Despite missing the fiscal cliff, we still have a huge fiscal gap

From the Deseret News this past Tuesday.

So we avoided the fiscal cliff.  Forgive me if I am less than impressed with our political leaders.

The temporary Bush tax cuts passed in 2001 and 2003 are now permanent for incomes less than $400,000 per year.  The increase in taxes on incomes over this threshold is expected to net $617 billion over ten year.  To be exact, that is $617 billion more in revenue than would have been collected had tax rates on higher incomes remained unchanged.  On the spending side, automatic across-the-board cuts that would have gone into effect on January first will be delayed for two months.

As has been pointed out by numerous voices, this amounts to kicking the can down the road just a little further and does nothing to correct the fundamental underlying problem.

That problem is actually quite simple; our federal government is spending much more money than it collects.  The latest figures from the Bureau of Economic Analysis for the 3rd quarter of 2012 show that the federal government collected $2.7 trillion (at annual rates) in revenue, almost all of it in the form of taxes.  It spent $3.8 trillion, $2.3 trillion of that on transfer payments like Social Security and Medicare.  Fortunately, with interest rates near zero, the interest paid was only $288 billion.

Our fundamental problem as pointed out by University of Chicago economist, John Cochrane, is that we are spending like we are Europe, but still taxing like we are the U.S.  This is simply unsustainable.  In the long run the U.S. government must either cut spending or increase taxes.  And the movements on either end will need to be large.  How large? Well, note that all federal spending in the 3rd quarter on everything other than interest payments and transfer payments totaled just under $1.1 trillion.  In other words, we could completely eliminate all federal government services defense and non-defense and we would still not be able to close the budget deficit.

All this creates a large fiscal burden that must eventually be dealt with in the future.

When the government spends money it must get the funds in one of three ways:  tax, borrow, or inflate. In the short run, how the government gets the funds is not relevant.  Think of U.S. GDP; all the goods and services produced in a given year.  When the government spends it acquires some of these goods, whether it produces the revenue used to buy them by taxing, borrowing, printing the money, or simply seizing them, is irrelevant.  They have been taken and are at the disposal of the government.

In the long-run, however, if the government borrows it is obligated to repay its debts in the future.  One measure of how much the government owes is the national debt.  This is the dollar value of all the U.S. treasury bonds outstanding.  Currently this is $16.4 trillion.  However this number is misleading for a variety of reasons.  For example, it includes the value of bonds held by the U.S. Federal Reserve System, and excess revenue earned by the Federal Reserve is returned to the Treasury.  It also included bonds held by the Social Security Trust Fund.

In addition, naming conventions can cloud the issue of what is debt and what is not.  If the government promises future transfer payments to retirees, for example, it has taken on an obligation which must be paid at a later date, but the debt, as measured above will not change.

A more accurate measure of the level of underfunding of current and future spending versus revenues is the fiscal gap, which has been strongly promoted by Boston University economist, Larry Kotlikoff.  The fiscal gap takes the net present value of all promised payments plus the current net debt and subtracts the net present value of all likely revenues.  The net present values are taken from now to infinity, so it is important to have some notion in mind what will be happening in the long-run.  However, since the present values of amounts several decades in the future are small, the results are not very sensitive to these long run assumptions.

Using this method, Kotlikoff calculates that he fiscal gap is $222 trillion.  In other words the amount of money we have promised to pay in the future is short of the likely revenues we will collect by an amount that is greater than the value of all the goods and services that will be produced in the U.S. over the next decade.

The $617 billion in revenue collected by resolution of the fiscal cliff takes us less than three-tenths of a percent of the way to closing that $222 trillion gap.  Forgive me if I am less than impressed.