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Implications of the Looming Budget Adjustments for Macroeconomic Activity

Implications of the Looming Budget Adjustments for Macroeconomic Activity. Alan J. Auerbach University of California, Berkeley December 2, 2005. Outline. What We Face Policy Changes to Expect The Impact of These Changes How We Could Do Better. What We Face. Huge Long-Run Imbalance

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Implications of the Looming Budget Adjustments for Macroeconomic Activity

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  1. Implications of the Looming Budget Adjustments for Macroeconomic Activity Alan J. Auerbach University of California, Berkeley December 2, 2005

  2. Outline • What We Face • Policy Changes to Expect • The Impact of These Changes • How We Could Do Better

  3. What We Face • Huge Long-Run Imbalance • Using CBO 10-year baseline: • 4.6% of GDP through 2080 • 7.9% of GDP permanently • Using Adjusted 10-year baseline: • 7.3% through 2080 • 10.6% permanently

  4. What We Face • Long-run gap substantially larger than five years ago • January 2001: 3.3% - 4.1% • Now: 7.9% - 10.6% • What happened? • Spending growth • Tax cuts • The end is near(er) • The economy (very little over long run)

  5. Policy Changes to Expect • Three places to look (in decreasing order of importance): • Health Care (Medicare, Medicaid) • General Revenue (i.e., not dedicated) Taxes • Social Security

  6. Policy Changes to Expect • Primary focus has been on potential effects of current deficits (crowding out, interest rates, current account, etc.). • But what about effects of necessary policy adjustments? • What will happen to the economy when the music stops?…or when people realize that it will stop?

  7. Coming Policy Changes: Taxes • Taxes as a share of GDP lower than at any time since the 1950s • The current share is even lower if one excludes payroll taxes, which have risen as a share of GDP along with Social Security and Medicare, to which they are dedicated

  8. Coming Policy Changes: Taxes • Taxes as a share of GDP lower than at any time since the 1960s • The current share is even lower if one excludes payroll taxes, which have risen as a share of GDP along with Social Security and Medicare, to which they are dedicated • Given history and current gap, an eventual tax increase of 4% of GDP plausible

  9. How Would Taxes Change? • Likely a mix of base broadening and marginal tax rate increases • Base broadening: look at recent tax reform panel report: • housing • state and local taxes • So, expect shifts in spending patterns from these sectors

  10. What Would Tax Changes Do? • Sectoral shifts aside, what effects should we expect from higher tax burdens and higher marginal tax rates? • Higher future tax burdens  • higher private saving • higher labor supply • Higher future marginal tax rates  • lower private saving • higher labor supply

  11. What Would Tax Changes Do? • Overall effects of impending tax changes: • sectoral shifts away from activities currently tax-favored • increases in labor supply (employment/hours) • uncertain impact on private saving

  12. Coming Policy Changes: Entitlements • Consider recent responses to Social Security and Medicare problems • Medicare: in face of huge long-run gap, increase long-run cost by 1/3 with unfunded prescription drug benefit • Social Security: no progress at addressing this “easy” problem • Implication: nothing will happen without a crisis

  13. Coming Policy Changes: Entitlements • A crisis will be characterized by the need for immediate action • gap too big to be closed by increased payroll taxes alone • but sizable benefit cuts unlikely for less affluent retirees, so • Means testing of entitlements is in our future

  14. What Would Means Testing Do? • Mixed incentives to accumulate retirement wealth • positive, if benefits reduced • negative, if reducing assets wards off benefit cuts • In first scenario, increased incentive to work and save; in second scenario, the opposite: save less, and therefore need to work less

  15. What Would Means Testing Do? • Overall effects of impending entitlement changes: unclear

  16. Further Effects: Trade • Adjustment will eventually involve trade surpluses, to service accumulating international obligations • Should lead to relative growth in trade-sensitive industries

  17. Further Effects: Uncertainty • Until we know what will happen, there should be a higher equity premium • …once we realize that something must happen

  18. Summary • Policies outlined are costly to economic well-being • sharp marginal tax rate increases • means-testing and its disincentives • uncertainty about future policy • Costs could be reduced by more gradual, systematic plans, but recent policy actions not promising

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