiling disaster may end up being one of the biggest achievements out of Washington this year. Not really the stuff of Olympic glory.

Tough Sledding on the Debt Limit – Congress managed to avert going to the brink of a national default by agreeing to suspend the debt limit once again. The suspension lasts until March 15, 2015. House leaders had floated a wide range of proposals to pair with raising the debt ceiling, but in the end gave the president the clean increase he wanted. The Senate quickly followed suit and it was signed by President Obama on Saturday. The suspension means there will be no more major fiscal fights until at least October 1, when government funding expires. However, it does nothing to improve the debt outlook, which the latest projections from the Congressional Budget Office (CBO) show is now even worse than previously forecast. A statement from the Campaign to Fix the Debt urges, “It’s critical that lawmakers not take steps backwards or undermine this progress by considering legislation that has the ability to add to the deficit or worsen the country’s already strained fiscal outlook.” The recent debt limit fights have led to increased calls to improve the mechanism so that it can more effectively be used to put the country on a sustainable fiscal path without threatening the economy.    

Gimmick Olympics Produce No Winners – Lawmakers are facing heightened pressure not to add to the deficit, but some proposals they are offering to offset the costs of new policies are not medal caliber. A host of budget gimmicks have popped up that technically pay for new policies but, in reality, add to the deficit. Republicans in the House considered the “pension smoothing” gimmick to pay for rolling back recent military retirement reforms while Democrats in the Senate offered it to offset the cost of a three-month extension of expanded unemployment insurance benefits. The Senate proposal to reverse the military retirement changes used another gimmick – “war savings” – as an offset. We urged rejecting these gimmicks in a statement, and fortunately they were not used. However, gimmicks are still an attractive avenue. We created a chartbook identifying gimmicks to watch out for using helpful charts that illustrate how they work and why they add to the deficit.     

Skating Around Reform – On Saturday, the president also signed into law legislation rolling back the reduction in the cost-of-living adjustment (COLA) for working-age military retirees that was included in the Ryan-Murray budget deal. The House and Senate passed the change as they worked on the debt ceiling legislation separately. Now, only service members who start this year and afterwards will be impacted. The original version was a modest reform of a military retirement system in need of change that has now been diluted. As pressure mounts to find more savings from defense, it will be impossible to exclude military compensation, which is accounting for more and more of the Pentagon budget. The military COLA change is also a rare instance of entitlement reform that policymakers have been able to achieve. Although it is positive that lawmakers rejected blatant budget gimmicks to offset the change, it is still a step backwards because it replaces savings that would be realized far beyond the ten-year budget window with extending the cleaver of the mandatory spending sequester for an additional year. As a CNN article put it, “in reality the measure to reverse most military retirement cuts is the legislative equivalent of a cocaine hit: a feel-good high that obscures current problems, makes future issues worse (for the Pentagon and taxpayers) and sends one of the best signals yet that Congress is nowhere near making the tough decisions needed to avoid the financial storm set to crash on the federal budget in just a few years.”   

Downhill from Here for Doc Fix? – The military COLA bill also contained a provision creating a $2.3 billion "Transitional Fund for Sustainable Growth Rate Reform," which could be used to pay for a permanent repeal of the Sustainable Growth Rate (SGR). The relevant congressional committees recently jointly introduced “doc fix” legislation that didn’t include an offset.

Tax Reform an Olympian Task – The prospects for changes to the tax code remain cloudy. New Senate Finance Committee Chair Ron Wyden (D-OR) says that major reform won’t happen this year because of the partisan divide in Congress. Wyden hopes to take action on the “tax extenders” this year as a "bridge" to broader reform. Meanwhile, Wyden’s House counterpart, Ways and Means Committee Chair Dave Camp (R-MI), may go ahead with introducing comprehensive tax reform legislation. Also, the economic plan proposed by House Republicans has a tax reform component. However, the Olympic spirit has indeed gripped legislators as a bipartisan push has gained steam to exclude the value of Olympic winnings from income.  

A Golden Opportunity for Budget Reform? – The budget dysfunction of recent years is bolstering calls to reform the budget process. Last week the House Budget Committee approved of two budget process reform bills. One would introduce fair value accounting for federal credit programs and the other would institute biennial budgeting, which would move from yearly budgets to a two-year process. Advocates say two-year budgeting would allow more time for oversight of government spending and cut down on annual budget battles. For more budget reform ideas, visit budgetreform.org. Meanwhile, the Office of Management and Budget (OMB) confirmed that the White House Fiscal Year 2015 budget request will be released in two parts, with the topline numbers released March 4 and more detailed information following the next week.

