Deficit reduction targets unlikely to be hit

By Robin Harding in Washington

Published: February 14 2011 19:13 | Last updated: February 14 2011 19:13

The US is set to run a loose fiscal policy for years into the recovery – although this is more due to default and deadlock than to any cunning economic strategy.

Under Barack Obama’s budget, the deficit would peak at 10.9 per cent of output in 2011 and then drop to 7 per cent in 2012 and 4.6 per cent in 2013. By 2014, the budget would be broadly back to primary balance, with debt stable at about 75 per cent of gross domestic product.

But it is unlikely to turn out that way. The short-term deficit reduction is the most plausible, because it largely rests on a recovery in tax revenues, which are projected to rise by 21 per cent and another 14 per cent in 2013.

But most of the medium-term reduction hinges on spending cuts that will be hard to put into effect and revenue increases that will struggle to pass Congress. The long-term issues that will cause the deficit to rise again after 2020, such as the rising cost of healthcare and Social Security, are not addressed in detail at all.

The budget assumes that a temporary payroll tax cut expires as planned at the end of 2011 and that Bush-era tax cuts for higher earners expire at the end of 2012. “This is probably most people’s baseline for the current year,” said Neal Soss, chief economist at Credit Suisse in New York.

As a result, fiscal policy will remain highly stimulative throughout 2011 but will pay some of that back the year after, assuming the payroll tax really is put back up again going into the presidential election year of 2012.

In the medium term, the budget assumes a series of tax increases, many of which failed to get through Congress last year. About $321bn of deficit reduction over the next decade is supposed to come from a 30 per cent cut to the deductions that higher earners are allowed to make from their income tax bills. That includes deductions for mortgage interest payments.

Another $129bn comes from cutting tax breaks for corporations on their overseas income, $53bn from a change to inventory accounting, and $46bn from tax breaks to the oil and gas industry. All of these provisions have champions in Congress who will try to protect them.

On healthcare, the budget proposes $62bn of tweaks to healthcare in order to maintain payments to doctors for seeing Medicare patients, but then assumes that it will find more tweaks to pay for another eight years of the “doc fix” after that. Some $315bn of deficit reduction is supposed to come from these promised future savings.

The final big area of savings is a five-year freeze on discretionary spending for programmes such as transport and housing, which is intended to save $400bn.

It may be possible to freeze such spending for a year or two, but it will be hard to sustain it for a decade. For example, under the president’s plan, non-security discretionary spending is supposed to almost halve as a share of GDP, from 3.4 per cent in 2011 to 1.8 per cent in 2021.

In practical terms, that would mean, for example, that the Environmental Protection Agency had a smaller nominal budget in 2021 than it did in 2010 with no increase at all for inflation in the meantime.

The most probable outcome is that not all the tax cuts will be passed, the envisaged cuts to health spending will not be found, and that the long-run squeeze on discretionary spending will be too severe for either the public or Congress to endure.

As a result, actual budget deficits are likely to come in far higher than those proposed by the president’s budget, unless both Republicans and Democrats are willing to address the important areas of the budget – defence, health and Social Security – in more detail.