Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

Is it too late to defuse the debt bomb?

Last week we examined the bipartisan debt limit agreement that promised to reduce the deficit over a decade. We also observed that if the plan’s most optimistic forecasts are attained (and there are no economic recessions), the national debt will only explode by 90% instead of 96%. Small beer.

Back in 2010, a consensus appeared to be forming around action to forestall a generational debt crisis. Total debt held by the public stood at 62% of GDP, and similar blueprints from two well-respected bipartisan task forces proposed structural reforms that would hold the line on debt at around 60%. Sadly, there was insufficient political courage to act, and the debt has surged to 100% of GDP on a rocket sled toward 120% by 2033. It is also hard to argue that statesmanship is in any greater supply today, begging the question: is it too late to defuse the debt bomb?

We begin with the premise that it’s not too late, but our lethargy in dealing with the crisis insures that the medicine will taste much more bitter, and we’ll need a bigger dose.

Those plans to stabilize the debt at 60% of GDP now seem almost quaint. That ship has sailed, and any coherent scheme must accept reality and aim for a level closer to 90% over a 10-year horizon, a tall enough order. As we have seen, only a little over a quarter of spending is discretionary and subject to annual appropriations. Major entitlements make up 62% and interest on the debt consumes 10% of total spending. Slowing the runaway debt will require substantial reforms to these entitlement programs as well as increases in revenues (tax hikes). As John Adams noted, facts are stubborn things.

Any honest deficit plan begins by setting broad spending and revenue targets and then allocating available revenue to spending priorities via the appropriations process. For example, the 2010 Simpson-Bowles commission proposed reducing spending to 21% of GDP and increasing tax revenue to 21% over 10 years. Had we adopted this approach the picture would look much different. Instead, the current CBO baseline projects spending of 24% of GDP and revenue of only 18% through 2033. The first rule of holes is to stop digging. Or at least trade in the backhoe for a spade.

Discretionary spending is too small for cuts to balance the budget. Entitlement and tax reform must carry the load. Here are the most obvious and impactful targets.

Health care. Major health care programs like Medicare make up 40% of all discretionary spending and are growing faster than inflation.

The US healthcare and pharmaceutical industries lead the world in innovation and product development, but our delivery system is the least efficient among the world’s richest nations. According to the Commonwealth Fund, America spends nearly twice as much per capita on healthcare than any of the other 12 wealthy OECD nations. But the US has the highest infant and maternal mortality, the lowest life expectancy, the highest rate of preventable deaths, and is the only member of the group that does not provide universal coverage. Specific solutions are beyond our scope, but slowing the debt growth demands a sober evaluation of our costly delivery system.

Social Security. Retirement security programs make up the next largest portion of mandatory spending, and like Medicare, the Social Security trust fund is scheduled to run dry within a decade. Solutions are well known including gradually delaying eligibility over 40 years, means testing benefits, raising the income cap for payroll taxes, and raising tax rates. Additionally, increasing the long-term investment return of the trust funds by investing a portion in equities through third-party managers or index funds should be considered.

Tax reform. Given the magnitude of the crisis, it unrealistic to exclude revenue increases. Since the landmark Reagan tax simplification of 1986, the code has become riddled with exceptions that have largely obliterated the original reforms.

The greatest source of revenue leaks is so-called “tax expenditures”, various tax breaks that act like spending but are disguised and deductions or credits intended to favor one particular group. The biggest examples include the exclusion of employer health care insurance contributions from taxation, tax-deferred retirement contributions, and tax preferences like lower capital gains rates. Tax expenditures cost the Treasury $1.7 trillion each year, more than the entire discretionary budget. Some combination of higher marginal rates and closing loopholes will be required to boost tax revenue by around 3% of GDP.

Not to pile on, but other dangers lurk. Like each of us individually, America is aging. By 2030, all the Baby Boomers will be 65 or older and will be supported by a smaller workforce, increasing pressure on healthcare and retirement security entitlements. Meanwhile, the debt limit compromise only suspended the cap through 2025, setting up an even more contentious standoff after the election.

Furthermore, the 2017 tax cuts technically expire after 2025. But as Milton Friedman quipped, nothing is so permanent as a temporary government program, and extending these tax breaks would add an additional $3.5 trillion to the debt over 10 years according to the CBO.

The magnitude of the task is imposing. By failing to address it earlier we have already compromised the financial outlook for the next generation. The question now is whether we can summon the courage and cooperation to defuse the bomb for their progeny.

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