 

 

Key Upcoming Dates (all times are ET)

 

February 20

  • Bureau of Labor Statistics releases January 2014 Consumer Price Index data.


February 28

  • Bureau of Economic Analysis releases second estimate of 4th quarter GDP growth.

 

March 4

  • White House releases topline numbers for Fiscal Year 2015 budget request.

 

March 7

  • Bureau of Labor Statistics releases February 2014 employment data.

 

March 18

  • Bureau of Labor Statistics releases February 2014 Consumer Price Index data.

 

March 27

  • Bureau of Economic Analysis releases third estimate of 4th quarter GDP growth.

 

March 31

  • "Doc fix" expires.

 

February 14, 2014

Earlier this week, Congress moved quickly on a bill to repeal the military cost-of-living adjustment (COLA) reduction for working age retirees that was included in the Ryan-Murray budget deal. The bill repeals the reduction for all service members who started before 2014, effectively delaying any part of the reform for 20 years and delaying its full phase in until 2058. The new spending from repeal is offset by extending the mandatory spending sequester an additional year to 2024, and it also designates $2.3 billion (the savings from the sequester extension in excess of the 10-year cost of repealing the COLA reform) to help pay for the next needed "doc fix," whether temporary or permanent. The bill passed with dissent from only 90 members of the House and 3 Senators.

Although the bill is technically offset over ten years, it is a step backward for fiscal responsibility. It partially repeals one of the few entitlement reforms in the budget deal and offsets it with an extension of a policy that cuts spending across the board in a ham-handed manner. Moreover, the modest COLA reduction repeal has costs over the longer term whereas the sequester extension only produces savings in two years. Also, the higher accrual payments the Department of Defense (DoD) must put away to pay the higher COLAs will put a squeeze on other defense priorities, given the tight spending caps already in place.

This last fact is why the bill would make a good candidate for a longer-term scoring technique, even if it has a relatively small budgetary impact. For one, repealing the COLA for current service members means that the policy does not apply to anyone for 20 years (because military pensions do not vest for 20 years). However, the cost of repeal will phase out over time, eventually reaching zero once all retirees face the COLA reduction. The extension of the sequester, alternatively, produces savings in the tenth year and the year immediately following, but it does not produce any savings in subsequent years. Thus, both the cost and the offset have different effects over time.

For the first decade, the primary effect (not including interest costs) of the bill is almost exactly deficit-neutral. However, accounting for interest costs, the bill increases the debt by about $2 billion. Looking over the next twenty years, the bill with interest could cost about $15 billion. Another thing to account for, however, is accrual payments by the federal government. When retirement benefits are increased, agency pre-funding contributions (which are effectively monies paid to ourselves on paper to highlight future costs) also increase. With discretionary caps in place, because those pre-funding contributions count toward the caps, that additional spending is ultimately taken out of other programs, so the net effect is to reduce deficits. After accounting for the effect of accrual payments and related interest savings, the bill is actually roughly deficit-neutral over twenty years.1

Note that since there are no official CBO numbers beyond the first ten years, the two-decade estimates are rough.

Budgetary Impact of the Military COLA Bill (Billions of Dollars)

Source: CBO, CRFB calculations
Note: Second decade estimates are very rough and rounded calculations.

Regardless of the fiscal impact, though, the bill is a step backward for responsible budgeting in that it shows a lack of commitment to entitlement reform, and feeds the notion that similar reforms may not take effect. As House Budget Committee chairman Paul Ryan (R-WI), who voted against the bill, said, "Rather than making the tough choices, it sidesteps them. I’m open to replacing this reform with a better alternative. But I cannot support kicking the can down the road." Sen. Jeff Flake (R-AZ) asked, "How do we convey to the nation the seriousness about solving the debt crisis when at the first sign of political pressure, we repeal one of the deficit reduction measures?" House Armed Services Committee ranking member Adam Smith (D-WA) noted, "By repealing the COLA provision that was just agreed to a month ago in this very body, we are forcing the Department of Defense to focus on personnel costs...forcing cuts to readiness and procurement."

Granted, military retiree pensions are a particularly politically sensitive topic, but if lawmakers are unwilling to stick with a modest reform, it speaks poorly to their ability to agree to the reforms that will be needed for health care programs, Social Security, and the tax code. The bill's impact is deficit-neutral on paper over the next twenty years, but its portent is much worse.


1 Although CBO notes the size of changes to accrual payments, they do not include these in their estimate of the bill's effect on direct spending because the final amount of discretionary appropriations are still subject to annual appropriations bills not yet enacted.

