The Fiscal Cliff Kabuki Dance

Sometimes, pretending to do something serious about a problem is more dangerous than doing nothing at all. At least when you do nothing, you don’t fool yourself into believing that the problem is being solved.

Congress and President Obama are fooling themselves – and the country – that they are addressing the long-term federal budget crisis. They are not.

Currently, the president and the Republicans are offering plans that would reduce spending and increase taxes to the tune of around $2.3 trillion – give or take a few hundred billion – over the next 10 years. That sounds like a lot of money. It is not.

Oh, certainly, it will help slightly. But, in terms of actually solving our fiscal woes, their plans barely rise to the level of sticking your finger in the dam to save time.

So, what would it take to get our deficits down to manageable levels (mind you, not to balance the budget but to get our deficits low enough that they don’t increase our overall debt as a percentage of GDP)? Well, a lot.

To put things into perspective, entitlement spending (Social Security, Medicare, Obamacare and Medicaid) currently clock in at 10.3% of GDP. In less than 20 years – unless structurally reformed – they will grow to 15.3% of GDP.

Next up is interest on the debt. The United States currently has debt held by the public equal to 70% of GDP, but that figure is expected to increase to 100% of GDP over the next decade. Interest rates are quite low at the moment, but let’s assume that they move back to their historic average of around 4% over the next decade or so. That means that the government would need to spend 4% of GDP on interest on the debt.

So, in less than twenty years, the government will be spending 19.3% of GDP on entitlements and interest on the debt.

Now, historically, federal government revenues have been around 18% of GDP. It’s a little lower right now due to high unemployment and the general economic malaise, but we’ll assume that it recovers.

Hmm. Those numbers don’t quite add up, do they? It looks like we’d need to borrow 1.3% of GDP just to pay for entitlements and interest on debt.

Of course, we’d probably be able to borrow another 3-4% percent of GDP if the economy is growing at ~5% without increasing our debt to GDP ratio, i.e. you can borrow as much as your economy grows. This means that the government would have around 3.5% of GDP (borrowed money, mind you) to spend on everything else – defense, welfare, infrastructure, education, and, of course, Big Bird.

The only problem is that that the government currently spends around 12% of GDP on those things, though for the past 20 years or so, that figure was around 11% of GDP, so let’s use that figure.

So, even assuming that we don’t balance the budget, the president and Congress are looking at cutting around 70% of government spending that’s not on entitlements and interest on the debt to get our house in order over the next 20 years.

Of course, the government could raise taxes to make up the difference. Let’s see, to leave government spending alone, we’d need to increase taxes by 7.5% of GDP (remember, we’re borrowing 3.5% of GDP but need 11% of GDP to keep spending the same). Well, since federal income taxes currently make up 10% of GDP, we’d only need to raise taxes by 75% to get us through the next 20 years!

To put that in everyday terms, a household making $100,000 would have to pay an additional $7,500 a year in federal taxes. I’m sure that family will have no problem cutting back other spending by $625 a month. Who needs food anyway?

Well, that seems a bit harsh on taxpayers, so let’s split that 7.5% of GDP equally among taxpayers, entitlement spending and non-entitlement spending. Here’s what that looks like:

  • A 25% increase in taxes
  • A 23% cut in non-entitlement spending
  • A 16% cut in entitlement spending (or increased revenue from higher Medicare premiums and/or raising the age of eligibility)

That’s what real budget reform looks like. Somewhere or other, we need to find 7.5% of GDP – either through increased taxes, decreased spending or, more likely, both – to get our house in order over the next 20 to 30 years. The president and Congress are proposing deals that get us around 1.5% of GDP. It’s not chump change, but it doesn’t come close to solving the problem.

About Mark Helm, CFP, EA

Mark Helm is a Certified Financial Planner and Enrolled Agent. He is the founder of Helm Financial Advisors, LLC, a fee-only financial planning firm dedicated to helping people reach their life goals.
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