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As individuals we know that we cannot run a Ponzi scheme indefinitely. We might be able to roll over an old loan and replace it with a new loan for some period of time, but eventually creditors will demand repayment of the loan. Keynesians argue that the U.S. government should borrow to finance expenditures in the short run, while ignoring the long run impact of the increase in debt (Keynes 1923, Krugman 2010). In the short run loans can be rolled over, but governments can’t run a Ponzi scheme indefinitely. If a government spends more than it takes in in revenue, at some point it must generate surplus revenue to repay the loan; governments that fail to meet this obligation go bankrupt. In fact, throughout history governments that did not meet their financial obligations have gone bankrupt. The recent financial crisis, which resulted in bankruptcy for Greece and threatened bankruptcy for other countries, has again focused attention on the long run solvency of governments (Merrifield and Poulson 2016).

A fiscal imbalance exists when a country’s future expenditures, including servicing of outstanding debt, exceed future revenues. A measure of this fiscal imbalance is the fiscal gap, which is equal to the difference between the present value of a country’s future expenditures and future revenues. Measuring the fiscal gap requires estimates of future revenues and expenditures; and, an assumption must be made regarding the interest rate used to discount the future stream of revenues and expenditures.

The U.S. government provided estimates of the fiscal gap during the last year of the George W. Bush administration and the first year of the Clinton administration (Kotlikoff 2013). Since then estimates of the fiscal gap have either been censored or simply not calculated. The explanation for this lack of transparency regarding the nation’s debt burden is cowardice on the part of elected officials. Kotlikoff (2013) cites political pressure as the explanation for the unwillingness of the federal government to provide this information.[1] This is not surprising given the magnitude of the fiscal gap and the sharp deterioration of fiscal balance in recent years. However, several studies have estimated an ‘unofficial’ fiscal gap for the U.S., using CBO long term budget projections.

Miron (2016) estimates the fiscal gap over the historical time period 1965 to 2013. These estimates capture the impact of abandonment of the un-written fiscal constitution of balanced budgets over this period. In the initial year there is no fiscal imbalance, the fiscal gap is a positive $7 trillion. The present value of future revenues exceeded the present value of future expenditure by that amount, evidence of a sustainable fiscal policy. Beginning in 1965 there is a long run deterioration in the fiscal balance, and by 1969 Miron estimates a negative fiscal gap. He finds evidence of a discontinuous deterioration in the fiscal balance beginning in 2000, which he attributes to the acceleration in Medicare expenditures. Another discontinuous deterioration in fiscal balance occurs during the Great Recession in 2008-2009, due to a sharp increase in Medicaid and other health care costs. There was some improvement in the fiscal balance after 2010, which Miron attributes to the slowdown in expenditures growth following the Great Recession. By 2014 he estimates the fiscal gap at negative $118 trillion. Miron finds that the major drivers in this long run deterioration in fiscal balance are entitlement expenditures. Medicare, Medicaid, the Affordable Care Act (ACA), and to a lesser extent Social Security, account for most of the deterioration in the fiscal gap in the U.S.

Other studies provide a markedly grimmer picture of fiscal balance in the U.S. compared to the Miron study. These studies also rely on the CBO long term forecast, but make refinements in that forecast to reflect changes in fiscal policy likely to occur over the next 75 years (Auerbach 1997; and Auerbach and Gale 2014).

Kotlikoff (2013) provides an estimate of the fiscal gap incorporating current and future liabilities incurred by the federal government in entitlement programs. In his view the federal government is in fact engaged in a Ponzi scheme. Each generation of citizens transfers wealth from the younger generation through entitlement programs that promise the young that they in turn will be able to transfer wealth from their children when they retire. These wealth transfers are hidden from the public because they take place off the books through the trust funds established for these entitlement programs. Kotlikoff maintains that the emergence of a transfer society over the past half century is the major source of fiscal imbalance. Combining the much larger debt incurred through entitlement programs with the official debt reported by the federal government Kotlikoff estimates the fiscal gap over an infinite time horizon at $205 trillion.

Closing the Fiscal Gap

The financial crisis that began in 2008 focused attention on closing the fiscal gap. By 2011, average public indebtedness increased to 100 percent of GDP in the OECD as a whole (Organization for Economic Cooperation and Development 2014).  While there are wide differences in the debt burdens, all the OECD countries perceived that these high levels of debt are not sustainable in the long run. Within the OECD countries a consensus emerged that countries should target a debt/GDP ratio below 60 percent for a sustainable fiscal policy. That target debt/GDP ratio is then translated into mandated fiscal policies within the European community.

