December 5, 2012

Balancing on the Cliff:

Why Entitlement Reform is Essential to Balance and Can Even Make Room for a Deal
Balance is in the eye of the beholder. In the case of the fiscal cliff, the President has focused his argument for balance on the need for higher taxes on the wealthy in addition to spending cuts. But it is equally true that no deal will be balanced if entitlement reform is not a part of it. Without entitlement reform, no deal will be balanced in the long-run and the U.S. will careen from one Grand Bargain to another over a period of years.

For Republicans, this means negotiating from a higher tax base the next time we need a Grand Bargain. Essentially, if Republicans give in on tax rates without entitlement cuts today, they will cede a larger government without really solving fundamental longterm problems. Matt McDonald Russ Grote Hamilton Place Strategies 805 15th St NW, Suite 700 Washington, DC 20005 (202) 822-1205 Rather than complicating negotiations, acknowledging the centrality of entitlement reform for balance can open up potential compromises that fall along current messages from both parties. Additionally, compromise on long-run issues could create the necessary political space to maintain or even increase short-term stimulus measures to address our current economic difficulties.

Without entitlement reform, no deal will be balanced in the long-run and the U.S. will careen from one Grand Bargain to another over a period of years.!

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The Uneven Trade of Real Tax Hike for Nominal Spending Cuts
The problem with a deal comprised of tax rate increases and spending cuts without any entitlement reform is that the tax increases would be real, while the spending cuts would be nominal. So while the tax increases will grow with the economy, the spending cuts would remain constant, making any deal appear balanced in the short-run, but weighted heavily towards tax increases over time. To illustrate this concept, lets look at a hypothetical deal consisting of a 1:1 ratio of tax increases to spending cuts totaling $2 trillion over ten years and then extended into the following decade. In the first ten years, this approach may fit the balance test. However, as the economy continues to grow, the same tax policy changes that raised $1 trillion in revenue in the first ten years will raise significantly more in the out years. Meanwhile, nominal spending cuts will stay constant. In this static analysis, a 1:1 ratio of tax hikes to spending cuts nears 2:1 in the next ten-year window (Exhibit 1).1
EXHIBIT 1

Over Time, Tax Hikes Will Grow Larger Than Nominal Spending Cuts!
A 1:1 10-Year Deal Applied Over 20 Years !
350 350! 300 300! 250 250!

Spending Cut!

Tax Hike!

An initial 1:1 deal that pairs tax increases and nominal cuts becomes skewed towards tax revenue over the longer run.!

Dollars ($B)!

200 200! 150 150! 100 100! 50 50!

0! 0

2013!

2014!

2015!

2016!

2017!

2018!

2019!

2020!

2021!

2022!

2023!

2024!

2025!

2026!

2027!

2028!

2029!

2030!

2031!

Source: HPSInsight, Based on CBOs Alternative Fiscal Scenario plus 0.5% of GDP in tax hikes ($1 trillion over ten years) and annual spending cuts of $100 billion ($1 trillion over ten years)!

2032!

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Grand Bargain or Slippery Slope

This longer-term perspective also illustrates the other challenge facing our current federal finances. Outside the ten-year window, entitlement spending explodes. !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
1

By 2032, annual revenue increases from the CBOs Alternative Fiscal Scenario total $185 billion, compared to just $100 billion in spending cuts ($1 trillion applied evenly over ten-year period).

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While taxes on the rich may be enough to alleviate our fiscal imbalances in a tenyear window, they do not solve the main driver of government spending and our fiscal imbalances in the long-run. Under virtually any deal that provides nominal spending cuts rather than curbing the growth of entitlement spending, another Grand Bargain will be necessary to actually solve our fiscal problems (Exhibit 2).
EXHIBIT 2

Progress On The 10-Year Window Will Mask Longer Term Problems With Entitlement Spending!
A 1:1 10-Year Deal Applied Over 20 Years !
26 26!

Taxes!

