Shredding the Deficit

 

Takeaway

  • The bipartisan supercommittee must craft a plan by Thanksgiving to trim at least $1.2 trillion from the deficit.
  • If they don't, then $1.2 trillion will automatically be slashed, spread evenly across defense and non-defense programs.

It’s a bird…It’s a plane…It’s a supercommittee!

In the latest episode in America’s deficit saga, a 12-member Congressional panel, nicknamed the “super committee,” is trying to slow down a runaway train: the national debt. It’s crafting a plan to trim at least $1.2 trillion, on a deadline that’s approaching faster than a speeding bullet. The plan is due before Thanksgiving.

It’s a job that might require superpowers, say faculty at the McCombs School of Business: a superhuman grasp of economics combined with superhuman political skills. The committee has to tighten Uncle Sam’s belt without squeezing him into another recession, and do it in an atmosphere where compromise is treated like kryptonite.

“Many of our problems are solvable,” says accounting professor Michael Granof. “But we certainly can’t do it with a dysfunctional political system. At this point, there’s no evidence that the economic needs of the country will trump the political realities.

Politics aside, Granof and other McCombs professors offer some economists’-eye views on the challenges the super-panel faces, along with some nonpartisan advice on what to include in the plan.

Several of the committee’s challenges stem from the August law that created it. The Budget Control Act of 2011 mandates $900 million in spending cuts over the next ten years. If the committee can’t agree on $1.2 trillion more — or if Congress rejects its plan — then $1.2 trillion will automatically be slashed, spread evenly across defense and nondefense programs.

At first glance, the new law might sound like progress. Says finance professor Lewis Spellman, “It’s a token recognition of the problem. But at least it’s a recognition that there’s a problem.”

Look closer, though, and the bucket of red ink will still be more than half-full. Even with $2.1 trillion in budget cuts, the national debt will balloon by at least $3.5 trillion over the next decade, projects the Congressional Budget Office.

“That doesn’t solve the debt problem,” says Jim Nolen, senior lecturer in finance. “That just means the debt is not growing as fast.  And what happens to our deficit if interest rates start to rise on our increasing federal debt?”

Another challenge is that the Budget Control Act kicks the biggest cuts down the road. It carves only $21 billion in 2012, out of total spending of $3.6 trillion. The reductions get deeper over time, reaching $266 billion in 2021. But, as Nolen observes, “Most cuts occur in the outlying years, and future Congresses can override the cuts.”

Suggestions for the Supercommittee

How can the supercommittee fashion a more effective plan? The three professors suggest several principles to Congressional debt-busters, though they don’t always agree on those principles:

Promote growth. The prime villain behind the exploding deficit is the Great Recession, says Granof. “The deficit we’re facing today is not because of increased expenditures, but reduction of revenues.”  

Nolen disagrees, noting that while revenues did decline $600 billion from 2007 to 2010, federal spending grew from $2.9 trillion to $3.6 trillion — not counting the bailouts. 

Uncle Sam needs to cut spending in some areas, says Granof. But he should invest in others to fuel the economy. He should offer tax credits to small businesses that hire workers and to firms doing basic research, in areas like health care.

Spellman adds that regulators should snip red tape: make it easier for businesses to hire and fire workers, and to close and open plants where they make economic sense.

“Every tax and spending bill should be appraised for its effect on the growth of the GDP,” says Spellman. “Our only hope is to grow our way out faster than we accumulate debt.”

Cut today, not tomorrow. If you want financial markets to take you seriously, says Nolen, make serious cuts in the first year. “We need real cuts now that show we’re making a conscious effort. It means making $500 billion to $1 trillion worth of cuts right now, not 10 years from now.”

To get savings of that size, he advocates changes to entitlement programs,  including Social Security, Medicare, and Medicaid.  Because he believes the federal government is “a horrible allocator of resources,” Nolen would also close federal agencies like the Department of Education, and return those funds to the states.  “We don’t need administrators, we need teachers,” he says.

Not everyone wants to cut so far, so fast. Spellman notes that the federal deficit equals 10 percent of America’s Gross Domestic Product (GDP). If the government went cold turkey and borrowed nothing next year, the GDP would drop 10 percent, he says — compared to a drop of 4 percent during the 2008 recession. 

Granof warns, “You can’t go cutting spending to that magnitude without having an impact on the short run. Why should anyone be surprised the unemployment rate is going up when governments are laying off thousands of employees?”