February 12, 2014
Good Economic Policy Would Call for the Opposite

In May of last year, CBO expected the 2014 deficit to fall to $560 billion from 2013's total of $680 billion. Now, CBO is estimating a deficit of $514 billion this year, a reduction of $46 billion compared to May. By contrast, CBO revised its estimates of ten-year deficits up by about $1.4 trillion over the 2014-2023 period and nearly $1.7 trillion over the 2015-2024 period on an apples-to-apples basis that removes non-recurring disaster costs.*

Ironically, most economists would have preferred exactly the opposite: somewhat higher deficits today, when the economy is weak, and lower deficits in future years to allow the debt to fall as a share of GDP. In fact, had the opposite occurred, it would have boosted GDP both this year and the end of the decade by about 0.35 percent, using CBO rules of thumb (Appendix D of the report).

Many articles (here and here and here) have reported the lower deficits that CBO now projects in the short term. Less attention, however, has focused on the far worse projections over the rest of the ten-year window (and likely beyond). As we explained in recent blog posts on CBO's new report, falling deficits in the near term are being driven by higher revenues and lower spending as a result of the economic recovery, along with payments to the Treasury from Fannie Mae and Freddie Mac, but higher deficits of about $1.7 trillion than previously thought over the decade are being driven by slower economic growth, a slower recovery of the labor market, and lower levels of labor participation.

Unfortunately, it would have been far better if CBO had said the opposite was occurring. Luckily, lawmakers can adopt measures to control long-term debt and improve the country's growth potential.

 

The Short Term

CBO's updated projections show slower economic growth over the next few years than previously thought – growth in 2016 only reaches 3.4 percent in 2016 instead of 4.4 percent – and a slower recovery in the labor market. Such information could prompt lawmakers and economists to call for additional temporary short-term investments to aid the recovery, should they deem it necessary. According to CBO, short-term relief in form of emergency unemployment benefits and/or additional sequester relief could boost near-term GDP growth and employment. Using rough rules of thumb from CBO, an additional $45 billion in deficits this year from aid for the jobless and/or additional sequester relief could boost 2014 inflation-adjusted GDP by between 0.30 and 0.35 percentage points (raising real growth from 2.7 percent to about 3.0 percent) and boost full-time equivalent employment by between 350,000 and 400,000.

Importantly, however, CBO also cautions that higher federal borrowing for short-term measures "would eventually reduce the nation's output and income slightly below what would occur." When presented with the option of providing additional relief to the economy in the near term while offsetting the costs over the long-term, CBO would say it would be a net positive for the economy (as would most economists), especially if the offsets continued to hold down deficits over the long term.

The Long Term

Higher expected deficits after 2015 will come at a time when population aging, health care costs, and rising interest payments will place even larger demands on the government to borrow. As CRFB and CBO continue to stress, increased federal borrowing when debt is already at elevated levels poses serious risks to economic growth, investment, budgetary flexibility, and financial stability.

In addition to the reasons cited for lower projected growth this decades, which include lower labor force participation and lower productivity growth, CBO cites higher levels of debt as a central component. As a result of higher debt levels than in previous projections, CBO now forecasts that the nation's capital stock (the cumulation of current and past investments in physical capital) will grow more slowly each year – 3.1 percent, down from an average of 3.4 percent.

Using CBO's rough rules of thumb over the longer term, an additional $1.5 trillion in primary deficit reduction (which is what would occur if CBO's deficit increases from the May baseline became downward revisions) could increase the size of the economy by between 0.35 and 0.40 percentage points by 2024 as a result of a larger capital stock. Greater deficit reduction, and particularly pro-growth tax and spending reforms, could produce additional economic gains.

Combining the Short Term and Long Term into One Strategy

A far better strategy than short-term austerity or elevated deficits in later years would be to reverse the trends simultaneously. Such a strategy could allow for slightly higher deficits in the near term, something than many economists have suggested, while at the same time paying for these measures over the ten-year window and undertaking far-reaching reforms to the tax code, entitlement programs, and other spending to put the debt on a downward path relative to the economy. The upfront measures could help encourage the recovery, while entitlement and tax reforms would put downward pressure on the debt over the long term, enhancing overall growth. Most economists would call that a win-win, plain and simple.

If the changes since the May baseline had been in the opposite direction – lowering ten-year deficits by about $1.7 trillion instead of increasing them – debt would have been on a roughly stable path later this decade instead of an upward path. Importantly, however, lawmakers would have to do far more in order to put the debt on a downward path – an outcome that should be the ultimate goal.

