Bush's Budget Blues


My piece in Tuesday's Times has led to the usual wilful misreadings, accusations of siding with terrorists, etc.. Life is too short to address all the objections from my journalistic stalkers; let me go straight to the economics.

First, about the future of the budget. Right now we're running a deficit of about 1.5 percent of GDP; but since the economy is operating with a substantial output gap, maybe 4 percentage points, that's bigger than the "structural" deficit. Federal taxes are about 20 percent of GDP; the elasticity of tax revenues with respect to cyclical movements in GDP is substantially greater than 1, with 2 a good guess; so each point of output gap closed might reduce the deficit by around 0.4 percent of GDP. This suggests that a full cyclical recovery would lead to a roughly balanced budget, other things equal. (Although I seem to remember certain candidates promising to run a surplus of at least 1.5 percent of GDP, that is, not to dip into the Social Security surplus.)

But other things are not equal: the pieces of the tax cut that have not yet phased in - basically cuts for people in upper tax brackets and heirs to large estates - will eventually subtract close to 1 percent of GDP from revenue. And that's the core reason why we now face the prospect of deficits forever.

What about spending? Some people, bizarrely, think that I don't know that spending plays a role in the deficit. Well, duh. If you look at my book Fuzzy Math, p. 75, you'll see a table I took from Auerbach and Gale. It shows that if you replace the unrealistic assumption of zero growth in real discretionary spending with the more reasonable assumption of constant spending per capita, the projected 10-year surplus falls almost $500 billion. If you use the even more reasonable assumption that discretionary spending remains constant as a share of GDP, the projection falls more than $600 billion more. So going from zero real growth in discretionary spending to keeping such spending constant as a share of GDP - which is the implicit assumption in my back-of-the-envelope calculation above - subtracts more than $1.1 trillion from the budget projection. That's still well short of the $1.7 trillion in direct and indirect costs from the Bush tax cut (close to $2 trillion if you ignore the nonsense about expiring tax cuts in 2011), but it's substantial.

But what I said was that runaway spending is not the reason we're stuck in deficit. Is having discretionary spending grow, maybe even grow with GDP, "runaway"?

It's true that CBO is required, by rules imposed by a Republican Congress in the 1990s, to assume that absent changes in policy discretionary spending will remain unchanged in real terms. But this is nonsense, for reasons that have been obvious to lots of good people - CBPP, Auerbach and Gale, and yours truly - since the whole tax-cut debate began. A growing population and a growing economy place increasing demands on government services. Trying to keep real spending constant in the face of growth doesn't feel like no change in policy: it feels like painful austerity. Just look at what's happening: this administration has hardly begun to cut, yet it's already trying to avoid giving veterans health care and firefighters new radios.

And it's worth looking at the magnitudes. Defense spending is presumably off limits. Civilian discretionary spending is only a bit more than 3 percent of GDP. So to make room, not even for the whole Bush tax cut, but for the part that hasn't happened yet, you would have to slash that share by about 30 percent. We're talking savage austerity here. Indeed, CBPP's latest analysis shows that the administration's new budget calls for a 4.6 percent real cut in non-security discretionary spending just over the next year.

Maybe you favor that. Smaller government is a great catchphrase, until you actually start cutting things like mine safety and nutritional aid for poor children. Apparently some people even think that, as Martha Stewart would say, it's a good thing to trick veterans into not getting health care. But the most important point is that Bush did not run on a platform of severe austerity; his tax cut was sold on the pretense that there was plenty of money for everything. Remember the routine with the four dollar bills?

Now his administration is in a nasty pickle. It has no realistic prospect of returning to surpluses, ever. If it doesn't want to see most of the budget gains from economic recovery wiped out by growing tax cuts, it will have to keep hacking away at the budget, producing many scenes like the ones we saw last week.

Do I have to point out that this is exactly the outcome critics of the tax cut were predicting, more than a year ago? True, the budget picture is even worse than we expected. None of us foresaw Sept. 11, though we did notice that the administration's talk of re-arming America didn't seem to be matched by its military spending plans. None of us realized how much a bear market would cut into revenue, though I did warn, in Fuzzy Math, that the end of the bull market could reduce the 10-year surplus by as much as a trillion dollars. Still, it was obvious to those willing to see it that the Bush administration's claim that we could easily afford a large, long-term tax cut, remaining "compassionate" while using the whole Social Security surplus to pay down debt, was nonsense. And so it has turned out.

Originally published on the Official Paul Krugman Site, 8.21.02