Historically budgeting rules focused on a four year budget cycle. Budgeting rules focusing on a four year election cycle do not provide the information required for long term financial planning. Only recently have governments begun to issue reports on their long term fiscal sustainability, as a supplement to these budget reports.
The European Precedents
The European countries have taken the lead in issuing reports on long term fiscal sustainability (European Commission. 2016). Great Britain, Germany, Switzerland, and the European Commission have been issuing ‘long term fiscal sustainability’ reports for more than a decade.
The concept of long term fiscal sustainability has been adopted as an international standard by the OECD, the IMF, and the European Commission (European Commission. 2016; International Monetary Fund 2009, 2015; Organization for Economic Cooperation and Development 2005, 2010). According to this concept, fiscal policies are considered sustainable if government debt as a proportion of GDP (the debt ratio) can be stabilized at a sufficiently low level. That level is unique for each country; but the rule of thumb adopted by these organizations is a target ratio of 60%. Some countries, such as Switzerland, have adopted a more stringent measure of fiscal sustainability.
The European countries use a fiscal gap approach in estimating the impact of structural changes and fiscal policies on long term state finances. The fiscal gap measures the annual savings, and/or additional revenues required to reach the debt ratio target. Fiscal sustainability reports focus on the impact of demographic and economic changes on the public sectors most affected, i.e. social insurance, health care, and education. Some reports break the fiscal gap measure down for federal and subnational governments.
Long term fiscal sustainability studies usually assume that fiscal policies are unchanged over the forecast period. This allows the fiscal gap measure to reveal the magnitude of policy changes required for a sustainable fiscal policy in the long term. However, some countries, such as Switzerland, incorporate policy changes into their estimates of the fiscal gap.
The Swiss ‘Report on the Long-Term Sustainability of Public Finances’ is especially important because it is an integral part of the fiscal framework created by their ‘debt brake’ rules (Federal Department of Finance 2016). The report focuses on economic growth, and changes in the age structure and retirement of the population, and migration. The study estimates the impact of these changes on public finances, particularly social insurance, health care, and education.
The Swiss reports usually assume a given set of fiscal policies over the forecast period. However, the most recent (2016) report adopts a different methodology. That report takes into account the Federal Council 2020 retirement pension proposal. That proposal includes some measures that reduce social security expenditures, i.e. the increased retirement age for women, and reduced benefits for disability insurance. The proposal also calls for a value added tax increase of 1.5 percentage points, earmarked for the Social Security Fund. Even with the proposed reforms, the report concludes that further reforms in social security will be required if the sustainability of the system is to be assured. In Switzerland there has been no change in the retirement age. Many European countries have proposed increasing the retirement age threshold to 67 in the long term, including Germany, France, the Netherlands, and Spain. Some countries, i.e. Italy and Denmark, couple the retirement age to life expectancy; this will result in a retirement age of 69 by 2050.
The Swiss debt brake targets the stabilization of debt in Swiss francs, i.e. in nominal terms (Federal Department of Finance 2016). If debt is fixed in nominal terms, the debt ratio will fall as the economy grows. The ‘Report on the Long-Term Sustainability of Public Finances’ reveals how difficult it will be to meet this target, even with reforms in social security. The most recent estimate is that the debt ratio will increase from 35% to 59% of GDP between 2013 and 2045. Public expenditures for all levels of government as a share of GDP are project to increase from 32% to 36%. Over this period the fiscal gap is estimated at 0.9% of GDP. Without the proposed change in social security, the fiscal gap is estimated at 1.6% of GDP. The Report breaks the fiscal gap down by public sectors most affected: social security, health care, and education. The Report also breaks this fiscal gap measure down for federal and subnational governments. Public expenditures for all levels of government as a share of GDP are project to increase from 32% to 36% over the period.
These reports reveal how challenging it will be to achieve long term fiscal sustainability. When the reports are part of the fiscal framework, as in Switzerland, they create incentives for elected officials to enact fiscal reforms, including reform in entitlement programs, required for fiscal sustainability.
