Policy, U.S.

Fiscal Follies, or Fundamental Reform?

April 19th, 2011 | By Nick Sargen


After a prolonged period in which budgetary restraint was all but forgotten in Washington D.C., it is shaping up to be a central issue in the run-up to the 2012 elections. Paul Ryan, Republican Chairman of the House Budget Committee, recently put forth a plan to reduce the projected federal deficit proposed by the Obama Administration by $6.2 trillion over the next 10 years. This elicited a response by President Obama, who announced the broad outlines of a plan to cut the cumulative deficit by $4 trillion as of 2022.

According to Richard Stevenson of the New York Times (April 17), the current budget debate is about far more than the usual bickering over accounting and arcane policy issues: “ What is under way now is the most fundamental reassessment of the size and role of government – of the balance between personal responsibility and private markets on one hand and public responsibility and social welfare on the other – at least since Ronald Reagan and perhaps since F.D.R.”

It remains to be seen whether Republicans and Democrats will be able to reach a meaningful compromise. After having read synopses of the two plans, my initial reaction was that the differences are too great, because the Republicans rule out any tax increases while the Obama Administration is reluctant to overhaul Medicare and Medicaid. However, I now regard the two proposals as opening salvos in what is likely to be a long, contentious debate.

While it is too early to tell what the final outcome will be, I am encouraged that the debate is finally beginning and key issues such as tax and entitlement reform are now being discussed. The time-table before a decision is reached is likely to be the next two years, and the 2012 election could well be the final arbiter. Thereafter, if the United States Government is unable to take decisive action, Standard & Poor’s has indicated that it is prepared to lower its AAA-bond rating for U.S. government securities.

Comparison of the Ryan and Obama Plans

The proposal put forth by Congressman Ryan represents a radical departure from previous attempts to rein in the federal budget deficit and the size of government. Among the main elements of the Ryan Plan are the following:

  • Medicare. The proposal would convert the current program to a system under which beneficiaries will receive program support payments that are used to pay premiums for a private health insurance policy. The change would apply to people turning 65 beginning in 2022 (those who turn 65 before then would remain in the traditional program.)
  • Medicaid. The proposal would convert the matching payments the federal government makes to states into block grants of fixed dollars beginning in 2013.
  • 2010 healthcare legislation. The proposal would repeal key provisions that deal with insurance coverage. Mandatory spending for healthcare would be about 6% of GDP in 2030.
  • Social Security. The program would not be altered.
  • Discretionary spending. The proposal specifies a path for discretionary spending to decline as a share of GDP from 12% in 2010 to 6% in2022 and 3.5% by 2050.

Congressman Ryan’s proposal also specifies a path for revenues relative to GDP to rise from 15% in 2010 to reach 18%-19% by 2022. The resulting budget deficits would be around 2% of GDP in the 2020s and the estimated debt saving over the life of the plan is $6 trillion.

As a response to Congressman Ryan’s plan, President Obama provided the broad outlines of a plan to reduce the federal deficit by $4 trillion over the next 12 years. Of this total, one half of the deficit reduction is slated to come from tax increases on the wealthy and interest savings from deficit reduction. By comparison, just over 10% of the total is slated to come from Medicare and Medicaid cuts, mainly in the form of price controls and rationing, while another 9% would come from other entitlement cuts. The remainder would come from defense cutbacks (10%) and non-defense cuts (20%).

As a guiding principle, President Obama has indicated he favors $3 in spending cuts (including interest savings) for every $1 in tax increases. One of the most noteworthy aspects of his speech was the trigger for spending cuts and tax increases if specified targets are not reached. His trigger would exempt from cuts Social Security, Medicare and Medicaid – which collectively account for most of the budget. According to the ISI Group, this will be a non-starter with Republicans, as will any consequential tax increase if not paired with major entitlement reforms.

Can the Gap Be Bridged?

With the two sides very far apart, it is unclear that they will be able to reach a meaningful compromise. Toward that goal, President Obama has called for bipartisan negotiations beginning next month with the aim of reaching a framework for deficit reduction by June. They are intended to coincide with discussions about extending the ceiling on federal debt. With both the Administration and Congressional Republicans favoring a multi-year cap on discretionary spending (defense and non-defense), a mechanism to enforce those caps could be part of the legislation to raise the debt ceiling.

The more difficult balancing act, however, applies to the three main entitlement programs – Social Security, Medicare and Medicaid. They currently account for 40% of the budget and are also the main drivers of the deterioration in the budget imbalance over the long run. My guess is that they will become an important part of the 2012 election campaign, and voters in the end will decide which plan they favor.

The bottom line is that we will probably have to wait two years to find out what budget reform will look like. If meaningful steps are not taken at that time, the consequences could be a loss of investor confidence in the U.S. Government.