The OECD (2014) measures the improvement in the primary balance required to achieve a target debt/GDP ratio below 60 percent. The primary balance is the difference between non-interest expenditures and revenues. The assumption is that this debt/GDP target is reached through an annual improvement in the primary balance at a maximum of half a percentage point of GDP over the period 2016 to 2030.

Some of the OECD countries have initiated fiscal consolidation efforts (OECD 2014). The OECD identified one group of prudent countries –Austria, Belgium, Finland, Germany, Greece, Israel, Netherlands, and Slovenia- which have debt ratios not far from the target level and that began saving a primary surplus. These countries will require either no additional fiscal consolidation, or modest consolidation efforts, less than 1 percent of GDP, to reach the target debt level in this period.

Another group of countries have larger debt burdens and will require greater but manageable fiscal consolidation efforts, between 1 percent and 3 percent of GDP. These countries include Canada, France, Hungary, Ireland, Iceland, Italy, Poland, and Portugal. A third group of, profligate, countries have debt ratios in excess of 100 percent of GDP and will require major fiscal consolidation efforts, in excess of 3 percent of GDP- these include Japan, Spain, the United Kingdom, and the United States.

The Congressional Budget Office (2016b) estimates reveal that the fiscal gap in the U.S. has deteriorated further since the OECD study was conducted. The CBO measures debt held by the public, which does not include federal debt held in trust funds and other government accounts which are included in measures of total federal debt. The CBO estimates the increase in revenue or decrease in noninterest spending required to achieve a target debt/GDP ratio in 2046. If the target is set at the current debt/GDP ratio, 75 percent, the CBO estimates the required increase in revenues, or decrease in expenditures at 1.7 percent of GDP. If the target is set at the average debt/GDP ratio over the past 50 years, 39 percent, the CBO estimates the required increase in revenues or decrease in expenditures at 2.9 percent of GDP. That target debt/GDP ratio could be achieved with a 16 percent increase in all federal revenues each year over the period 2017 to 2046. The target could also be reached with a 14 percent reduction in noninterest expenditure over the same period. The longer that these policy changes are delayed the larger the adjustments required to achieve the target debt/GDP ratio.

Auerbach and Gale (2014) use fiscal gap estimates to measure the impact of policy changes require to reach a given debt/GDP target in a given future year. These estimates are based on expenditure and revenue projections that they argue are more realistic than that estimated in the CBO long term projections.

<Insert table 5.2 about here>

In table 5.1 the fiscal gap is estimated for three different time horizons. Setting the target debt/GDP ratio at 72.1 percent, the level in 2013, fiscal gap is estimated at 1.92 in 2040, and 3.53 percent in 2089. If that target debt/GDP ratio is set for an infinite time periods they estimate that this would require revenue increases or expenditure reductions equal to 4.52 percent of GDP; that translates into an annual tax increase or cut in spending in excess of $700 billion per year. Note that the fiscal gap is larger as the time horizon is extended, perhaps the best indication of fiscal imbalance.[2]

Miron (2016) conducts a sensitivity test to measure the impact of alternative policy reforms on fiscal balance. He finds that only expenditure cuts, especially in Medicare, Medicaid, and ACA subsidies can significantly restore fiscal balance. If all mandatory expenditure programs were capped at the rate of growth in GDP this would improve rates of economic growth, and the fiscal gap would be significantly reduced.

Kotlikoff (2013) is more pessimistic regarding fiscal policies required to close the fiscal gap. He finds that including the liabilities in the entitlement programs, the U.S. fiscal gap now stands at $205 trillion, which is equal to 10.3 percent of the estimated present value of all future U.S. GDP. .He estimates that to close the fiscal gap today would require an immediate and permanent 57 percent increase in all federal taxes. Closing the fiscal gap through spending cuts would require an immediate and permanent 37 percent reduction in expenditures. Kotlikoff concludes that for all intents and purposes the U.S. is bankrupt, since the probability of enacting such draconian fiscal policies is close to zero.


[1] Fiscal gap measures estimated by Laurence Kotlikoff, Alan Auerbach, and Jagadeesh Gohale were included in the President’s Budget in 1992 (Kotlikoff 2013).
[2] Auerback also provides a sensitivity analysis of these estimates of fiscal gap based on different time paths for expenditures and revenue (Auerbach 1997, 2014).

 

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Fiscal Imbalance and the Fiscal Gap

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