Should we care about deficit reduction or deficits?

Budget Director Peter Orszag wrote a blog post last Tuesday titled “A Short History of Deficit Reduction” in which he wrote:

The President’s Budget represents an important step towards fiscal sustainability: it put forward $1.2 trillion in deficit reduction over the next ten years, even excluding savings from the assumed ramp-down in war funding over time. Including these war savings, the deficit reduction proposed in the President’s Budget rises to $2.1 trillion.

This provokes an important question: should we care about how much proposed policy changes reduce future projected budget deficits? Or should we care about the deficits that result after those policy changes are made?

I think this is easiest to explain with an example. We will look at FY 2012, which begins 20 months from now in October 2011.

1. Suppose I tell you that if we enact my policies, the deficit in 2012 will be 5.1% of GDP.

  • You remember that any number above 3% means that our debt will expand as a share of the economy.
  • You know that the average budget deficit since the end of World War II is 1.8% of GDP.
  • You know that this 5.1% will be tied for the fifth-largest deficit since the end of World War II.
  • You therefore conclude that this is a bad outcome.

2. Now suppose I tell you that if we just continued current policies, the deficit in 2012 would be 5.8% of GDP.

  • You would conclude that my proposed policies would result in reducing the 2012 deficit from 5.8% to 5.1%. That’s 0.7 percentage points of deficit reduction.
  • You would therefore conclude that my policies would make things better than if we just continued current policies.
  • I will talk about how my policies would reduce the deficit, and I would emphasize the 0.7 percentage points of deficit reduction that I have proposed.

3. Finally, suppose I tell you that if we just continued current law, the deficit in 2012 would be 3.8% of GDP.

  • You would conclude that my proposed policies would result in increasing the 2012 deficit from 3.8% to 5.1%. That’s 1.3 percentage points of deficit increases.
  • You would therefore conclude that my policies would make things worse than if we just continued current law.
  • You could attack me for increasing the deficit, emphasizing the 1.3 percentage points of higher deficits.

What’s the difference between current policies and current law?

  • Current law is precisely defined. There is no debate about the 3.8% or 1.3% numbers above in (3).
  • Current policy is a more ambiguous definition, and it depends on who is defining what current policies are. The Obama Administration argues that current policies include extending the Bush tax cuts, indexing the AMT, and continuing to allow Medicare physician payments to grow. The Bush Administration included the first of these but not the other two.
  • When you measure changes against current policies, you are not “charged” for the deficit increases that result from continuing those policies. Thus when the Obama Administration says “let’s continue to allow Medicare payments to doctors to increase,” they don’t charge themselves for the $371 B of higher spending and higher deficits that this policy would mean relative to current law.
  • A current policy baseline therefore allows you to claim credit for more deficit reduction.

Now substitute “President Obama” for “I” above in the example. All three of these conclusions are therefore simultaneously true for President Obama’s budget in 2012:

  1. If enacted, President Obama’s policies would result in a deficit of 5.1% of GDP. This would tie the fifth-largest deficit since World War II, is far larger than the post-WWII average deficit of 1.8%, and would increase our debt as a share of the economy. This is a bad outcome.
  2. If enacted, President Obama’s policies would result in 0.7 percentage points of deficit reduction compared to current policies. This is an improvement over current policies.
  3. If enacted, President Obama’s policies would increase the deficit by 1.3 percentage points compared to current law. This is a deterioration relative to current law.

Most of the public debate you will see about the Obama budget will be about conclusions (2) and (3). The President and his team argue their budget reduces the deficit. CBO and Congressional Republicans will argue that it increases the deficit.

You will find that nobody argues about the 5.1% of GDP number in (1).

Nobody argues about the 1.3% of GDP number in (3).

But there is much debate about the 5.8% and 0.7 percentage points numbers in (2), because there is judgment involved in determining the starting point for this measurement.

Relying on a current policy baseline is difficult because nobody agrees what current policies are. The Bush and Obama Administrations differed on whether continuing to allow Medicare physician payments to grow is current policy or not. These judgment calls make it difficult to trust claims of deficit reduction relative to current policy, because you always have to follow up and ask about the assumptions in the current policy baseline. To be fair, this same critique applies to the Bush Administration for which I worked and the extension of the Bush tax cuts.

At the same time, the debate between (2) and (3) is very inside-the-Beltway. Everyone focuses on the actions they propose to take, and whether those actions make things better or worse. This works particularly well in a zero-sum political debate like we usually have on fiscal policy.