Many bipartisan deficit reduction plans have allowed for slightly higher near-term borrowing in exchange for much lower borrowing down the road. For example, the original Domenici-Rivlin plan coupled an upfront payroll tax holiday for both employees and employers along with trillions of dollars in health care reforms, tax reforms, spending reforms, and Social Security reform. In addition, the recent Simpson-Bowles proposal called for repealing a larger portion of the sequester than lawmakers were able to agree on and combine those near-term measures with more than $2.5 trillion in savings through 2023. President Obama's deficit reduction offer to Speaker Boehner in the fiscal cliff negotiations included $50 billion of immediate infrastructure investments coupled with $1.8 trillion in savings through 2023.

Let's hope that the FY2015 budget season focuses attention on CBO's worsened projections and produces proposals to improve the economy and guide the budget toward long-term sustainability.


 

*The $46 billion change in FY2014 deficits would change only slightly when correcting for the differences in Sandy aid between the baselines.

February 11, 2014

Last week's report by the Congressional Budget Office showed that our debt remains on an unsustainable path, (see our ongoing blog series) and is projected to be $1.7 trillion higher by 2024 than we previously thought.

Despite the dismal fiscal picture, Congress may be considering measures to worsen the deficit, and covering their tracks with so-called "budget gimmicks."

Today, we released a chartbook, "Avoiding Budget Gimmicks," which explains and illustrates several of the tricks and slights of hand that policymakers may use to avoid identifying genuine offsets and payfors.

We encourage our readers to share these charts and graphs and to hold policymakers accountable for efforts to worsen the long-term fiscal situation.

A pdf version of this chartbook is available here. The individual charts, with descriptions, are also posted below.


 

Chart 1: The National Debt is High and Growing

Debt is currently at its highest level since World War II, and is expected to continue to grow later this decade. Assuming the wars in Iraq and Afghanistan continue to unwind and policymakers abide by current law, debt is projected to rise from 72 percent of GDP in 2013 to 77 percent by 2024.  

 

Chart 2: Deficit-Financed Extensions Would Make the Debt Much Worse

While abiding by current law will allow debt to grow to 77 percent of GDP, continuing expiring (or expired) provisions without legitimate offsets could make the situation far worse. Extending the current doc fix, the recently expired tax extenders, and certain refundable tax credits would increase debt levels to 80 percent of GDP by 2024. Adding a repeal of future sequestration cuts would increase it to 84 percent. Additionally reinstating and extending unemployment benefits and "bonus depreciation" could drive the debt to 86 percent of GDP.

Chart 3: The War Gimmick May Allow Policymakers to Avoid Tough Choices

Under current budget conventions, uncapped discretionary spending, like war spending, is assumed to grow with inflation in the CBO baseline regardless of future plans. Some have suggested taking advantage of this quirk to cap war spending below the CBO baseline but well above the levels consistent with the drawdown currently underway. Yet capping spending above what current policy dictates and what Congress intends to spend will not result in lower future spending, and will generate only phantom savings.

 

The Congressional Budget Office, as well as budget experts on the left and right, all warn that war savings are illusory:

 

Chart 4: Using the War Gimmick Can Create a Slush Fund to Further Worsen the Debt

If war spending is capped at levels in excess of expected costs, these caps will create a slush fund for future spending. Specifically, lawmakers could further lower the caps to offset new priorities, or could sneak normal defense costs under the war spending caps if they are still elevated above drawdown levels. For example, if lawmakers set war spending caps $50 billion (over ten years) below the CBO baseline, it would create a $600 billion slush fund to avoid paying for future initiatives.

 

Chart 5: Policies Which Save Now and Cost Later Don't Really Save At All

Some policies take advantage of the ten-year budget window by taking credit for alleged savings that only represent a timing shift. For instance, a provision called pension smoothing would increase tax revenues in the first six years, but lose revenue beyond that and have no significant budgetary impact over the long-run.


Similarly, budget experts from across the political spectrum warn that this sort of timing shift is a gimmick:


Chart 6: Moving Savings from Year 11 to Year 10 Doesn't Reduce the Deficit

Another timing gimmick takes savings which would have occurred in the 11th year – just outside the ten year budget window – and moves them into the 10th. This shift may appear to reduce ten-year deficits, but in fact results in no net savings. Policymakers used this gimmick when approving a 3-month "doc fix" in December 2013.

Chart 7: Offsetting Permanent Costs with Temporary Savings Results in Permanent Costs

Some policy changes have largely temporary deficit impacts, while others have largely permanent impacts. Using a temporary policy to pay for a permanent one may appear to add up over ten years, but would worsen the fiscal outlook over the long-run. For example, adopting LIFO accounting in the tax code would generate mostly temporary revenue; using that revenue to pay for a permanent rate reduction would increase long-term deficits and debt.

