The fed and an uncertain fiscal future.

• Author: Holtz-Eakin, Douglas
• Position: Federal Reserve Board

The United States faces a fiscal policy disaster. As is now becoming more widely appreciated, spending commitments under current laws and policy will outstrip the ability of conventional tax-based federal finance. More important, left unchanged these spending commitments are an economic threat that may undermine the future of U.S. macroeconomic performance. Because Federal Reserve policy is built on the outlook for the economy, the risks associated with the path of future fiscal policy, uncertainty over the pace, scale, and nature of fiscal reforms, and financial markets assessment of these risks will be a steady part of the Fed's policymaking diet.

What Is the Fiscal Problem?

The fiscal problem has little to do with current budgetary outcomes. In fiscal year 2006, the federal budget deficit was 2 percent of GDP. In itself, this is hardly problematic, indeed it's business as usual in the postwar era--federal spending is typically 20 percent of GDP, revenues 18 percent, and the difference made up by federal borrowing. Thus, while a budget deficit of the current size could continue indefinitely, the problem is that it will not. Instead, current laws and policies will lead to tremendous budget pressures in the years to come.

To see this, consider the ratio of debt (in the hands of the public) to GDP, which is a bit below 40 percent. This ratio has two desirable characteristics as an indicator the long-run sustainability of current policies. First, the numerator reflects any cumulative mismatch between the outlays of the government and its tax receipts, which is the core concept of sustainability. Second, the denominator reflects the scale of the national economy that could, in principle, be devoted to the imbalance. Moreover, to the extent that there are pro-growth policies that might worsen the numerator but sufficiently augment economic growth, then the indicator will decline. This is exactly the type of sustainability barometer that one should examine.

Now, consider the political and policy mechanics of trying to sustain something close to current federal budget practice. At present, the federal government raises about 18 percent of GDP in receipts. That is, despite the tremendous attention paid to the tax bills passed in 2001 and 2003, revenues have recovered to their typical levels. In the other direction, the past two years have witnessed revenue "windfalls"--receipts growth above that expected on the basis of economic growth--that cannot persist into the future. Thus, on balance the revenue system is configured to raise approximately 18 percent of GDP.

On the spending side, assume that Social Security reform remains unrealized and the benefits are paid as currently scheduled. That implies that outlays for Social Security will rise with the retirement of the baby-boom generation from about 4.5 percent of GDP now to 6.5 percent of GDP in 2030, and then continue to drift north to about 7 percent of GDP for the foreseeable future. In the process, Social Security will be...