September 17, 2014

House Budget Chairman Paul Ryan's Dilemma

* Updated based on the CBO Preliminary Analysis of the President’s Budget released on March 18 

As the new chairman of the House Budget Committee, Paul Ryan faces a daunting task in producing a budget resolution that satisfies the policy goals of House Republicans -- especially the new members -- while still showing substantial deficit reduction.

Specifically, the combination of a still sluggish economy, extension of expiring tax cuts (a top Republican priority), continuing war costs, growing costs for popular entitlements (Social Security, Medicare, Medicaid) and interest payments on the debt make swift and dramatic improvements in the deficit a very challenging goal.

Nevertheless, expectations are running high. Republicans took control of the House based in part on a “Pledge to America,” which warned about the dire consequences of deficits and promised to address them without raising taxes or cutting national defense spending.

The pledge was silent on entitlement reforms, other than to call for a “responsible, fact-based conversation.” More recently, Speaker John Boehner has said that cost containment goals for entitlement programs would be included in the budget resolution, but he did not commit to any specific policy objectives. Moreover, many Republicans have been critical of the Medicare cuts already enacted as part of the 2010 Affordable Care Act (ACA). And the experiences of recent deficit reduction commissions indicate that savings from Social Security and Medicare reform may not produce high levels of immediate deficit reduction because changes in those programs must be gradually phased in so that beneficiaries can adjust to the changes.

Last year, House Democrats, who were more open to higher taxes and defense cuts, failed to write a budget because of their reluctance to be seen as voting for high deficits throughout the budget window.

For Ryan, however, the political risk of not writing a budget outweighs the risk of writing one -- even if the numbers in it are not everything his caucus may hope for. The Democrats’ failure to write a budget in the House was among the top items Ryan criticized during the campaign season and in his response to President Obama’s State of the Union message. Furthermore, the President’s proposed budget was criticized by Ryan and other Republicans for not bringing deficits down enough, and for not doing so quickly.

Yet the same ugly deficit fundamentals that stymied Democratic budget-writers last year, and that made the President’s recent budget proposal seem so inadequate, will confront Ryan and his fellow budget committee members with some very difficult choices.

Here are just a few of the stickiest of these choices:

Economic Projections and Deficit Levels

Presumably, Ryan will want to produce a budget that improves upon the deficit levels in the President’s budget. This, however, will not be as easy as some of his colleagues may assume.

The President’s budget includes the administration’s policy proposals and the administration’s own estimates of economic growth over the next 10 years. In this year’s budget, the administration projects that economic growth will exceed the projections of the Congressional Budget Office (CBO), which the House Budget Committee traditionally relies on for economic estimates.

The administration’s current-law (BEA) baseline assumes 10-year deficits totaling $1.2 trillion less than the comparable CBO baseline ($5.5 trillion versus $6.7 trillion). The difference is mostly because the administration assumes much higher baseline revenues (meaning revenues before the enactment of new policies) over the 10-year period. This comes from more favorable economic assumptions and more favorable technical assumptions about the amount of revenues the tax system will yield.

Thus, the administration has given itself a head start by assuming lower deficits to begin with. It also has a policy advantage in that it is willing to include tax increases in its policy recommendations, both as offsets for new initiatives and for deficit reduction.

By contrast, Ryan will be restricted on the policy front by his party’s position that the deficit is strictly a spending problem. Furthermore, while there is nothing that prevents the Budget Committee from creating its own economic estimates, or even adopting the President’s numbers, GOP rhetoric chastising the President’s budget and past experience would make that difficult.

One of the main disputes between the Clinton administration and the Gingrich Congress during the government shutdown battles in the mid-1990s was over the use of CBO estimates instead of Clinton administration estimates. Republicans insisted that CBO numbers be used in any negotiations over spending and tax levels because they felt the CBO was more neutral.

Maintaining that stance and using CBO numbers is the proper course for Ryan. It does, however, mean that the President has more leeway to produce favorable deficit numbers because he has two levers at his disposal -- legislative changes and his own economic estimates -- where even small changes towards higher growth can have a fairly significant impact in lowering deficits over the budget window.