Chart 8: Waiting Ten Years to Start Paying May Be Unwise

Although it may not be considered a gimmick, waiting until the end of the decade to pay for new spending can be both risky and costly. First, an offset far in the future may not be viewed as credible. Even if it were, however, substantial interest costs would accrue over the decade. In the example below, waiting ten years to pay a $25 billion bill results in interest costs equal to one-third of the primary budget impact.

 


 

The long-term debt problem is daunting enough, and it will be worse if lawmakers continue to suggest using budget gimmicks to hide or obscure the costs of new policies. We encourage readers to use these tools to hold lawmakers accountable for their efforts to worsen the long-term fiscal situation. Our whole chartbook is available here, or as a printer-friendly PDF. You can read more detail about these and other gimmicks in our paper Beware of Budget Gimmicks.

Related Blogs:


Note: The last chart was updated on February 12 to include estimates from CBO's newest interest projections.

 

February 11, 2014

With the debt ceiling having been reinstated last Friday, lawmakers are scrambling to come up with legislation to lift or suspend it again before extraordinary measures likely run out by the end of the month. Originally, House Republicans had planned on attaching a repeal of the military retirement cost-of-living adjustment reduction for people who joined the service prior to 2014 to a debt ceiling suspension through March 15 of next year. Now it appears they will pursue the "beware the ides of March 2015" strategy separately from the military COLA change, opting to vote on a clean debt limit suspension instead.

Avoiding default on the national debt is, of course, a good thing. The military COLA bill is more of a mixed bag.

As we have said before, the reduction in COLAs for working age military retirees in the Ryan-Murray deal is a modest change in the military retirement system that is need of reform.  Funding the obligations for health and pension benefits for miiltary retirees is placing an increasing burden on the defense budget. Repealing or limiting application of the COLA provision in Ryan-Murray without offsetting it with other changes reducing obligations for pension or health benefits for military retirees will require further cuts in other defense programs to accomodate higher accrual payments to fund these obligations.

The bill the House is considering would exempt current service members and retirees from the COLA reduction and apply the reduction to service members who enlisted after January 1, 2014. As a result, the policy would not achieve any savings for at least twenty years, which is the vesting period for military pensions. Grandfathering current enlistees and retirees would cost $7 billion over the next ten years. These costs would be offset by extending the mandatory spending sequester through 2024 (it had previously been extended to 2022 and 2023 in the Ryan-Murray deal).

The good news is that unlike the legislation currently being considered by the Senate, which would completely repeal the military COLA reduction without offsetting the costs, the bill the House will consider would be fully offset within the ten-year window, and it would at least maintain the COLA policy for new service members. The less good news is that it partially rolls back one of the few entitlement reforms in Ryan-Murray, and it offsets the cost with savings in the tenth year, meaning that interest costs will accrue on higher debt in the years prior. Also, it will be replacing a targeted cut with the across-the-board cuts from the mandatory sequester. Moreover, it accelerates the timing of the sequester cuts in 2024 to move some of the savings that would have otherwise occurred in FY 2025 (outside the ten year budget window) into FY 2024. 

As a side note, the legislation also contains $2.3 billion for a "Transitional Fund for Sustainable Growth Rate Reform," which would provide funds for the Secretary of Health and Human Services to supplement Medicare physician payments in 2017. Most likely, though, the fund will be rescinded and used as an offset in SGR reform legislation.

The military COLA bill at least complies with PAYGO on paper but just barely clears the bar. While it is encouraging that the legislation the House will be considering offsets the costs, replacing savings from a specific reform of an entitlement program with one-time savings from an across-the-board spending cut is a step back from responsible budgeting.

February 11, 2014

In order to avoid bumping up against the statutory debt ceiling, the Department of the Treasury has begun undertaking a number of so-called "extraordinary measures." The current debt limit is $17.211 trillion.

Keep checking back as we update this table (and click here for last year's Debt Ceiling Watch 2013, here for the 2012 watch, and here for the 2011 watch).

Date Extraordinary Measure

Headroom Given

Debt (Gross / Subject to Limit)
2/10/2014

Debt Issuance Suspension Period for CSRDF and Suspension of Investment in G-Fund

The Treasury Department will enter into a "debt issuance suspension period" from 2/10/2014 through 2/27/2014 and will suspend additional investments to the Civil Service Retirement and Disability Fund (CSRDF). Additionally, The Treasury Department has suspended investments of the Government Securities Investment Fund (G-Fund) of the Federal Employee's Retirement System in interest-bearing securities.

Measures like this have been used in 1996, 2002, 2003, 2004, 2006, 2011, 2012, and 2013. Read more here.

