All of us here at CRFB would like to congratulate Peter Diamond, an MIT economist, on winning the Nobel Prize for Economics this year. Diamond, along with fellow American Dale Mortensen and British economist Christopher Pissarides, was awarded the prize for his work on search markets, tracking why unemployed workers fail to find work when there are jobs in the market.

In addition to the work that made him a Nobel laureate, Diamond has also contributed specific ideas to strengthen Social Security. In conjunction with former OMB Director Peter Orszag, he wrote a book a few years ago detailing a plan for reforming Social Security, entitled Saving Social Security: A Balanced Approach. Diamond and Orszag propose many of the reforms that should be on the table today, in a combination of revenue increases and benefit reductions. Their plan addressed what they saw as the three main sources of Social Security's long-term insolvency: increased life expectancy, increased income inequality, and the program's legacy debt. To address these issues, they propose proportionally decreasing benefits in accordance with increased life expectancies (and thus longer amounts of time receiving benefits), increasing the maximum taxable earnings base and imposing a legacy tax on earnings over the maximum, while offsetting this with making Social Security coverage universal (read a summary of the plan here). Diamond showed the vision and gumption to advance specific fiscal reforms that we need now for a sustainable budget path in the future.

Thanks, Peter, for getting specific!

We spend much of our time discussing and pointing out the precarious state of our federal budget. But the federal budget isn't the only area of public finances facing serious challenges. States, counties, and cities are, as the media has been reporting, also in crisis. In a paper released today, Robert Novy-Marx of the Unviersity of Rochester and Joshua Rauh of Northwestern University warn that state, city and county pension systems are in horrible shape.

Novy-Marx and Rauh write that the current process our localities (i.e. any country, city, town, municipality) use to calculate pensions is flawed and overstates their assets by understating the investment risks. By re-engineering the accounting data, they examined two-thirds of all pension users (only 3 percent of all the plans, but they used the most populous cities) and found that 50 cities' (77 plans) pension plans are underfunded by $383 billion. They make a rough extrapolation that the total could be $574 billion of unfunded liabilities if there is a linear relationship. 

Furthermore, Novy-Marx and Rauh identify 6 areas where, they estimate, public coffers will not be able to meet pension promises through 2020 (Philadelphia, Boston, Chicago, Cincinnati, Jacksonville, St. Paul). An additional 20 will not be able to meet their promises through 2025 (New York City, Baltimore, Dekalb County, Fulton County, Kern County, Baltimore County, Detroit, Forth Worth, Phoenix, Sonoma County, Nashville and Davidson County, San Joaquin County, San Mateo County, Seattle, Constra Costa County, Cook County, Montgomery County and Orange County).

The research highlights the precarious state of local government finances. It also brings into question the notion that our localities must and always do balance their budgets when many have millions, if not billions of dollars in unfunded liabilities that must be paid. It is clear that like the federal government, our localities, which are even more prone to bond rate changes, must get their fiscal houses in order.

Day of “Discovery” – Today we celebrate the man who quasi-discovered the Americas with a quasi-holiday that not everyone gets off (including the Line). In that fine tradition, we “discover” some fiscal facts.

The Deficit is High – The Congressional Budget Office on Thursday in its Monthly Budget Review estimated that the fiscal year 2010 federal budget deficit will be just under $1.3 trillion. At 8.9 percent of GDP, that is the second highest (behind last year) as a share of the economy since 1945. The Treasury Department will release the official deficit figure later this month.

Washington is Too Dysfunctional – A bipartisan group of former members of Congress recently sent a letter to congressional candidates saying that there is currently too much focus on partisan politics and not enough attention to problem solving. Saying that the “political system has not shown itself to be up to the task” in confronting the major challenges facing the country, the group calls for more cooperation, compromise and civil debate. Rediscovering pragmatism and bipartisanship could help solve our fiscal problems.

In a politically diverse but ultimately centrist nation, it is axiomatic that the country's major problems are going to have to be solved through compromises worked out between the parties. That's especially the case for the problems that require tough solutions - like convincing taxpayers to endure some short-term pain for the promise of long-term fiscal stability. That will require partisans on both sides to give ground on some of their cherished beliefs, to lose some traction on a 'wedge issue' that can be used in campaigns against the other side, in order to find the broad coalition necessary to make a policy work.

Earmarks Need Reform – A group of lobbyists and government reform organizations have come together to promote earmark reform. The group has offered five principles for earmark reform that would make the process more transparent and reduce the link between earmarks and campaign contributions. Members of the coalition met with congressional offices last week to discuss their ideas.