On the other hand, Ryan has one advantage. Unlike the President’s Budget -- which lists policy proposals and numerical targets for revenues, deficits and spending -- the congressional budget resolution only requires numerical targets, and normally does not go into the specific policy proposals to achieve them. This will allow a degree of vagueness that will make it easier to tout bottom-line numbers without necessarily having to fight over every small proposal to achieve them.

Nevertheless, the numbers still have to add up and be plausible, and in this case sticking with CBO numbers leaves Republicans with a tough playing field. The economy is only slowly coming out of the recession and CBO does not project a rapid or dramatic change. The highest annual growth rate projected (3.8 percent in 2015) is still shy of the levels from the late 1990s, and growth slows closer to 2 percent annually later in the budget window, as more of the baby boom generation leaves the workforce. In CBO estimates, unemployment remains above 6 percent until 2015, and never reaches pre-crisis (2007) levels during the budget window.

As a result, all other things equal, tax revenues will be lower and mandatory spending programs will likely cost more than they would under stronger economic conditions. Thus, while Republicans are aiming for deficit levels achieved during relatively strong economic years (meaning deficits as low as during the end of the Bush administration, or even the balanced budget years of the late 1990s) achieving such low deficit levels now, even if only on paper, will require some heroic lifting from policy changes. Just how much heavy lifting is needed depends on the level of deficits acceptable to a majority of House Republicans.

As noted, CBO projects an additional $6.7 trillion in deficits over the budget window, with debt held by the public rising from 68.9 percent of gross domestic product in 2011 to 75.6 percent in 2021. By 2016, deficits drop from the 9.3 percent of GDP ($1.4 trillion) projected in 2011 to 3.3 percent of GDP ($635 billion). Deficits average just under 3.0 percent beyond then (ticking up to $729 billion in 2021). This is relatively consistent with where the Administration projects its budget to come out, aided by the administration’s more optimistic economic estimates. The CBO’s Preliminary Analysis of the President’s budget from March, which uses CBO’s economic estimates and policy analysis, projects substantially higher deficits totaling $9.4 trillion and averaging 4.6 percent of GDP over the final five years.

Deficits of 3 percent of GDP, as the CBO baseline achieves, are thought by many economists to be a meaningful goal because the added debt would, at least temporarily, grow no faster than the economy and would thus hover around a sustainable level. Given the large fiscal imbalances lurking in our future, this target should represent a floor of achievement for the next 10 years. Getting to a balanced budget would require a much greater pull on the policy lever.

Policy Lever

With the economy working against an easy path to low projected deficits, the “policy lever” for deficit reduction will be the most important tool for the Budget Committee. Right now, the House Republican conference seems to be focused on cutting “non-security” discretionary spending as its main policy lever for reducing the deficit. Yet this represents only about 12 percent of the budget and even zeroing it out would not produce a balanced budget.

Relying primarily on this policy lever will make it impossible to show substantial improvement in deficits over the budget window. It also makes it impossible to achieve better deficit results than the President’s budget, which draws on a wider range of potential savings.

A key consideration for Ryan’s committee will thus be the extent to which it is willing to venture beyond the safe ground of non-security spending to lower the deficit. Other policy options include restraining defense spending and entitlement spending, or increasing revenues.

The CBO baseline reaches a sustainable level of deficits because following current law brings deficits down through a very diverse set of fiscal policy levers. The CBO baseline contains much higher revenues in the future because it assumes the 2001 and 2003 tax cuts, which were extended in December 2010, will expire as written in current law at the end of 2012. It also has higher revenues due to the Alternative Minimum Tax’s (AMT) scheduled encroachment on the middle class, and the expiration of a number of “tax extenders” -- or narrow deductions and credits -- which are traditionally extended annually.

If all of these current-law assumptions are taken off the table because they might be defined by some people as “tax increases,” the revenue loss and associated debt service push the 10-year deficit projection up by another $5.6 trillion. That means the hole Ryan’s committee wants to fill with spending cuts alone rises to $12.3 trillion over 10 years rather than the baseline deficit of $6.7 trillion. The baseline deficit in 2016, without the assumed higher revenues, rises from $635 billion to $1.2 trillion.