CSRDF: $50-$75 billion

G-Fund: $175 billion

 
2/7/2014

Debt Limit Reinstated

The debt limit was temporarily suspended through February 7th under the Continuing Appropriations Act. With its reinstatement, Treasury will begin undertaking "extraordinary measures" to continue paying the nation's bills. However, Treasury was not confident that extraordinary measures would last past February 27th. Read more here.

 

$17,258,482/
$17,211,181

2/4/2014

Treasury Suspends Sales of State and Local Government Series Securities

The Treasury Department announced that it will suspend the sales of State and Local Goverment Series (SLGS) securities on February 7th when the debt ceiling is reinstated. The move does not create any headroom, but it does preserve existing headroom by preventing additional sales that would have counting toward the debt limit. Read more here and here.

  $17,263,040/
$17,215,738
1/22/2014

Treasury Department Warns Extraordinary Measures Will Not Last as Long as Previous Uses

Secretary Lew warned that extraordinary measures will not be able to extend the nation's borrowing authority as long as in 2011 and 2013, as February is a month with high net outflows due to tax refunds. In addition, there will be less headroom created than in 2013 as some extraordinary measures can only be used at certain times. About $200 billion in headroom can be freed up in February, compared to the $330 billion that was created in 2013. Read more here.

   $17,276,127/
$17,227,861

 

February 10, 2014
Weekly Update on Budget and Fiscal Policy Developments and a Look Ahead

Having Our Phil – Punxsutawney Phil saw his shadow last Sunday, traditionally meaning six more weeks of winter. That is no surprise to most of the country that has seen record low temperatures and extraordinary amounts of snow. Most of us have accepted the reality of more wintry weather ahead just as we recognize that little in the way of substantive action will come out of a polarized Washington. But that doesn’t mean we are happy about it. Congress and most government institutions continue to suffer from record-low approval ratings as our leaders are unable to effectively confront the issues that most concern Americans. Voters have seen this movie before have had enough of partisanship and brinksmanship. Will policymakers continue to see shadows and run back in their holes at every turn, or will the frozen apparatus in Washington finally begin to thaw?

No Shadow of a Doubt, Debt Still a Problem – The Congressional Budget Office (CBO) on Tuesday released its Budget and Economic Outlook 2014-2024 with the latest projections for the next decade. The numbers illustrate that the federal budget deficit will decline this year and next (though those numbers aren’t as impressive as they seem at first blush), but then begin rising again. While there is some improvement in the short-term picture, the longer term outlook has worsened with CBO projecting $1.7 trillion more in deficits this decade than previously forecast. Public debt will rise to 79 percent of GDP by 2024 (more than twice the average since World War II) and continue on an upward path. In addition, the new study underscores the budget challenges presented by an aging society and the financial problems facing Social Security in the not-too-distant future with the Disability Insurance Trust Fund due to be exhausted in less than three years. CBO also cautions that the large and growing national debt could impair economic growth and standard of living. We analyzed and distilled what the lengthy study says about our fiscal situation in a brief paper and also continue to focus on its findings in an ongoing blog series. The Campaign to Fix the Debt also produced highlights of the outlook.      

Debt Ceiling Coming Out of the Shadows Again – Congress is set to replay a familiar comedy of errors as the statutory debt limit was reinstated on Friday after the suspension imposed by the budget agreement late last year expired. The Treasury Department began “extraordinary measures” to maintain the ability to borrow to meet national obligations by ceasing to issue State and Local Government Series bonds. However, Treasury Secretary Jack Lew warned Congress via letter that those accounting techniques might not last beyond February 27. President Obama is demanding an immediate and clean increase in the debt limit while House leaders want something in return for an increase, but there is no agreement on what should be paired with raising the debt ceiling. A wide array of ideas has been offered, such as reforms to the budget process and ideas that have nothing to do with improving the fiscal situation, like approving the Keystone XL pipeline. There are now reports that the House may vote this week on a one-year debt limit suspension combined with extending the “doc fix” for nine months and reversing recent reforms to military retirement pay included in the budget agreement. However, one of the proposals for offsetting the costs of the plan is the “pension smoothing” gimmick that will actually add to the deficit in the long term. Another offset would include an extra year of cuts to mandatory spending. Meanwhile, the Bipartisan Policy Center and Concord Coalition offer ideas to improve the process so that fiscal responsibility can be promoted with threatening the economy. Have more questions about what the debt ceiling is and what it means? Check out our updated Debt Ceiling Q&A with everything you should know about it.       