The U.S. Precedent
The Congressional Budget Office (CBO) began publishing its annual ‘Long Term Budget Outlook’ in 2005 (Congressional Budget Office 2017). The report provides information on the long run sustainability of fiscal policies in the U.S., similar to the long term sustainability reports issued by European governments. The extended baseline projection measures the impact of structural changes and fiscal policies on the economy and the federal budget. The most recent report focuses on the 30 year period from 2017 to 2047, although some forecasting for social security expenditures extends for 75 years to 2091.
Like the European reports, the CBO report assumes that current laws generally remain unchanged, and estimates the impact of economic growth and demographic change on the federal budget (Congressional Budget Office 2017). The CBO forecasts that expenditures will continue to outpace revenues over the forecast period. Federal spending as a share of GDP is projected to increase from 21% to 29% by the end of the period. Debt held by the public as a share of GDP is projected to double from 77% in 2017 to 150% in 2047. The deficit as a share of GDP is projected to grow to 5% in 2027 and 10% in 2047. Rising interest rates and increased federal borrowing will increase interest cost to more than 5% of GDP by the end of the period, at which point interest cost will be greater than discretionary spending.
The CBO forecasts that demographic changes will drive up spending relative to revenue primarily due to expenditures for Social Security, Medicare, and Medicaid. By the end of the period expenditures for these entitlement programs will account for about half of all federal expenditures compare to about two fifths today.
The CBO measures long term fiscal sustainability by estimating the fiscal gap, i.e. the changes in savings and/or revenue required to meet a target level of debt. To maintain the current debt ratio the federal government would have to cut spending and/or increase revenue, or both, annually by 1.9% of GDP. In 2018 that would be equal to about $380 billion. The CBO also estimates the fiscal reforms required for a lower target debt ratio. In other reports the CBO estimates the potential magnitude of savings from reforms in entitlement programs.
The CBO concludes that current policies will not provide for long term fiscal sustainability. It concludes that the rising debt ratio would:
“reduce national savings and income in the long run
increase the government interest costs, putting more pressure on the rest of the budget
limit lawmakers ability to respond to unforeseen events
raise the likelihood of a fiscal crisis” (Congressional Budget Office 2017 p. 3)
There is a fundamental difference between the CBO ‘Long Term Budget Outlook’ and the long term sustainability reports issued by European governments. In the European countries the reports are an integral part of the fiscal framework. The budget targets in the medium term are adjusted to meet the debt ratio target in the long term. In some countries, such as Switzerland, this means stabilizing the nominal debt level. In other countries, such as Sweden, a budget surplus is designed to target a lower debt ratio in the medium term, recognizing that demographic changes will tend to drive that ratio higher in the long term.
In the U.S., there is a disconnect between the CBO ‘Long Term Forecasts,’ and medium term budget negotiations. The annual budgets take little account of the long term impact of fiscal policy; and the ten year budget plans issued by Congress amount to nothing more than a wish list for the party in power.
In fact, the annual budgets are precluded from addressing long term impacts of some fiscal policies, because of the perverse effects of the Byrd Rule. The Byrd Rule amended the 1974 Budget Act, and was designed to block legislation that could significantly increase budget deficits beyond a ten year period. It outlawed provisions that are considered ‘extraneous’ and therefore not subject to reconciliation. Among these ‘extraneous’ provisions is any measure recommending changes in Social Security. It takes 60 Senators to overturn the Byrd Rule, so it is not surprising that Social Security reforms have not been enacted since the first Reagan Administration.
In recent years the CBO has come under fire, because CBO forecasting is dictated by the budget rules adopted in Congress. Until recently Congress required the CBO to use static scoring in its forecasting. In the last few years the CBO was permitted to use some dynamic scoring in measuring the impact of legislation. However, this has not satisfied critics who question CBO forecasts of the impact of ACA, tax reforms, and other legislation.
A more fundamental criticism of budget rules is the absence of a framework for fiscal sustainability that could incorporate the CBO ‘Long Term Forecasts’. Only with a fiscal framework in place will long term forecasts have an impact on legislation designed to target the debt ratio. In this regard the U.S. lags far behind the precedents set in European countries.