In the ongoing debate over finishing up FY2011 appropriations, Republicans have made it clear that they are prepared to vote for tough limits on non-security discretionary spending. However, the long-term potential savings in this area are restrained by the relatively small part of the budget they comprise and because the CBO baseline already has what would, by historical standards, be considered fairly tight constraints on domestic discretionary programs. CBO projects that such spending will only increase at the rate of inflation -- slower than it tends to rise historically, and slower than would be needed to keep up with projected economic and population growth. By 2021, non-defense outlays are projected to shrink from 4.4 percent of GDP in 2011 to 3.1 percent, the lowest level since 2001.

The CBO baseline also assumes some mandatory spending cuts -- especially in Medicare. For example, it assumes a dramatic cut in physician payments under Medicare (about 29 percent starting in 2012) which policymakers continually “fix” regularly. Enacting a 10-year fix without offsets would add another $360 billion to projected deficits.

The other Medicare baseline cuts are the ones enacted in the 2010 health care reform legislation. Not only did the ACA directly cut certain programs in Medicare, such as Medicare Advantage, it also set up a series of austere targets for spending on some Medicare providers. These cuts are reinforced, beginning in 2018, by an independent commission that can only be overruled through congressional legislation signed by the President.

Repealing the ACA, as Republicans have advocated, would eliminate not just the new spending in the bill but also the Medicare cuts and tax increases enacted to pay for it. According to CBO estimates, repeal of the ACA would thus be scored as a deficit increase.

By demonstrating what the fiscal result would be were Congress and the President to leave Washington, or at least leave current law alone, the CBO baseline shows that a broad fiscal policy effort can substantially slow the growth of debt.

While House Republicans need not make the exact policy choices inherent in the CBO baseline, they will have to at least pay for all of the choices they do make that diverge from the baseline. Otherwise, they will not be able to reach even the 3 percent of GDP deficit level targeted by economists.

If they aren’t prepared to let tax rates rise as they would under current law, Republicans will need to cut spending to offset the loss of revenue or raise revenue in other ways, such as by cutting tax expenditures and broadening the tax base. They will also need to acknowledge the costs of maintaining Medicare doctor payments, which Republicans have continuously supported, or pledge to allow scheduled cuts to take effect.

In short, a truly honest budget would either pay for the choices made to diverge from current law and the CBO baseline, or account for the higher deficits that come from not offsetting those choices.

The Results

Two hypothetical budgets serve to illustrate how difficult it is to substantially reduce the deficit using a narrow set of policy options. These are not intended to be predictions of where Ryan and his committee will end up or the eventual policy options they will choose. These hypothetical budgets simply show the results of extending current policies that enjoy widespread support among Republicans and applying different sets of proposed spending cuts.

The first hypothetical budget assumes that Republicans repeal the ACA and follow current policy in other areas -- extend all of the expiring tax cuts, reduce war spending over the next ten years (roughly following Obama Administration and CBO estimates), and prevent drastic cuts in Medicare physician payments. It then applies spending cuts proposed by the Republican Study Committee (RSC), which would freeze non-defense discretionary spending at 2006 levels and then cut another $200 billion in other spending. In all, the RSC estimates that its spending cuts would reduce the deficits by $2.7 trillion (including debt service savings) over 10 years.

Under this scenario, the resulting deficits would be $2.1 trillion larger over 10 years than the CBO baseline ($8.8 trillion vs. $6.7 trillion). Deficits would be lower than CBO’s analysis of the President's budget by $700 billion. Deficits as a percent of GDP would never drop below 4.0 percent (2017) or $755 billion (2014). Debt held by the public would rise to 84.3 percent in 2021.

The second hypothetical broadens the policy options and borrows some generous scoring assumptions utilized in the President’s budget and at times by past Congresses.

It freezes defense spending at current levels (FY 2011) over ten years, which reduces deficits by $389 billion. Consistent with the President’s budget and some past Congressional budgets, it assumes the Medicare “doc fix” for the currently programmed cuts in Medicare physician reimbursements will be offset throughout the budget window. This reduces baseline deficits.

The second hypothetical also assumes that AMT relief will be offset for three years and then add to the deficit beyond that. Prior Congressional budgets have been all over the map on how many years of AMT relief are proposed and paid for -- so this analysis follows the Administration’s proposal to pay for three years which reduces baseline deficits.