Still Looking for Common Ground on Unemployment Insurance – The Senate last week came up short in extending emergency Unemployment Insurance benefits. Two votes on a three-month extension, one not offset and one “paid for” with pension smoothing failed to garner enough support. Just after the vote, CBO scored the extension. The CBO assessment confirms what we have been saying all along, that pension smoothing is a gimmick. While the provision reduces the deficit in the first six years, it then begins to increase deficits thereafter.  

White House Budget Won’t See the Light of Day Until MarchReports are (subscription required) that the White House Fiscal Year 2015 budget request will be released in two parts in March. By law, the budget was supposed to be unveiled February 3. The word is now that topline budget numbers will come on March 4 and more detailed numbers will come one week later on March 11. Despite the recent budget and appropriations agreements, there is still little question that the federal budget process still needs to be improved. The House Budget Committee marks-up two budget reform bills on Tuesday, one to adopt fair-value accounting for federal credit programs and one to institute biennial budgeting. In addition, the Brookings Institution has an ongoing blog series highlighting budget process reform ideas. For more budget reform proposals visit budgetreform.org.

Farm Bill Finally Comes Out of Its Hole – Last week the Senate passed major farm bill legislation and it was signed by President Obama Friday. The bill reduces deficits by about $17 trillion over ten years by streamlining direct payments to farmers and nutritional assistance programs. Combined with sequester savings, about $23 trillion in deficit reduction is achieved. 

Tax Reform Grounded? – The Senate confirmed Max Baucus to be U.S. Ambassador to China, meaning that Congress loses a leader of efforts to overhaul the tax code. While the future of fundamental tax reform this year is up in the air, Baucus’ replacement as chair of the Senate Finance Committee, Sen. Ron Wyden (D-OR), says he will take on the 55 tax breaks that expired at the beginning of the year – known as the “tax extenders” – as a gateway to fundamental tax reform.

Will Doc Fix Hog the Spotlight? – The relevant House and Senate committees last week jointly announced legislation to permanently replace the Sustainable Growth Rate (SGR), known as the “doc fix.” However, no agreement has yet been reached on how to offset the cost of a permanent doc fix. How lawmakers decide to pay for the fix could be the subject of much debate. 

Casting Sunlight on Budget Gimmicks – Budget gimmicks abound and we are exposing them. We issued a press release warning about the “pension smoothing” and “war savings” savings gimmicks. The Senate unsuccessfully tried to use pension smoothing to offset the three-month Unemployment Insurance extension and the House is considering it to pay for rolling back military retirement reform along with raising the debt ceiling. Meanwhile, legislation was introduced in the Senate to pay for the military reform reversal with so-called war savings, which is a gimmick because the “savings” result from the expected drawdown of forces from Afghanistan, not any new policy.  

Déjà Vu on Military Retirement – This week the Senate is set to take up the issue of repealing reforms to military retirement included in the budget agreement. This could be a recurring theme as many lawmakers are not pleased with the cuts. As with virtually everything nowadays, a main sticking point is whether to pay for the change and how to do so. Senators will consider repeal without any offsets, but amendments paying for the change may be offered. The Bipartisan Budget Act reduced cost-of-living adjustments for working-age military retirees. Though the reforms are minor and there is widespread recognition that more will be required to reform military compensation, many lawmakers are facing pressure to reverse the changes. This episode illustrates why the optimal approach is a comprehensive "grand bargain" that achieves savings from all parts of the budget, so that one group cannot claim to be singled out.

 

Key Upcoming Dates (all times are ET)

 

February 11

  • House Budget Committee mark-up of budget process reform legislation at 10 am.
  • Senate Budget Committee hearing on the CBO Budget and Economic Outlook at 10:30 am.

 

February 12

  • Treasury Department releases monthly federal budget data.

 

February 20

  • Bureau of Labor Statistics releases January 2014 Consumer Price Index data.


February 28

  • Bureau of Economic Analysis releases second estimate of 4th quarter GDP growth.

 

March 4

  • White House releases Fiscal Year 2015 budget request.

 

March 7

  • Bureau of Labor Statistics releases February 2014 employment data.

 

March 18

  • Bureau of Labor Statistics releases February 2014 Consumer Price Index data.

 

March 27

  • Bureau of Economic Analysis releases third estimate of 4th quarter GDP growth.

 

March 31

  • "Doc fix" expires.

 

February 10, 2014
Agreement on “pay-fors” still needed

Last week, on the day Senate Finance Chairman Max Baucus was confirmed to his new post as Ambassador to China, the Senate Finance, House Ways and Means, and House Energy and Commerce Committees announced a bipartisan agreement to reform the Sustainable Growth Rate (SGR) formula for Medicare physicians, reportedly with a ten-year cost of $126 billion. If the so-called health extenders from the previous Senate Finance proposal were included as well, that would add roughly another $45 billion in costs through 2024, bringing the total cost to around $170 billion.

