What's the best plan of attack for the deficit? How do we even begin to address this issue?
Well, there's no easy way to get on top of the budget deficit. Obviously, the deficit is large today because of the downturn in the economy. Tax revenues are low, payments for things like unemployment insurance are higher. But going forward, the baby boomers' retirement pushes up costs for Social Security and Medicare. We're transitioning from a large short-term deficit to a large long-term deficit. Based on the CBO's projections, just to stabilize the debt, we would need a 23% increase in all tax revenues or a similar reduction in spending. This isn't a nibble-around-the-edges, trim-a-little-fat thing. It's a structural deficit, which means it won't go away as the economy recovers. We've got some pretty big choices facing us.
For a recent report, we looked at the experience of foreign countries that have tried to balance their budgets over the last several decades. We tried to look at what differentiated the countries that successfully tackled their budget problems, using a data set put together by the OECD with detailed numbers on budgets, revenues, and economic factors. And what we found, which is consistent with a lot of other research in the field from folks like the IMF and the World Bank, was that countries who tried to tackle their budget problems by reducing spending were far more likely to succeed than those that tried to tackle them by increasing taxes.
It's not simply that countries that cut spending were more likely to balance their budgets. They focused on certain types of spending. One category is called "social transfer," things like entitlement spending, and the second is the government wage bill, which means the pay for government employees. There's two ways this could lead to success. One is a sort of a psychological effect, that these are sacred cows. A government willing to take on this kind of spending shows it's really serious about getting on top of its budget problems. That gives ordinary people and financial markets more confidence, and they're willing to invest for the future because they don't think they have a huge tax increase coming. The second part is simply that if you grow your economy a little bit faster, that helps reduce your debt levels as well. Raising taxes, the data does show, has a negative impact on economic growth, at least in the short run.
When you say we're going to have to make cuts to these entitlement programs, what does that mean in concrete terms?
The costs are pretty significant. For something like Social Security, we would be looking at things like raising the retirement age so people have to work a couple of years longer, reducing benefits for high-income earners so it's a safety net but not a retirement program for the middle and upper classes. On Medicare, you could be looking at things like introducing a deductible. That's another thing that would, again, focus Medicare on people who need it most. The fact that these cuts to benefits have to be large is just an indicator of how big our budget shortfall is. There's a variety of different ways to reduce costs. But the basic point is that the choice between balancing the budget by raising taxes or by reducing spending isn't just a philosophical choice about whether I like big or small government. One of those approaches is more likely to succeed than the other approach.
Specifically on the subject of Social Security--you say we'll maybe move in a direction where it's more of a safety net. What would that mean for retirement planning and the way we provide for the elderly in this country?
It would definitely mean a change in how people prepare for retirement. If social security shifts to be more of a safety-net focused program, middle and high income Americans are going to have to save more for retirement. There's no question about that. People who are not maxing out their 401(k)s or IRAs are simply going to have to do that. But I think the typical person would be happier paying more into their own 401(k) than paying more taxes that may or may not be saved in the Social Security trust fund and may or may not go to their retirement. So the solution isn't a perfect one or a painless one, but I think it's better than the alternatives.
The idea of privatization was discussed in the Bush administration. How has the recession impacted the willingness to embrace that plan?
I don't see a huge impact. People are definitely saving more today than they were four or five years ago. On the one hand, market returns have not been great over in the last few years, so people don't see the stock market as a money machine anymore. But they have a renewed appreciation for the need to save. And so I think the idea of preparing better for retirement and putting more into 401(k)s and other savings vehicles is something most Americans can accept now.
Do these types of cuts necessary to balance the budget pose a risk to the economic recovery?
There is some risk of that in the very short term. From the evidence, the risk is far smaller than if you were to raise taxes. In the short term what we found was that cutting spending had essentially no effect on economic growth, whereas raising taxes tended to have a negative effect.
But we would not be making massive spending cuts today. It's a path for going forward where we gradually reduce these costs, increase the retirement age, and reduce benefits over time. The idea isn't to have the hammer come down today, but to have some slow and steady but still very significant reductions in government outlays over a period of decades.
But how politically feasible do you think this is? How ready are people to tackle this challenge?
It's going to depend really on where the president decides to go with this. We'll know more in a few days when he does the State of the Union address. I think there are real incentives for him to get on with this, though. Clearly, from a budgetary standpoint, we need to do something, to give financial markets in particular some confidence that we can get on top of these problems.
Politically speaking, balancing the budget is something that is very important to people who are independent or in the political center, and those are precisely the people that Obama and the Democratic Party lost in the midterms. The problem will be that the liberal wing of the Democratic Party is really opposed to any spending reductions.
Is there something that you don't think gets enough attention in the national discussion over cutting the deficit?
A good way of thinking about these programs is to back up and ask why we have them and what is the best way to achieve these goals. The programs are complicated, and often people spend so much time learning how they work that once they do, they can't really think outside the box. Radical reforms might be easier than simply tweaking things, because more radical reforms signal to people that we're all going to have to make some adjustments. And we really need to rethink how we do a lot of this stuff.
What's an example of a possible large shift we might consider?
There's the idea of setting up universal retirement savings accounts or even mandatory retirement savings accounts, where you're telling people, 'Look, you have to set aside some money today where you can cover your income and your health care needs in retirement. You can't just count on having millions of younger Americans there to pay for these things for you, because those people aren't there anymore.' We've got an older society with more retirees and fewer workers. That's a way that is new but also a commonsense way of getting on top of these things.
Andrew G. Biggs is a resident scholar at AEI.