Unemployment Still High – The official unemployment rate remained at 9.6 percent in September. Unemployment remains high as policymakers continue to debate how to spur the sluggish economy in the short run while not exacerbating the longer run fiscal problems marked by high public debt. CRFB President Maya MacGuineas offered some ideas for fiscally responsible stimulus last week.

Government Could Be More Efficient – A group of high-tech executives said in a report last week that the federal government could save over $1 trillion by 2020 by following the lead of corporations and streamlining operations through innovative technologies and processes.

U.S. Needs Better Fiscal Policy – Federal Reserve Chairman Ben Bernanke gave a hard-hitting speech last week on the need for fiscal sustainability and fiscal rules. The Fed usually concentrates on monetary policy, so the speech was a clear sign of the importance of fiscal issues to the economy. CRFB applauded the remarks on the need for fiscal rules that are strong and transparent.

CBO, in its most recent Monthly Budget Review, estimated that the FY 2010 budget deficit (the fiscal year that ended at the end of September) was just short of $1.3 trillion, $125 billion less than last year's deficit of $1.4 trillion. At 8.9 percent of GDP, this is the second highest deficit-GDP rate since World War II, with the highest being last year's 10 percent. This number also represents a slight drop from the 2010 deficit CBO reported in its most recent Budget and Economic Outlook this past August.

While the deficit is slightly lower than last year, we are by no means on the path to triumph over our fiscal challenges. In our recent realistic baseline, CRFB projected that while deficts will decline in the next few years, the debt will continue to rise as a share of the economy to unsustainable levels without action.

Although an improving economy (hopefully) will reduce deficits in the short-term, we must devise a plan of action now to address the structural issues that will cause the debt to skyrocket. Click here to try doing so yourself.

The Hill reports that Senator Ron Wyden (D-OR) urged fellow lawmakers this week at a tax policy conference to focus on fundamental tax reform instead of the narrow debate over the expiring 2001/2003 tax cuts. Sen. Wyden is calling for lawmakers on both sides of the aisle to work together to overhaul the tax code. He has co-sponsored a tax reform proposal with Senator Judd Gregg (R-NH), “The Bipartisan Tax Fairness and Simplification Act of 2010.”

Wyden spoke about the bill and the need for reform at CRFB’s “Getting Specific” event last week. Wyden wants tax reform to be debated during the post-election lame duck session of Congress; arguing that the debate over extending the tax cuts should serve as a “bridge” to overall tax reform.

Senator Wyden is right about the need to fix our complex and inefficient tax system in a way that simplifies the tax code and broadens the tax base. We hope his fellow lawmakers will agree as well.

A summary and video of CRFB’s “Getting Specific” event are available here.

CRFB has just launched a new policy paper series entitled "Let's Get Specific." The Let's Get Specific series is intended to help focus national attention on finding specific solutions to our mounting fiscal challenges and on understanding the types of changes we will have to make. Not all the policies in this series are necessarily endorsed by all members of CRFB.

In the first round of papers for the series, CRFB details a reform plan for Social Security and a plan for putting further downward pressure on health care costs over the near- and long-term. Let's take a brief look at what's in our health care plan...

Health care costs represent the single largest threat to the federal budget. In just a few years, federal health spending will reach 6 percent of GDP and will grow to almost 10 percent of GDP by 2030 under the Alternative Fiscal Scenario (and to almost 9 percent under the Extended Baseline Scenario). Under either scenario, the path is clearly unsustainable and more will have to be done despite the cost-saving measures enacted in health reform.

To help further control these costs, CRFB shows how focusing on a few reform areas could help greatly. Here's a summary table of our recommendations:

In the long-term, putting Medicare and Medicaid on a budget would be a direct way to control costs, and many other countries have set budget limits to control health spending. As an alternative, policymakers could also transform federal health programs into a premium support system whereby the government would give beneficiaries a fixed amount each year to purchase health care services through either a fee-for-service system or through private insurers.

These reforms are not an exhaustive list of reform options, and simply represent one approach to controlling costs. Other approaches could incorporate a public health care option and/or increases in Medicare premiums.

But the bottom line remains--the less that is done to control rising health care costs, the more savings we will need to find from other areas of the budget if we are to get back on a sustainable fiscal path. Read the full plan here.

CRFB President Maya MacGuineas has a new commentary today on CNN.com. The piece offers some stimulus suggestions that balance aiding the economy in the short term with reducing the debt in the longer term. Read it here.

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

Should Old Performance be Forgot, and Never Brought to Mind? – The new fiscal year (2011) began on Friday. Instead of imbibing in champagne, CRFB presented some sobering statistics on fiscal year 2010 (see here). There is a lot that needs to be resolved; here’s hoping that solutions can be achieved for a better FY 2011.