Spending (Non-interest)!

24 24!

Percent of GDP (%)!

22 22!

10-year window moves us closer towards primary budget balance!

20-year window highlights longterm problems!

20 20!

The ten-year window suggests increased tax revenue and some small cuts may be adequate, but Republicans fear the 20-year window. !

18 18!

16! 16

14! 14

2013!

2014!

2015!

2016!

2017!

2018!

2019!

2020!

2021!

2022!

2023!

2024!

2025!

2026!

2027!

2028!

2029!

2030!

2031!

Source: HPSInsight, Based on CBOs Alternative Fiscal Scenario plus 0.5% of GDP in tax hikes ($1 trillion over ten years) and annual spending cuts of $100 billion ($1 trillion over ten years), exclude net interest payments! !

2032!

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This is the fundamental Republican fear and the real issue holding back a deal. What will happen when we have to solve this problem again (Exhibit 3)? Will we cut spending drastically on seniors (without any time for more gradual approaches) or will a more balanced approach again be pushed? Under our hypothetical 1:1 deal, by 2032 the remaining fiscal gap, not counting interest payments, is just above six percent of GDP. Another 1:1 balanced approach would raise taxes by an additional three percent of GDP. This increase would bring taxes to 22 percent of GDP, just under the Progressive Caucus Budgets long-term target and a full one percent above Bowles-Simpson. As Table 1 in Exhibit 3 illustrates, the exact ratio of tax hikes to spending cuts can change these numbers somewhat. Yet, for illustrative purposes, our calculation ignores interest payments, most likely making these estimates low compared to the revenue that would actually be needed to balance the budget. Morevoer, they are all significantly higher than the Ryan Plan, which raises 19 percent of GDP, and would also most likely be above 20.6 percent of GDP, the highest amount of taxes

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collected by the federal government set at the height of the dotcom bubble in 2000. Ultimately, offers that push entitlement reform into the future are simply asking Republicans to negotiate the real Grand Bargain from a default position of a higher tax base and a larger government.
EXHIBIT 3

What Happens When We Have To Solve This Problem Again In 10 Years? More Taxes.! Spending Cuts! Tax Hikes! Total!
A 1:1 10-Year Deal Applied Over 20 Years ! 7! 7 6! 6 5! 5 Table 1! Assuming tax changes equaling $1 trillion of new revenue over ten years and no structural entitlement reforms!

Percent of GDP!

4! 4
3 3! 2 2! 1 1! 0 0!

To close the remaining gap, Republicans will be asked to compromise based on the previous deal.!

2nd Deal!

Next 10 Years!

Spending Cuts ($ Trillions)! 0.6! 1! 1.5! 2!

"Taxes as a % of GDP to Balance Primary Budget in 2032! 22.8 %! 22.0 %! 21.4 %! 20.9 %! 20.4 %!

1st Deal! 2013 Grand Bargain! 2023 Grand Bargain" !

1st

10 Years!

3!

Total Fiscal Consolidation to Get to Primary Balance!

Hamilton Place Strategies | 3

Source: HPSInsight, *Based on CBOs Alternative Fiscal Scenario plus 0.5% of GDP in tax hikes ($1 trillion over ten years) and annual spending cuts of $100 billion (1 trillion over ten years)! !

Recipe for Gridlock or Opportunity for Compromise?

While the politics of entitlement reform can be tricky, recognizing it as essential for a balanced approach to avoid the fiscal cliff may actually open up room for compromise. The Congressional Budget Office estimated the savings from many types of entitlement reforms by 2020. They actually do not raise much money. For example, gradually raising the Medicare eligibility age saves a paltry $30 billion. Simply put, systemic reforms to entitlements save little over the typical ten-year budget window. This means that a deal including entitlement reform could skew toward the rich paying more in the near-term, pleasing the Democrats, and more significant and real spending cuts over the long-term, pleasing Republicans.

Hamilton Place Strategies |