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How the Republicans Can Get Debt under Control

Ryan Bourne

Until I came to work in the US, I had little understanding of
the federal government’s long-term fiscal challenge.

The UK’s long-term debt outlook was only too familiar, and
pretty frightening — mainly because it concerned an ageing
population interacting with pay-as-you-go state pension and
healthcare systems. But there was, at least in the near-term, a
consensus of sorts for fiscal restraint and reducing the
debt-to-GDP ratio.

Not so in America. Sustained budget deficits under George W
Bush, followed by the financial crisis and subsequent Obama
stimulus, had seen debt held by the public explode from 32.6 per
cent of GDP in 2002 to 77 per cent in 2016 — a level only
previously touched following World War II.

While that debt spike fell quickly due to military spending cuts
and high growth, projections now show that debt-to-GDP levels will
rise rapidly in the coming decades. The Congressional Budget Office
(CBO) projects the deficit will widen to 5.2 per cent of GDP even
by 2027, ballooning public debt further to 91.2 per cent of
GDP.

In the two decades following that, debt is expected to climb
even further to 150 per cent of GDP on unchanged policies, driven
both by surging Social Security and Medicare spending and debt
interest payments. This ignores any deficit-widening effects of the
recent tax cuts.

The trick is to find the
sweet spot between rules being strict and transparent enough to
have real consequences, and being flexible enough to ride out
recessions and unforeseen circumstances.

Most people realise status quo policies are unsustainable. But
so far, Congress has been reluctant to act. Hooked on borrowing,
it’s far easier to sustain programs knowing the costs are
spread across future generations. Entitlements, the key driver of
debt, seem untouchable, in part because the American public
consider these to be “earned rights”. Meanwhile, the
ideological divide between Democrats and Republicans on the size
and scope of the state has paralysed previous attempts to strike a
grand bargain to ease the debt path.

Yet delaying action only worsens the long-term outlook. Getting
the debt-to-GDP ratio back to a historic norm of 40 per cent by
2047 will require permanent spending cuts equivalent to 3.1 per
cent of GDP (15 per cent of federal spending, excluding debt
interest). Putting off such restraint until 2028 would require
annual cuts of 4.6 per cent of GDP thenceforth to achieve the same
goal.

It is welcome, then, that House speaker Paul Ryan tasked a
Congressional Republican working group late last year with
proposing budget reform to constrain federal debt. The so-called
“debt ceiling” has clearly been a failure, with
significant economic costs, and many Republicans yearn for an
alternative.

As we know, politicians can be prone to “deficit
bias”, which is why over the last three decades as many as 96
countries have made use of long-lasting constraints on spending,
tax revenues, deficits or debt called “fiscal
rules”.

Clearly, some have been more successful than others. Given the
utter failure of the Maastricht rules in the eurozone, and the
UK’s ever-changing fiscal targets, fiscal rules are neither
necessary nor sufficient for containing debt. Yet well-designed
strictures can help improve the functioning of fiscal policy,
binding politicians to good outcomes.

The trick is to find the sweet spot between rules being strict
and transparent enough to have real consequences, and being
flexible enough to ride out recessions and unforeseen
circumstances.

I have reviewed the extensive literature on fiscal rules for a
forthcoming paper, including those in US states and the federal
government, Switzerland, Chile and the UK. Here are the 10 key
lessons I learned from my research, which the GOP should keep in
mind:

1 Political will is needed to achieve fiscal discipline
and sustain rules, particularly without constitutional
backing.

Governments around the world, including the UK of late, and the
US in the 1980s, tend to abandon or circumvent rules when they get
tough

2 Rules must have provisions to deal with recessions or
worse-than-expected growth.

Inflexible rules, such as strict deficit targets or hard annual
balanced budget rules tend not to endure when shocks hit. With
fiscal rules, “tougher” is not always better, and
certainly not more durable.

3 Fiscal rules should primarily cap spending, since that
is the variable that politicians directly control.

Tax revenues are, to a large extent, determined by the health of
the economy, the prospects for which can be uncertain. Deficits,
likewise, are merely a byproduct of spending and tax revenues.

4 A falling debt-to-GDP can be obtained
through balancing spending and revenues over the economic
cycle.

This can be roughly achieved by setting caps for spending to
trends in tax revenues or to an estimate of revenues if the economy
were at full potential. Both allow automatic stabilisers to operate
and borrowing to adjust to the state of the economy, but ensure
falling debt-to-GDP in the medium-term.

5 Spending caps should include all spending to minimise
creative accounting.

There is lots of evidence that otherwise politicians redefine
spending, e.g. by calling consumption spending
“investment”.

6 Long-term entitlement spending requires a secondary
rule.

Structural balanced budget rules do not restrict politicians
today from making entitlements more generous for future
generations. Restrictions preventing new entitlement promises are
therefore desirable to ensure long-term sustainability.

7 Formulaic rules, which use trends to estimate
revenues, are simpler, more transparent and less prone to
over-optimism
.

The alternative, predicting potential revenues, requires
estimating a host of unknowns, including the potential of the
economy, and how revenues respond to moving towards potential.

8 The rule should correct for missed
targets.

Deviations in spending outcomes from caps should not be ignored.
As with the Swiss “debt brake”, deviations should be
used to adjust future spending caps to ensure the overall budget
really does balance over the cycle.

9 There should be a clear but limited escape clause for
genuine emergency situations and wards.

This should require a high-threshold vote, with a
well-acknowledged pathway back to achieving balance.

10 The best way to obtain credibility for a fiscal rule
is to get to the stage where it binds.

Pushing targets for achieving balance further into the future is
especially dangerous given the risk of a changed political
consensus and new economic downturns. You need to make the rule the
norm quickly.

The Republicans have a chance to implement a spending-cap fiscal
rule in the coming years. They should heed these lessons and seek
to get the debt-to-GDP ratio back on a downward path in
anticipation of the fiscal headwinds to come. But this will require
political will, and a sophisticated approach that is durable to
changing economic trends.

Ryan Bourne
holds the R. Evan Scharf Chair for the Public Understanding of
Economics at the Cato Institute