(By Mani) The Great Recession helped to swell the size of the U.S. budget deficit over the past few years. Not only did the downturn impart a blow to revenues via reduced tax collections, but legislative changes like the extension of the Bush tax cuts and the reduction in the payroll tax have also helped to depress the revenue-to-GDP ratio.
The ratio should rise from its current rate of roughly 16 percent. Under the Congressional Budget Office (CBO's) baseline scenario, individual income tax rates are assumed to revert to their pre-2001 rates in 2013, and the CBO projects that the revenue-to-GDP ratio will trend up to roughly 24 percent over the next 25 years. Under the alternative fiscal scenario, the ratio rises to 18 percent over the next few years as the economy continues to recover.
"The United States faces some painful revenue choices," Wells Fargo economist John Silvia wrote in a note to clients.
On the one hand, the economy likely will fall back into recession in 2013 if tax rates are allowed to rise as the baseline scenario assumes. On the other hand, the United States faces the possibility of another downgrade by the major ratings agencies if deficits evolve as the alternative fiscal scenario projects.
Sooner or later, long-term borrowing costs could jump higher, which could lead to slower economic growth, if the debt-to-GDP ratio grows unchecked.
"Either the U.S. government spends too much at its current level of revenues, or it takes in too little revenue at its current level of spending. Either way, the current policy mix is unsustainable," Silvia noted.
The future path of revenues clearly depends on the tax policy decisions that will be made in the coming months. Under current law, which is represented by the CBO's baseline scenario, there is a host of tax rates that are set to increase beginning in January 2013.
Not only are the 2001 tax cuts that are set to expire at the end of 2012, but the alternative minimum tax (AMT) will have expanded its reach in 2013, and the tax provisions within the Affordable Care Act will be implemented. The result of these legislated tax hikes is that revenues as a share of GDP would jump to 18.4 percent in 2013 from an estimated 15.7 percent in 2012.
"Looking further ahead, revenues as a percent of GDP would then continue to grow to 23.7 percent by 2037," the economist said.
Under the alternative fiscal scenario, the CBO assumes that current policy is maintained. That is, the alternative fiscal scenario assumes that many existing tax breaks are extended. Under this scenario, the Bush tax cuts would be extended, and the alternative minimum tax relief would continue (shielding many taxpayers from higher liabilities).
In addition, the 2012 estate tax rates and taxable asset levels would remain in place, and other expiring tax provisions would be continued, with the exception of the social security payroll tax cut. Under the extended alternative fiscal scenario, revenues would edge up to 16.3 percent in 2013 from an estimated 15.7 percent of GDP in 2012, primarily due to the expiration of the payroll tax cut. Revenues would then continue to rise until they stabilize in 2022 at around 18 percent of GDP, consistent with the 40-year average for revenues.
"Regardless of the election outcome in November, important fiscal policy changes will be needed in order to keep our country on a long-run path to fiscal stability," Silvia noted.