US Fiscal Policy: Not Credible Under the Ryan Plan

The Fiscal Choice Facing America

The rapidly approaching US Presidential election seemingly presents America with a stark choice about the conduct of fiscal policy. In the short-term, however, the Obama Administration and Congress need to reach a compromise about how best to avoid the “fiscal cliff” scenario, where fiscal policy could be tightened by as much as 4% of GDP in 2013. The most likely outcome seems, at present, to be a deferral of the expiration date of the Bush tax cuts and lower payroll taxes, but some fiscal tightening will still happen in 2013.

The choice of Paul Ryan by Mitt Romney to be his running mate has stirred much debate about the long-term direction of government intervention in the US economy. Congressman Ryan is Chairman of the House Budget Committee and has a reputation of being a fiscal conservative. In 2011, Congressman Ryan was famous for outlining long-term budget plans aimed at aggressively reducing the share of government spending relative to GDP. The credibility of his long-term budget proposals will be critically appraised in this piece.

Fiscal Policy Will Be Tightened Regardless of November’s Election Outcome

It is important to note that some fiscal tightening is inevitable moving forward, regardless of the outcome of November’s election. President Obama’s long-term budget proposals, revealed in February, although less draconian than the Ryan plan, envisage government spending shrinking as a percentage of GDP until 2018.  Spending will be equivalent to 22.3% of GDP in 2016. The Congressional Budget Office (CBO) estimates that federal government spending will be 23.4% of GDP in 2012. Meanwhile, Congressman Ryan’s plan calls for spending to be cut to 19.7% and 19.5% of GDP by 2016 and 2020, respectively.

Interestingly, President Obama’s long-term budget plans aims at capping discretionary spending at 5.9% of GDP by 2016. This would be identical to the figure targeted by Congressman Ryan. According to the CBO, discretionary spending will be equivalent to 8.4% of GDP in 2012. The idea that both parties are offering starkly different budget choices in the realms of discretionary spending seems somewhat over-hyped.

Fiscal Policy Management: Budget Surpluses Were Squandered

It is essential to appreciate that the clamour for fiscal rectitude is a reaction to the inept policy conduct under the George W Bush Administrations.

The origins to the current fiscal crisis go back to the 2000 Presidential election. The US was running a healthy budget surplus in 2000 (2.4% of GDP). At the time, the Congressional Budget Office (CBO) was forecasting budget surpluses for the next 10 years. George W Bush campaigned on the premise that budget surpluses were bad, because they would eventually be squandered by Congress. President Bush inherited a budget surplus of $236bn from President Clinton in 2000. At the end of President Bush’s first term in 2004, the US was running a budget deficit of -$413bn. Deficits were the order of the day in the second Bush Administration. The tax cuts enacted in 2001 and 2003 were significant contributors to the deficits, along with the rise in defence spending associated with wars in Iraq and Afghanistan.

When President Obama took office in 2009, the Great Recession was in its final stages. At the time, the CBO was forecasting a deficit of -$1.3 trillion without the proposed economic stimulus of $787bn. The Obama stimulus was opposed by every Republican in Congress and helps to explain its inadequate size. The CBO is currently forecasting a 2012 budget deficit of -$1.2 trillion. Assuming expiration of the Bush-era tax cuts, the deficit would fall to -$612bn in 2013, equivalent to a 4% of GDP tightening of fiscal policy. The magnitude of the tightening would be unprecedented. Fed Chairman Bernanke believes the tightening would tip the US economy into a mild recession in 2013. This scenario has clearly not been embedded in corporate profit expectations for 2013.

Timeline of Future Events Based on Current Legislation

On the revenue side of the equation, the expiration of the Bush tax cuts and reduced payroll taxes is scheduled for 31 December unless there is a change in law. With respect to spending, there will be discretionary spending caps imposed by a sequester on 1 January 2013 under the auspices of the Budget Control Act (2011). Defence spending would bear a 50% burden of the spending caps. It will require another change in law to alter the sequester process and structure of the spending caps.

The Ryan Budget Proposals

The proposals put forward by Congressman Ryan have all of the rhetorical hallmarks of being ultra-conservative. They have been hailed as being far-reaching in terms of reducing the role of government. The proposals look less convincing under the microscope.

The Republicans are ideologically against the idea of defence having to endure half of the squeeze in discretionary spending. Congressman Ryan will push for a dilution of the defence cuts. Other parts of the discretionary spending budget will therefore have to face the sequester’s cuts. Total discretionary spending comprises 36% of total spending. If defence cutbacks are deemed off-limits, it leaves just $400bn of domestic discretionary spending available for pruning, accounting for just 11% of total outlays.