Transform the tax code. Many economists agree the federal budget can’t be balanced by spending cuts alone. Tax increases should be part of the equation. Where they don’t agree is on what taxes and who should pay them.

A good start, suggests Granof, is to close loopholes that benefit high-income taxpayers and large corporations, like hedge fund managers and oil companies. “That’s not going to bring in very much money,” he admits. “Ultimately, to reduce the deficit, we’re going to have to raise tax rates on the middle class. But we can’t do that until we raise taxes on the wealthy.”

The problem, says Spellman, is that wealthy taxpayers can take their money and run. “If you balance the budget by raising taxes, you give them incentives not to invest and to flee the country with their capital.” He prefers a tax system that takes equal bites out of all income groups, like a flat tax or a value-added tax, similar to a national sales tax.

Nolen wants to see deep budget cuts before putting taxes on the table. “You have to get your fiscal house in order,” he says. “Then, you can have revenue increases and use the excess revenue to start paying down debt. But you don’t see anybody saying, ‘Tax me more so you can spend more.’ With trillion-dollar deficits, I don’t think we can afford new parks and statues. Right now, we need to prioritize expenditures.”

Restructure social insurance. The $14 trillion national debt sounds like a lot of money — until you look at what’s ahead for Medicare and Social Security. As baby boomers retire, the two programs will fall $43 trillion in debt over the next 75 years, projects the 2010 Financial Report of the United States Government.        

To make those programs solvent, says Granof, start with low-hanging fruit. Bring in more money by lifting the limit on how much of a taxpayer’s income is taxed. Right now, the cap is $106,000. At the same time, cut expenses by gradually raising the retirement age. Many economists also favor means testing, which would pay smaller benefits to rich retirees.

Medicare will be the toughest budget to balance, adds Granof. “In the long term, you’re not going to be able to reduce it in a meaningful way until you reform health care in general. It probably means reducing administrative costs, and it probably means changing the pay-for-services model we have.”

Share the pain.  If the super committee hopes to break through Washington’s gridlock, says Spellman, it will have to face a political reality. No interest group will agree to higher taxes, fewer services or stingier benefits unless it sees other groups making sacrifices.

“In Europe, in countries like Spain, both right and left have bought into a universal sharing of the burden,” he says. ”The only hope of reaching a political agreement will come from a mutual sharing of the burden.”

What if gridlock wins out? What if the supercommittee proves to be only human, and Congress ends up doing nothing?

From one perspective, that outcome might not be so bad. If current laws don’t change, predicts the CBO, the deficit will drop, from 8.5 percent of GDP this year to only 1.6 percent of GDP in 2014. That’s because Bush-era tax cuts are due to expire that year. If Congress acts to extend them, along with a few other tax breaks, it could add $5.5 trillion back to the national debt.

The problem, says Nolen, is that businesses can’t afford to wait until 2014 to see how this story ends. Uncertainty about taxes, regulations and health care costs is already killing investment, and trying to stimulate it through low interest rates or government subsidies won’t work until the debt starts shrinking. “We’ve got to have a real plan to balance the budget down the road,” he says. “Once the world sees we’re making moves to get our fiscal house in order, then businesses will have more clarity. They’ll start spending and start hiring.”

If you want to see the dangers of inaction, just look across the Atlantic, says Spellman. Greece, Spain, and Italy are all in danger of defaulting on their national debts. If any of them do, they could take down the banks and pension funds that hold much of their debts. “Europe,” he says, “is a demonstration project for how bad things can get if you don’t act while you still have time.”

 

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Faculty in this Article

Jim Nolen

Distinguished Senior Lecturer (retired), Department of Finance McCombs School of Business, The University of Texas at Austin

Jim Nolen received his BBA and MBA from The University of Texas at Austin. Until his retirement in May 2012, he taught both undergraduate and...

Jim Nolen teaches in the Texas Executive Education program, featuring open enrollment, custom and certificate classes for executives and organization teams.

Lew Spellman

Professor, Department of Finance McCombs School of Business, The University of Texas at Austin

Lewis Spellman received his BBA and MBA from the University of Michigan and his MA and Ph.D. from Stanford University. His research interests include...

Michael Granof

Professor of Accounting McCombs School of Business

Michael Granof received an A.B from Hamilton College, an MBA from Columbia University, and a Ph.D. from the University of Michigan. His research...

About The Author

Steve Brooks

In a quarter-century as a journalist, Steve Brooks has won two Neal awards for excellence in trade reporting and a Press Club of New Orleans award...

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