Republicans may or may not want to use these same assumptions, and in the case of AMT reform, it seems unlikely that they would agree to the administration’s three-year offset, which limits itemized tax deductions for upper-income households. In any event, since assumptions about the “doc fix” and AMT relief have often been altered in budgets from both parties, in order to make the numbers look better, for purposes of this analysis we assume that the Republicans will match the administration’s assumptions.

There has also been some discussion of including fundamental entitlement reform in the House Republicans’ budget. While the appropriate committees of jurisdiction must write specific legislation within the overall framework of the budget resolution, Ryan could assume entitlement changes consistent with known options. One such option is his proposal (made with former Clinton Administration OMB Director Alice Rivlin) to reform Medicare by turning it into a voucher-based system. CBO estimates that this would reduce deficits over the first 10 years by $389 billion.[1]

Making these changes, combined with the spending cuts in the RSC proposal, gets the Republican budget to $7.3 trillion in deficits relative to CBO’s $6.7 trillion. In this scenario, debt held by the public as a percentage of GDP increases over the 10-year period from 72.4 percent to 77.9 percent.

Additional entitlement cuts could be thrown into the mix. However, within the 10-year budget window it will be difficult to come up with enough savings to dramatically improve the basic budget picture. Changes such as raising eligibility ages or altering the Social Security benefit formula would need to be phased in. Other options, such as charging higher Medicare premiums or switching to a less generous (if more realistic) cost-of-living index, could have a more immediate effect. But Ryan has repeatedly stated that current beneficiaries or those near retirement would not be affected by reforms.

The Takeaway

House Republican leaders are very familiar with the numbers. They know that the deficit must be brought down. Yet they also know that even meeting the modest deficit-reduction goal of the CBO baseline will require spending cuts that go far beyond what can be achieved by targeting non-security appropriations alone, particularly if anything labeled a “tax increase” is removed from consideration.

Managing expectations about what can realistically be accomplished in the current budget window is thus a crucial first step in crafting a budget. If budget balance is what it will take to get the votes of the Republican conference, Ryan and his budget committee are in for a rough ride. Even the aggressive deficit-reduction plans recommended by the President’s National Commission on Fiscal Responsibility and Reform (Bowles-Simpson) and the Bipartisan Policy Center’s Debt Reduction Task Force (Rivlin-Domenici) failed to produce balanced budgets within the coming decade. And these two groups were far more open to a broader range of spending cuts and tax increases than House Republicans currently appear to be.

Budget scoring gimmicks or adopting a rosy economic scenario can always be used in place of hard choices, but this comes at the expense of credibility.

So the dilemma is plain. A budget that uses honest numbers and reflects Republicans’ current policy preferences will result in large continuing deficits with growing debt and growing interest costs. On the other hand, a budget that shows greater progress on reducing the deficit will, of necessity, require an openness to changes that Republicans have been reluctant to put in play such as defense cuts, revenue increases and entitlement reforms that could affect current beneficiaries.

Ideally, the Republicans will take this second route -- acknowledging the unpleasant realities of the federal budget and presenting the serious and specific fiscal reform plan that they have promised the American public.

A good place to start would be to give closer consideration to the recommendations of the bipartisan Bowles-Simpson and Rivlin-Domenici commissions. They put everything on the table, including defense cuts and tax reforms that increase revenues by limiting tax “entitlements” -- federal subsidies administered through the tax code. The commissions also include savings from Social Security and Medicare reform, but for those programs the focus must be on cumulative savings stretching beyond the 10-year window.

Republicans have criticized the President for failing to incorporate more of the policy recommendations of his own fiscal commission in his proposed budget. The question now is whether they will do any better.

 


 
Footnotes

[1] CBO Letter to Ryan, Preliminary Analysis of the Ryan-Rivlin Health Care Proposal, November 17, 2010. The CBO subtracted $70 billion from the deficit-reducing potential of Ryan-Rivlin because it includes a repeal of the CLASS act (which saves money over its first 10 years). Since that is already counted in both scenarios as part of the cost of ACA repeal, we have added $70 billion in additional savings to the score of the Ryan-Rivlin plan.