Lew Still Waiting for the Ball to Drop – Jacob Lew’s nomination to be the next director of OMB hit a snag when Senator May Landrieu (D-LA) put a “hold” on his nomination in order to protest the administrations’ temporary ban on deepwater drilling. The FY 2012 budget process is gearing up within the administration, and they could use a leader to shepherd the process along.

CBO Warns on Tax Cuts – Last week Congressional Budget Office Director Douglas Elmendorf testified before the Senate Budget Committee that extending the 2001/2003 tax cuts either fully or partially will reduce economic growth in the longer run because it will add to the debt.

New Fiscal Year, No Budget – The new fiscal year began without Congress approving of any of the appropriations bills to finance federal operations. A government shutdown was avoided with legislators approving of a stopgap continuing resolution to fund federal agencies through December 3. Congress opted for a relatively clean CR without much of the additional spending that the White House asked for. An amendment from Senator John Thune (R-SD) to reduce non-security spending in the CR by 5% was defeated in a 48-51 vote. Congress must either enact another CR or approve of the appropriations bills when it returns from recess.

No Lame Excuses – Congress adjourned right after approving of the continuing resolution. Lawmakers must return after the election in a “lame duck” session to complete unfinished business. Topics that will be addressed in the session beginning November 15 include FY 2011 appropriations (most likely through an “omnibus” package); the 2001/2003 tax cuts; patching the Alternative Minimum Tax (AMT) so that it does not affect the middle class; the estate tax (which under current law will return at its 2001 level after expiring in 2010); extending items like the “doc fix” and the research and development tax credit; and any recommendations from the White House fiscal commission, which are due by December 1.

Fiscal Commission Looks at Government Performance – The President’s National Commission on Fiscal Responsibility and Reform held its fifth public meeting on Wednesday. It heard testimony on performance budgeting and eliminating government waste. CRFB live-tweeted the proceedings.

Resolution for Policymakers: Be Specific – CRFB convened a policy forum on Thursday in Washington, DC to highlight specific ideas that have been offered to confront our fiscal challenges and called upon lawmakers to move from sound bites to solutions. Participants included Senator Ron Wyden (D-OR), Congressman Paul Ryan (R-WI), Congressman Jim Himes (D-CT), Harvard University economist Martin Feldstein, former Congressmen Bill Frenzel and Jim Kolbe, and former Comptroller General of the U.S. General Accounting Office Chuck Bowsher. CRFB heeded its own advice and released specific proposals on health care and Social Security, and CRFB President Maya MacGuineas, along with Brookings Institution Senior Fellow Bill Galston, unveiled a detailed fiscal plan.

New Report Says “No Silver Bullet” – A report released by the Fiscal Analysis Initiative of The Pew Charitable Trusts illustrates how difficult it will be to put the U.S. on a sustainable fiscal course by relying exclusively on any single approach. The report uses the Peterson-Pew Commission on Budget Reform goal of stabilizing the debt at 60 percent of GDP and assumes that action towards the goal will begin in 2015, when the economy should be stronger. The report’s findings suggest that everything should be on the table and concludes that “the challenge becomes more surmountable if more policies are included in the long-term solution.”

Boehner Calls for Reforms – In a speech last week, House GOP Leader John Boehner (R-OH) called for structural reforms in Congress, specifically the budget process. He suggested that Congress consider spending bills for agencies and departments separately, as opposed to the 12 appropriations bills Congress currently is responsible for. He also proposed a new “Cutgo” regime in which any new spending proposal would have to specify what in the budget would be cut to pay for it. The budget process definitely needs reforms that attract bipartisan support and deal with all parts of the budget. The Peterson-Pew Commission on Budget Reform will soon issue recommendations for reforming the process.

In testimony before the Senate Budget Committee last week, CBO Director Douglas Elmendorf quantified the impacts that extending some or all of the 2001 and 2003 tax cuts would have on the economy. CBO looked at both the near-term and in the long-term. The conclusion? CBO estimates that in 2011 and and 2012, any extension (full or partial, permanent or temporary) of the tax cuts would increase real growth (by varying degrees) in the short-term, but by 2020 and 2040, any extension would decrease national income (although by varying degress). The reason? Additional debt-- financing the tax cuts through borrowing will crowd out private investment.

To be exact, extending the tax cuts permanently could reduce GNP in 2020 by as much as 2% and anywhere from 2.5% to 11% by 2040.

CBO looked at four likely scenarios by which the tax cuts could potentially be extended (although others certainly exist). CBO looked at a permanent extension (permanently extend all the tax cuts for all households--keeping marginal tax rates where they are, indexing the AMT to inflation, and reinstating the estate tax in 2011 at 2009 levels), a permanent extension for all except those earning over $250,000 and for individuals earning more than $200,000, a full extension for only two years, and a partial extension for only two years.