I argue we should instead focus on the deficits that would result from policy changes, and therefore on conclusion (1). I don’t particularly care if President Obama’s proposed policy changes in 2012 increase or reduce the deficit compared to what it otherwise would have been. I care instead that his policies, according to his own numbers, would result in a deficit equal to 5.1% of the economy.

The Administration might respond that I have distorted this example by choosing 2012, when they assume we are still recovering from the recession. Their problem is that the same concept holds true for the entire decade. The President’s budget says that his policies would result in average deficits over the next decade of 4.5% of GDP, and that the smallest deficit in the next decade would be 3.6% of GDP.

Whether the President’s budget represents an improvement or harm isn’t that important to me. Arguing about deficit reduction is something of a distraction. We should instead focus on the deficits that would result from a particular set of policy changes. If the resulting deficits are too big, then we need to make bigger policy changes so that the resulting deficits are acceptable.

Those resulting deficits are too big. We need to do more than the President has proposed.

(photo credit: Official White House photo by Pete Souza)

I escaped Washington, DC and now teach at Stanford's Graduate School of Business.

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Posted in budget, taxes
9 comments on “Should we care about deficit reduction or deficits?
  1. Stephan says:

    This deficit and debt hysteria is totally overblown and beside the point. What matters is the spending. For what is the money spent? According to The Economist Debt Clock per capita debt ist US$ 23.000. Now let's assume Obama is a really nasty deficit hawk plus has an socialist agenda. Thus he confiscates 23.000 $ from every citizen to zero the debt. So? Is the US better off? Future generations will praise Obama The Saint? No! Because this is simply left to right pocket policy.

  2. Chris Smith says:

    This is a sad choice among forms of assault.
    The predicament we face is predicated upon the century of Progressive drift.
    I submit that it's time to make a substantial course alteration away from Progressive policy.
    The Progressives will give up their collectivist notions as quickly as they've abandoned global warming.
    Dump this noise, say I.

  3. […] This post was mentioned on Twitter by Andy Lancaster, b pfeifer and Keith Hennessey, Daniel Foster. Daniel Foster said: Will Obama's budget increase or reduce the deficit? Both: […]

  4. Austin says:

    I would like to know if we could stay ok financially by ceasing to raise spending once other countries stop lending to us. I.e. I desire clarity on just why is it that large debts are unsustainable for a country.

  5. Steve MacDonald says:

    As uncle Milton said, what is important/key is government spending, not the size of the defecit. The current argument is semantics and irrelevencies. What is important is the appropriate size and scope of government.
    I think that somewhere between 18% & 19% of GDP is as much federal government as we can stand in the short – medium – long term. Government should keep itself within the confines of these limits. Current levels and projections are insane and ruinous – and the longer term projections are worse.

  6. […] future budget deficits.  The Obama Administration argues otherwise.  This debate focuses on the current policy baseline question I discussed yesterday.  Mr. Chait is correct that President Obama inherited an economy in severe recession and a large […]

  7. Jeff W. says:

    This debate, while intellectually engaging, is all rather superfluous. The important measure is not what the Federal Government's Budget's share of GDP is, nor what our debt or deficit-to-GDP ratio is. The only question that matters is "Is the Federal Government's spending directly attributable to it's Constitutionally enumerated responsibilities?" If it is, then the tax rate must provide for that budget. If it is not, then that spending that violates the Constitution must be cut immediately and forever. I would submit that if you examined the Federal budget for the last fifty or more years you would find that the percentage of un-Constitutional spending has risen to roughly half (or more) of all outlays.

    When approached from this perspective, eliminating half of all taxes would still fund the Federal Governments budget requirements with surplus loft over.

  8. mercurino says:

    what i would like to know is what is driving the increase in the deficit to GDP ratio? is it due to weak economic growth or increases in government spending. i'm trying to figure out what "policies" the Obama administration is assuming are enacted? if they're assuming that the Bush tax-cuts are going to expire, doesn't that raise the revenue side of the equation? so where is the new spending coming from? or is the increased revenue from the expiration of the tax cut wiped out by poor economic growth?

    also, i would caution against these projections. it seems to me that the Administration has an interest in making its long-term deficits appear worse so that it can declare victory in the event it beats its targets.

  9. […] To my mind these are: 1) “Given that we now know that the January 2001 economic and surplus projections were wrong, it is misleading for Team Obama to use those knowingly incorrect projections to describe the effects of Bush Administration policies.” 2) Bush’s prescription-drug benefit needs to be placed in a political context in which both parties favored a big entitlement expansion without offsetting tax hikes or spending cuts, and in which the Democrats wanted a more expensive entitlement. 3) Obama’s policies increase the deficit compared to pre-existing law. […]

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