Mandatory spending, such as social security and Medicare, would not be touched in the next ten years. Meanwhile, under the Ryan proposals, Medicaid costs would increasingly become the responsibility of state governments. There is no way that states could undertake these extra spending obligations without some financial assistance from federal government.

The Ryan budget plan will also cut the top marginal rate of income tax to 25% from 35%. The revenue shortfall will be supposedly made up by an unspecified broadening of the tax base. It is widely believed that tax relief on mortgage interest, 401K contributions and charitable donations will be abolished. Estimates of the revenue shortfall and how it will be recouped have not been published. There will be rising pressure on the Romney-Ryan team to produce credible revenue loss/gain estimates of their proposals. In its embryonic form, the Ryan budget plan clearly lacks credibility, particularly with respect to revenue forecasts. The Ryan plan envisages revenues at 18.4% of GDP by 2016. The compares to a CBO estimate of 15.8% for the current fiscal year.

While the Ryan budget proposals have been hailed as ushering in a new era of smaller government, the voting record of Congressman Ryan on economic issues paints a very different picture. Congressman Ryan voted in favour of the Troubled Asset Relief Programme (TARP) and the government bailout of General Motors.

Not Dealing with the Fiscal Legacy of George W Bush

The lack of credible details in the Ryan plan reflects the unwillingness of the Romney-Ryan team to address the fiscal legacy left by the Bush Administrations. Under the Clinton Administration, any tax cut or spending increase had to be fully offset by spending cuts or tax increases, thereby imparting a neutral impact on the budget. This mechanism became known as Paygo, for pay as you go. In 2002, Paygo was abolished by the Republicans. Federal government spending subsequently rose from 18.2% of GDP in 2001 to 20.7% in 2008. Part of the increase incorporates the 2003 inception by the Republicans of Medicare Part D, a new entitlement programme. Democrats will also need to accept some responsibility for the unsatisfactory spending outcome: TARP would never have been needed if the Clinton Administration had not repealed the Glass-Steagall Act in 1999.

Tough Choices Will Not Be Addressed by the Next Administration

The biggest budget busters are demographically-linked to social security and Medicare. The need to engage in tough reform for these programmes will only increase with the passage of time, but the victor in November’s election will not institute those reforms. These need to include an income-based eligibility test in order to reduce to the number of beneficiaries under these programmes. This will considerably ease the upward pressure on outlays.

Significant changes to how spending programmes are funded also need to be instituted. This will require the introduction of a government sales or so-called value-added tax. A federal government sales tax would significantly broaden the tax base. There is an important lesson that the US can learn from Japan: the failure to boost consumption tax in Japan has been detrimental to the government’s financial position. Refusal to invoke a sales tax hike also contributed to the fragmentation of the Liberal Democrat Party and even greater policy paralysis in Japan.

Political Change Required for Budget Progress

The lack of political choice available in the US means that undertaking tough budget decisions is virtually impossible, particularly given that bi-partisanship is now firmly dead and buried. The other reason for the lack of willingness to take tough decisions is the way the US political system is funded: campaign contributors have strong vested interests that they wish to protect. The lobbyists are a powerful force, but they have helped to produce the political gridlock that everyone seemingly despises.

It will require the arrival of a new Third Party to beak the status quo, but the barriers to entry are high due to the need to undertake expensive television advertising. Furthermore, both the Democrats and Republicans wish to maintain the status quo by maintaining a minimum 15% opinion poll rating requirement before a Third Party candidate is allowed to participate in televised Presidential debates. The chances of a Third Party emerging are, therefore, slim for the moment, as are the chances of tough budget choices being made.

Summary and Conclusions

The outcome of the upcoming Presidential election could significantly re-define the level of government intervention in the US economy. The credibility of the Ryan budget plans are now under examination. Some form of fiscal tightening is likely in the next 4 years, regardless of the outcome of the election.

The rush to trim the size of the budget deficit is a reaction to the large deficits consistently run under the Bush Administrations. Surpluses were squandered. A potential fiscal policy tightening of 4% of GDP in 2013, which is unprecedented, could produce a mild recession.

The Ryan budget plans involves some ambition caps on government spending. There is also a cut in the top marginal rate of income tax from 35% to 25%. There are no specific details as to how the revenue shortfalls will be financed. Aggressive defence spending cuts appear to be off-limits under the Ryan plans. Medicare and social security cuts are untouched for the next 10 years.

Tough choices need to be made by the US government to deal with the long-term budget busters. Financing mechanisms need to be reviewed, including the potential introduction of a federal sales tax. The winner of the next Presidential election will not make those choices. There needs to be a Third Party to break the status quo, particularly the influence of the lobbyists. The chances of a Third Party emerging remain slim, partly due to difficult hurdles put in place by the established political parties.

About Said Desaque

I'm a professional economist in financial services, with a keen interest in international relations, along with their implications for economic development.

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