As CBO puts it, the ultimate effect of these policies on growth will be the combination of lower tax revenues pushing deficits upward (thereby crowding out investment) on the negative end and the effect of lower tax rates increasing people's savings and work effort on the positive end. Unfortunately, the negative effects from higher deficits and debt are larger than the benefits, making these tax cuts--unless they are offset--a poor public policy choice.

Below is a table summarizing CBO findings on the economic impacts of these four scenarios. For each scenario in each year, CBO provides a "low estimate" and a "high estimate" to reflect a range of the resulting economic impact based on the responsiveness of labor supply to the different tax policies.

^{^ CBO estimates the economic impacts of these scenarios based on changes in Gross National Product (GNP) and not Gross Domestic Product, because GNP is equal to national income, and therefore the most relevant measure of the total economy. As CBO notes: GNP differs from GDP primarily by including the capital income that residents earn from investments abroad and excluding the capital income that nonresidents earn from domestic investment.}

^{* CBO provided separate estimates in 2020 and in the long-term for situations where government spending and tax adjustments are enacted after 2020 to put fiscal policy on a sustainable path. For demonstrative purposes, we chose the spending cut path.}  

The takeaway: any unpaid-for tax cut extensions are bad not only for the long-term fiscal outlook, but also the long-term economic outlook. The billions (and in some cases, trillions) of dollars of additional debt even in just the next decade will outweigh the supply-side benefits of lower marginal tax rates from these extensions. CBO argues that these tax cut scenarios would lead to a smaller domestically-owned stock of capital as a result of higher budget deficits and required interest payments.

Based on CBO's findings, plans to permanently extend the tax cuts for families earning under $250,000 (the partial extension) would have the biggest negative effect on the economy in the long-term, followed by the plan to permanently extend all the cuts. It should be noted, though, that this measure assumes that fiscal policy would be put back on a sustainable path through other measures (the table and graph above assumes spending cuts).  But winning the growth battle between the two options isn't something to boast about: both scenarios seriously harm the economy.

So now, arguments for extending the tax cuts based on economic reasons no longer have basis. And with high budgetary costs and a weaker economy by the end of the decade, tax cuts would certainly not improve our fiscal outlook. 

Another finding in the CBO report (not included in the table above) is that in the long-term, getting back to a sustainable fiscal path via spending cuts is less damaging to economic growth than large tax increases. While the spending cut path with permanent extensions is projected to reduce 2040 GNP by anywhere from 2 to 4 percent, the tax increase path with permanent extensions is projected to reduce 2040 GNP by 8 to 11 percent. These projections support the claims of Alberto Alesina, an economist at Harvard University, who said that fiscal consolidations based on spending cuts are more conducive to economic growth than those based more on tax increases (although he was talking more about the short- and medium-term). This is not to say, however, that we should solely rely on spending cuts--everything should be on the table.

So the message of the report is that the tax cuts are bad for both our fiscal and economic health by the end of this decade and beyond, and that a temporary extension, in one form or another, would be much less harmful than permanent extensions. As CRFB President Maya MacGuineas has stated before, a two-year temporary extension could be used as a hammer to force fiscal reform. CBO takes it further, showing that temporary options are far less bad for the economy in the long-term.  

But another central element is that if tax cut extensions are being called for on stimulus grounds, CBO shows that these arguments are weak. Other various policies for temporarily reducing taxes or increasing spending would provide bigger boosts to growth and employment in the short-term at lower bugetary cost--a truly win-win scenario. For example, compare a two-year full extension of the tax cuts to a hypothetical temporary payroll tax holiday split between employers and employees. Extending the tax cuts temporarily would cost about $500 billion and we'll consider a payroll tax holiday that would cost $250 billion. Using the mean of CBO's multipliers, we see that the two-year tax cut option would increase output in 2011 by $125 billion, while the payroll tax holiday would increase output by $175 billion. Furthermore, since we can assume that the negative effects of these options in 2020 is solely due to crowding-out effects (since neither policy would be in effect in 2020), the payroll tax holiday would only have half the negative effect of the temporary extension. Thus, a payroll tax holiday would be better in both the short-term and the long-term than a temporary tax cut extension, if policymakers were to enact any sort of stimulative tax relief.

Source: CBO The Economic Outlook and Fiscal Policy Choices

Even though the benefits of the tax cuts are more tangible right now than the negative effects of higher national debt later in the decade, policymakers and voters must still realize that the tax cuts will ultimately hurt the economy if not paid for. Let's hope they'll heed CBO's warning.