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Balanced Budget Amendment Would Address Fiscal, Credibility Deficits

e21 | 11/14/2011
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A constitutional requirement to submit a balanced budget is essential to improving the economic governance of the nation and establishing trust with the electorate. The Balanced Budget Amendment that the House of Representatives passed in July as part of the Cut, Cap, and Balance Act is a far more sensible approach to fiscal policy than many commentators assume. The problem is not simply the size of current and projected fiscal deficits; the U.S. federal government faces a serious credibility deficit that is tied directly to dishonest and hyper-politicized budgeting. In its current form, the amendment is far from perfect, but its problems can be addressed in a way that promotes fiscal stability and probity in public finance. This issue is about to heat up again as the already enacted Budget Control Act requires a vote by each chamber this winter (before December 31st) on a balance budget amendment.

The ongoing European sovereign debt crisis reveals the critical importance of sound budgeting to the stability of the economy and broader society. Countries like Greece not only borrowed too much with no credible plan for repayment, but also failed to account honestly for their spending and anticipated tax receipts. In October 2009, the Greek government increased its projected budget deficit from 3.7% of GDP to 12.5%. Within 7 months, the country could no longer borrow in public debt markets, not only because its deficit was so large (it was roughly on par with the U.S. deficit), but because no one could trust the government’s figures. The deception continues to this day, with European and International Monetary Fund (IMF) inspectors continuing to identify irregularities and excessive optimism in forecasts related to the current austerity program. The leaders of France and Germany have proposed a Balanced Budget Amendment across the euro zone as part of the rescue not only to ensure budgets are balanced, but also to increase the transparency and integrity of the budget process in member countries.

While the problems in the U.S. are less egregious, the budget process also suffers from institutionalized corruption of its own. In 2010, the IMF published an assessment of the U.S. fiscal condition entitled “Reading the Tea Leaves” because of the lack of credible U.S. government statistics about likely budgetary outcomes. On the one hand, the Congressional Budget Office (CBO) is required to base its estimates on current law, which often includes a number of unrealistic assumptions about spending and tax policy. On the other hand, the Office of Management and Budget (OMB) includes the budgetary impact of expected policies, but tends to employ overly optimistic assumptions about economic growth, revenue, and interest rates that combine to produce unrealistically optimistic deficit figures. For example, this year OMB underestimated the deficit impact of the President’s policies by between $2.3 trillion (CBO) and $4.6 trillion (IMF) over ten years.

Either way, a citizen (or foreign creditor) seeking knowledge of the current budget situation is being misled. CBO states that current tax policy will expire on schedule and current temporary spending on items like the war will continue on indefinitely and increase annually at the rate of inflation; OMB provides a sense of the likely policy course (or at least the policies advocated by the President) but massages the books so as to reduce cumulative deficits by trillions of dollars.

As explained by e21 previously, this year the Administration took the budget deception game up another notch by refusing to provide details about a supposed “Grand Bargain” in the 2011 Mid-Session Review, which also came 48 days after its statutory deadline but yet was still based on dated economic forecasts despite the delay.

In the recent submission to the Select Joint Committee on Deficit Reduction, the Administration arrived at $3 trillion in cumulative deficit reduction by taking credit for $1.5 trillion in tax increases already included in the President’s Budget. In February, the President proposed a Budget plan that reduced the revenue baseline by $3 trillion to account for permanent extension of the 2001/2003 tax relief for households with less than $200,000 of income. Already “baked in” to the Administration’s baseline was the $900 billion from allowing current tax rates to expire for higher income households. In addition, the Administration proposed $320 billion of entirely new tax increases on high-income households through a reduction in itemize deductions, and more than $330 billion in new tax increases on oil and gas companies, foreign-sourced corporate income, and banks. Taken together, this tax increase was about $1.5 trillion relative to current policy.

The problem is these revenues were already included in the CBO score of the President’s Budget. And even with these revenues, CBO estimated the President’s budget would cause the federal debt to explode to 87% of GDP by 2021. The Administration takes credit for these revenues by pretending the CBO score of the President’s Budget doesn’t exist. Instead, they use an “adjusted baseline” that first adds $5.9 trillion (Table S-4) to the CBO baseline before “cutting” $4.03 trillion.

This means that the “deficit reduction” proposed by the Obama Administration generates $2 trillion more in cumulative deficits than the CBO baseline. It also means that the Administration believes that the expected cumulative deficits are nearly $6 trillion (40% of current GDP) larger than official estimates would suggest. An adjustment to the baseline of this size has a distinctive Hellenic flavor to it, does it not?

Moreover, schizophrenic use of baselines breeds cynicism by making it difficult to isolate true deficit reduction from shenanigans. The “American Jobs Act” would increase next year’s deficit by $447 billion (3% of GDP). But the Administration claims it is “fully offset” with the same revenues it already proposed in its fiscal year 2012 budget – which is also already accounted for by CBO.

The baseline adjusts to suit the political exigency of the moment, with talking points ready to defend whatever baseline the current circumstance deems more advantageous to the political objective at hand. On the one hand, the Administration demands that the baseline include revenues from the 2001/2003 tax cuts for high incomes for PAYGO purposes. This forces an extension of current tax rates to be offset with spending cuts or tax increases elsewhere when these rates expire. On the other hand, when asked for deficit reduction proposals, the Administration demands that the baseline exclude revenues from 2001/2003 tax relief so that existing law gets treated as a tax increase for the purposes of deficit reduction.

A balanced budget amendment could confront these problems if structured correctly. First, the President and Congress should be forced to use a common baseline so that any change to current policy is scored according to its budgetary impact. This would eliminate the multiple baseline trickery and double-counting that plagues current discussions. Secondly, a single economic and “technical” forecast should be used to ensure balanced budgets are not the product of overly optimistic assumptions about the economy or the growth in entitlement programs. Third, if the integrity of the numbers is assured, the balanced budget requirement should be based on cyclical-adjusted revenues and spending. This means that the budget could be in deficit for the year, but only if an unforeseen recession caused revenues to fall short of forecast or spending to exceed expectations due to increased claims on income support programs.

The last point is perhaps the most important: much of the commentary on the balanced budget amendment focuses on the supposed ignorance of those who’d force the government to tighten fiscal policy in a recession. An increase in tax rates to make up for a decline in taxable economic activity would be a bad thing generally during a time of stress, but discretionary fiscal stimulus has proven to be just as counterproductive. A balanced budget amendment based on cyclically-adjusted budget balance could straddle all of these issues, as it would remove the need to close deficits at inopportune times while also blocking the kind of large, ad hoc increases in transfer payments that have increased the deficit so substantially over the past few years.

If elected officials want robust income support programs, they could include them in the baseline and ensure their costs are paid for over the business cycle. Indeed, the recent Swedish experience suggests that automatic spending provides more bang for the buck. Sweden’s deficit temporarily increased to 1% of GDP in 2009, but quickly rebounded thanks to the automatic nature of the stabilizers. Their budget is back in surplus. Although citing Sweden may instinctively scare some conservatives who are worried about the trends in Scandinavian tax policy, the country’s debt ratio has fallen from over 70% of GDP in 1997 to less than 36% today – thanks largely to a 17% reduction in the size of government over that time frame.

The federal government needs to close both a fiscal and credibility deficit. A strong argument can be made that the best way to accomplish this is through a constitutional amendment that imposes fundamental reform of the budgetary process on the elected branches of government.


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