With the SGR set to cut physicians payments by nearly 25 percent on April 1, the three relevant committees have been working feverishly to reach agreement on a compromise set of reforms to encourage quality, rather than volume, of care. The compromise hems close to the previous committee proposals, particularly those from Senate Finance and House Ways and Means, but includes a few key changes and fills in much detail:

  • Medicare professionals will get 0.5 percent annual payment updates through 2018, rather than the payment freeze offered by Senate Finance, and in line with the House Ways and Means proposal. These updates will add roughly $10 billion to the ten-year cost of the SGR fix compared to the Senate Finance proposal.
  • However, possibly in exchange, the compromise bill would cut annual Medicare physician payment updates in half after 2023 from previous proposals – 1 percent for professionals paid through an Alternative Payment Model (APM) and 0.5 percent for everyone else, compared to 2 percent and 1 percent in previous iterations, respectively. This change will save the government close to $50 billion over the 2nd decade and in the range of $300 billion over the 2nd and 3rd decades combined, making it more likely that a fully offset final bill can greatly improve Medicare’s sustainability. This modification might also be an indication that CBO is planning to provide a rough estimate of the SGR’s bill budget impact in the 2nd decade, similar to what they have done for the Affordable Care Act and Senate immigration bill.
  • Far more detail was added to precisely how the Merit-Based Incentive Payment System (MIPS) would work to determine some of Medicare’s payments to medical professionals. The system:
    • Reduces the initial amount of spending on MIPS-eligible professionals tied to the system’s metrics for quality, resource use, and meaningful electronic health record (EHR) use in 2017 from 8 percent in the original Senate Finance draft to 4 percent. Similarly, once fully phased-in by 2021, 9 percent of spending would be subject to such metrics rather than 10 percent.
    • Adds “Clinical Practice Improvement Activities” into the calculation to determine relative Medicare payments to professionals under the bill’s new Merit-Based Incentive Payment System (MIPS).
    • Specifies more precisely how the positive and negative payment adjustments would be determined.
  • Provides $40 million between 2014 and 2018 to help small physician practices move toward an Alternative Payment Model (APM) or improve their MIPS performance, up from $10 million in the original Senate Finance draft.
  • Sets up a process to develop qualified clinical decision support (CDS) mechanisms.
  • Limits prior authorization requirements for advanced imaging for physicians with low adherence to “applicable use criteria,” now only allowed to apply to 5 percent of ordering physicians at most.

Even with all of this, though, they’re still only half-way home. Despite an agreement on how to reform the SGR, the question of how to pay for the roughly $130 billion in new spending remains unsolved.

February 7, 2014

In its February 2014 Budget and Economic Outlook, CBO continued its previous warnings from last year's February outlook and September's long-term outlook: elevated and rising debt level pose serious risks for economic growth and budget flexibility.

In its latest outlook, CBO highlights on page one the consequences of high levels of debt:

Such large and growing federal debt could have serious negative consequences, including restraining economic growth in the long term, giving policymakers less flexibility to respond to unexpected challenges, and eventually increasing the risk of a fiscal crisis (in which investors would demand high interest rates to buy the government’s debt).

Later in the report, CBO touches on how rising debt levels have contributed to the downward revisions in projected growth rates, as a result of population aging, lower labor supply, and lower productivity growth.

A downward revision to the projected growth of the capital stock (reflecting new data and lower projected investment resulting primarily from higher federal debt); the capital stock is now projected to grow by an average of 3.1 percent per year, compared with the 3.4 percent projected previously.

Again, in his testimony on Wednesday morning to the House Budget Committee, CBO Director Douglas Elmendorf reaffirmed the dangers of rising debt. In response to a question from Congressman Tom Price (R-GA) about whether Congress has adequately addressed the risk of a fiscal crisis, Elmendorf stated that the risks of such a crisis are still present and such a scenario, in a variety of potential forms, could put enormous pressures on the federal budget:

"Well, as you know, the Congress has taken a number of steps and I don’t want to diminish those, but it is clear from our report that the fundamental fiscal challenge remains which is significant increases in spending for certain programs. And even though all the rest of the government is on a track to become smaller relative to the size of the economy, we nonetheless show high and rising debt. And that means that the country will need to make choices it has not yet made about cutting back those large programs or raising tax revenue to pay for them."

The takeaway from CBO's latest projections is clear: the long-term economy faces serious challenges to strong growth, include large and rising federal debt. Lawmakers should heed these warnings and recognize that addressing the debt is a central component of an economic growth strategy.

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