The Economic Benefits of Deficit Reduction

On the same day they released their February Baseline projection, the Congressional Budget Office (CBO) released a companion report on Macroeconomic Effects of Alternative Budgetary Paths. The report estimates the effects on the economy of different fiscal paths. Importantly, it speaks to the potential economic benefit of deficit reduction, in contrary to those who claim that doing deficit reduction now, regardless of its composition and timing, is damaging. It also provides an important illustration of the reverse economic effects of fiscal policies that increase deficits beyond current law.

The report analyzes three alternative paths: (1) a $2 trillion deficit increase, (2) $2 trillion of deficit reduction, and (3) $4 trillion of deficit reduction. Its analysis does not make assumptions about the types of spending and revenue policy changes that lead to the level of primary deficit spending growth or reduction. Therefore, the only effects they are examining are the effects of deficit reduction itself.

The conclusions are not surprising, but highly informative about the benefits of deficit reduction and the importance of its timing:

• Paths 2 and 3 lead to slightly lower output between 2014 and 2016 than Path 1,
• Following paths 2 and 3 would lower deficits and lead to higher output by 2018 than Path
• With a $2 trillion deficit reduction/increase, output would be 0.9 percent higher/lower (respectively) by 2023. 
• On the other hand, the $4 trillion deficit reduction plan would increase output by 1.7 percent. The effects are much greater in 2023 than they are in 2014, and the 2014 effects could be muted more with greater back-loading.

Higher growth from deficit reduction is a result of less crowding out of private investment. That factor becomes more significant after the economy reaches its potential, which is projected to happen in 2017. The effects on growth would most likely get much larger beyond 2023.

^{Source: CBO}

These macroeconomic effects also feed back into budget deficits, taking into consideration that lowering the deficit would push interest rates lower, while raising output would bring more revenue into the government and reduce spending on means-tested programs. The economic effects increase deficits by an additional $150 billion over ten years for Path 1, reduce deficits by an additional $100 billion in Path 2, and reduce deficits by an additional $185 billion in Path 3.

^Source: CBO

The CBO's report illustrates the importance of not waiting to enact a package of comprehensive deficit reduction in order to secure our fiscal future. The economic benefit of deficit reduction when the economy has recovered is large, and conversely, the cost of waiting too long may be large as well. The report also shows, to a lesser extent, the importance of making those changes gradually so as to minimize the short-term harm. The CBO sums up the lessons from the paper quite well, saying:

The longer that significant deficit reduction is deferred, the larger the government’s accumulated debt will be (with its associated costs and risks), and the greater the policy changes will need to be when deficit reduction begins. Conversely, the sooner that the deficit is cut, the more the economic effects will be felt when the economy is still relatively weak, and the less time that households, businesses, and state and local governments will have to plan and adjust their behavior.