With the expiration of the current tax rates approaching at the end of the year, and a deep round of spending cuts looming, a new report sheds light on what effect that would have on the economy and the nation’s debt levels.
The Congressional Budget Office released a report Tuesday contrasting what would happen under current law, which assumes the Bush tax cuts will expire in December and the alternative minimum tax isn’t adjusted as usual, and current policy, which assumes those tax rates will be extended.
The CBO report found that if the tax cuts were to expire, and the AMT isn’t patched to keep it from affecting more taxpayers, the federal debt would gradually decline over the next 25 years—from an estimated 73 percent of gross domestic product this year to 61 percent by 2022 and 53 percent by 2037. Tax revenues would reach 24 percent of GDP by 2037, which is much higher than is typically the case, and would grow to ever larger percentages afterward.
Under this scenario, the CBO noted, government spending on every other government program aside from the major health care programs, Social Security, and interest—activities such as national defense and a wide variety of domestic programs—would decline to the lowest percentage of GDP since before World War II. “That significant increase in revenues and decrease in the relative magnitude of other spending would more than offset the rise in spending on health care programs and Social Security,” said the report.
However, there is growing pressure in Washington to extend the tax cuts at least temporarily, though it is far from clear that Democrats and Republicans will be able to agree on a deal before the November election. Republicans want to extend them for all income levels, but the Obama administration insists they should not be extended for those earning over $250,000 a year.
Still, after the latest monthly jobs report last Friday from the Bureau of Labor Statistics showed jobs growing at their slowest pace in a year, with only 69,000 added in May, there are worries about an increase in tax rates taking the economy over the so-called “fiscal cliff” and leading to a recession. Former President Bill Clinton told CNBC on Tuesday that the economy may already be in a recession, and he recommended that all the tax cuts be temporarily extended until early next year.
“What I think we need to do is to find some way to avoid the fiscal cliff, to avoid doing anything that would contract the economy now, and then deal with what's necessary in the long-term debt reduction plan as soon as they can, which presumably will be after the election,” he said. (He later retracted those comments.)
While an extension of the tax cuts may help the economy in the short term, the longer the nation puts off dealing with tax reform and budget deficits, the worse things will get, according to the CBO report. Assuming that most of the current tax cuts do get extended and the AMT is once again patched to keep it from spreading to millions of middle-class taxpayers, the CBO presents a much bleaker scenario for the long-term fiscal health of the country.
“Federal debt would grow rapidly from its already high level, exceeding 90 percent of GDP in 2022,” said the CBO. “After that, the growing imbalance between revenues and spending, combined with spiraling interest payments, would swiftly push debt to higher and higher levels. Debt as a share of GDP would exceed its historical peak of 109 percent by 2026, and it would approach 200 percent in 2037.”
The aging of the Baby Boom population will cause a greater percentage of the population to depend on programs like Social Security and Medicare. Meanwhile, this alternative scenario also assumes that the annual “doc fix” that prevents Medicare reimbursement rates to physicians from plunging would once again be enacted. The alternative scenario also assumes that the automatic reductions in spending required by last year’s Budget Control Act, which Congress passed as part of the deal to raise the debt ceiling, don’t get implemented for anything other than discretionary spending.
Assuming then that there are larger budget deficits and a growing level of national debt reducing national savings, the CBO predicts that would lead to higher interest rates, more borrowing from abroad and less domestic investment, in turn lowering the growth of incomes here at home and reducing gross national product.
Rising levels of national debt would also have other negative consequences, the CBO noted, including higher interest payments on that debt. That would eventually require higher taxes, a reduction in government benefits and services, or some combination of the two. Higher interest payments on the debt would also limit the ability of policymakers to respond to sudden challenges such as future economic downturns or another financial crisis. Indeed, higher interest rates on the national debt could even increase the probability of a sudden fiscal crisis, as the government would lose its ability to borrow at affordable rates, the CBO noted.
The report urges policymakers to act soon to avoid these crushing levels of national debt, but acknowledges there are stark trade-offs no matter what they do.
If they cut spending or increase taxes too slowly, that would lead to a larger accumulation of government debt and raise more doubts about whether longer-term deficit reduction would ultimately take effect. On the other hand, if the federal government abruptly implements spending cuts or tax increases, then families, businesses, and state and local governments would have little time to plan and adjust. That in turn would require greater sacrifices sooner from current older workers and retirees for the benefit of younger workers and future generations. In addition, any immediate spending cuts or tax increases would represent an additional drag on the already weak economic recovery.
It will be difficult for accountants to help their clients with tax and financial planning unless policymakers decide what to do. But chances are that Washington will put off making any tough decisions as long as possible.
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