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The Federal Government’s Long-Term Fiscal Outlook

GAO-13-148SP, Dec 3, 2012

Fall 2012 Update

GAO’s simulations continue to illustrate that the federal government is on an unsustainable long-term fiscal path. In both the Baseline Extended and Alternative simulations, debt held by the public grows as a share of gross domestic product (GDP) over the long term as shown in figure 1. While the timing and pace of growth varies depending on the assumptions used, neither set of assumptions achieves a sustainable path.

In the Baseline Extended simulation, which assumes current law, including the discretionary spending limits and other spending reductions contained in the Budget Control Act (BCA) of 2011 and expiration of certain tax cuts enacted in 2001 and 2003, debt as a share of GDP declines in the short term before turning up again.

In the Alternative simulation, in which these laws are assumed to not take full effect, federal debt as a share of GDP grows throughout the period. Discretionary spending limits alone do not address the fundamental imbalance between estimated revenue and spending, which is driven largely by the aging of the population and rising health care costs.

The Patient Protection and Affordable Care Act (PPACA) slows the growth of health care spending and federal debt under the Baseline Extended simulation, in which cost-containment mechanisms are assumed to be fully implemented and effective.

However, some have questioned whether these mechanisms can be sustained over the long term; this is reflected in GAO’s Alternative simulation.

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Figure 1: Debt Held by the Public under Two Fiscal Policy Simulations

Significant actions to change the long-term fiscal path must be taken and the design of these actions should take into account concerns about the near-term impact on economic growth.

In the near term, for example, the Baseline Extended simulation reflects a number of fiscal policy changes contained in current law that are projected to sharply reduce spending and raise revenue from their current levels beginning in 2013.

CBO, the Federal Reserve Board Chairman, and others project that such drastic fiscal tightening—commonly referred to as the “fiscal cliff”—could disrupt economic growth.

In the Alternative simulation, historcial trends and past policy preferences are assumed to continue; revenue is lower and spending is higher than in the Baseline Extended simulation.

While CBO projects that continuation of such polices would prevent disruptions to the economy in the very near term, it would lead to higher debt over the long term.

In both GAO simulations spending for the major health and retirement programs will increase in coming decades, putting greater pressure on the rest of the federal budget. For the first few decades this spending is driven largely by the aging of the population.

The oldest members of the baby-boom generation are already eligible for Social Security retirement benefits and for Medicare, and, as shown in figure 2, the number of baby boomers turning 65 is projected to grow in coming years from an average of about 7,600 per day in 2011 to more than 11,000 per day in 2029.

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Figure 2: Daily Average Number of People Turning 65 Each Year

Health care spending has been growing faster than the overall economy and is expected to continue growing as more members of the baby-boom generation become eligible for federal health programs and the cost of caring for each enrollee increases.

If PPACA is implemented as currently written and is effective, it would have a major effect on slowing the rate of growth in federal health care spending as shown in our Baseline Extended simulation.

In this simulation, spending on Medicare and Medicaid, the Children’s Health Insurance Program (CHIP), and exchange subsidies grows from 5 percent of GDP in 2010 to over 7 percent by 2030.

If, however, the cost containment measures are not sustained over the long term—a concern expressed by the Trustees, the CMS Actuary, the CBO, and others—spending on federal health care programs grows much more rapidly.

Spending on Medicare and Medicaid, CHIP, and exchange subsidies under the Alternative simulation grows to over 8 percent of GDP by 2030.

Figures 3 and 4 below show revenue and the composition of spending in the Baseline Extended and Alternative scenarios moving forward.

In the Baseline Extended simulation, not only is health care spending growth slower, but revenue as a share of the economy is higher and discretionary spending lower than at any point in the last 50 years.

Even in this simulation, revenue covers little more than spending on Social Security, Medicare, Medicaid, CHIP, exchange subsidies, and interest in 2040 (see fig. 3).

There is little room for “all other spending,” which includes not only national defense, homeland security, veteran’s health care, and investment in highways and mass transit, but also smaller entitlement programs such as farm price supports and student loans.

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Figure 3: Potential Fiscal Outcomes: Revenues and Composition of Spending in the Baseline Extended Simulation

As figure 4 shows, if the federal government continues on the current path, as assumed in the Alternative simulation, and borrows from the public to finance the growing imbalance between revenue and spending, by 2040 more than half of all federal revenue will go to net interest payments.

Overall, our simulations illustrate the difficult trade-offs that policymakers will have to consider in order to put the federal government on a more sustainable path.

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Figure 4: Potential Fiscal Outcomes: Revenues and Composition of Spending in the Alternative Simulation

Balancing Near-Term and Long-Term Considerations

One measure of the challenge over the long term is the “fiscal gap.” The fiscal gap represents the difference, or gap, between revenue and noninterest spending over a certain period, such as 75 years, that would need to be closed in order to achieve a specified debt level at the end of the period.

From the fiscal gap, one can calculate the size of action needed—in terms of tax increases, spending reductions, or, more likely, some combination of the two—to close the gap.

For example, to keep debt held by the public as a share of GDP in 2086 from exceeding its level at the beginning of 2012 (roughly 68 percent of GDP) in our Alternative simulation, the fiscal gap is 8.3 percent of GDP.

This means that revenue would have to increase by 46 percent or noninterest spending would have to be reduced by about 32 percent (or some combination of the two) on average over the 75-year period. Even more significant changes would be needed to reduce debt to lower levels.

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Figure 5: Debt Held by the Public under Fiscal Policy Simulations with Different Assumptions for Major Entitlement Programs

The simulation results depend largely on what is assumed about growth in large entitlement programs. As in previous updates, we also show the Baseline Extended simulation using both Trustees and CBO estimates for long-term spending on Social Security and major health entitlement programs (Medicare, Medicaid, and others).

In addition, we show the Alternative simulation using different assumptions about certain health care cost-containment provisions based on CBO and CMS Actuary alternative projections. As figure 5 shows, the results are not materially different. The outlook under either set of assumptions is unsustainable.

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When considering action to address the longer-term fiscal challenge, it is important to recognize the current state of the economy.

With this in mind, policy changes could be designed to phase in over time allowing for the economy to fully recover and for people to adjust to the changes. However, the longer action is delayed the greater the risk that the eventual changes will be disruptive and destabilizing.

Under our Alternative simulation, waiting 10 years would increase the fiscal gap to nearly 10 percent of GDP—meaning a revenue increase of more than 54 percent or a noninterest spending cut of about 37 percent or some combination of the two would be required to bring debt held by the public back to its level in 2012 by 2086.

Concluding Observations

Addressing the long-term fiscal challenge will likely require difficult choices affecting both revenue and spending. In addition, the need to act soon to develop a plan for addressing the long-term fiscal imbalance must be balanced with concerns about the near-term impact of policy decisions.

Action now would allow for the greatest range of options to address the fiscal imbalance and strengthen the economy for the long term. Many of the long-term drivers highlighted in past updates, including health care cost growth and the aging population, have already begun to affect the federal budget. These are challenges for which there are no quick or easy solutions.

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