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News Release

Uncertainty over the rebuilding of US government finances

September 21, 2010

Overview

The US federal budget deficit reached $1.47 trillion in 2009. This unprecedented high is due in part to the shortage of revenue and large increase in government spending in conjunction with the economic recession that was triggered by the subprime loans crisis of 2007. Footing the bill for spending under the Bush administration has also been a burden on government finances.

The outlook for federal government finances is harsh, with problems on both the cyclical and the structural fronts.

・A major demand shortfall contributing to a recessionary GDP gap and continued stagnation of employment
In the second quarter of 2010 the GDP gap was recessionary at –6.3%, owing to a substantial demand shortfall. In spite of a large-scale economic stimulus package, positive signs such as capital investment growth and wages growth have been slow to emerge and there is little hope of a sustained high rate of growth. The unemployment rate is likely to remain close to double digits for some time.

・State and local governments also facing difficult times
State government finances are also suffering from a continued slump in tax revenues due to the recession and are reliant on fiscal support from the federal government under the provisions of the American Recovery and Reinvestment Act (ARRA). However, as support under the ARRA will come to an end, more or less, at the end of fiscal 2012, it is likely that state governments will face continued difficulties. Local governments have started to cut back on core public services in an effort to restore their fiscal balance. This will have a negative impact on the lives of ordinary citizens and risks triggering a vicious cycle in which further deterioration of the economy leads to further deterioration of government finances.

・An increase in the fiscal burden due to population aging
According to the Congressional Budget Office forecast, the Medical Care Insurance Reform Bill will reduce the fiscal deficit by more than $140 billion over the ten years to fiscal 2019. However, even if the intended reduction of the fiscal deficit is achieved, population aging means that healthcare-related spending will not stop growing: between 2015 and 2030, the baby-boomer generation will be reaching the age of 65.
What measures should the US explore with a view to ensuring steady progress towards rebuilding government finances in the midst of these medium- and long-term problems?

・Escaping from dependence on foreign finance
The United States depends on foreign investors for roughly half of its government bond finance and if these investors begin to have doubts as to the sustainability of US government finances, there is a risk that this will present an obstacle to the disposal of government bonds. Although, in the short term, there is little likelihood of foreign investors selling off large volumes of US government bonds, in the medium-to-long term, as the Chinese economy becomes less dependent on external demand and starts to see growth driven by internal demand, it may become more difficult for the US to procure the finance it needs to make up for a lack of savings. One measure the US should consider is increasing the proportion of government bonds sold domestically by promoting increased savings in the private sector.

・Bold cuts in healthcare-related government spending
Given the structure of the federal budget deficit, reform of medical care and social security, which account for a large part of expenditure, will be essential, especially reform of the Medicare program. A breakdown of income and expenditure under the Medicare program (parts B and D) reveals that the burden on the federal government is growing every year, putting federal government finances under increasing pressure. In addition to raising the rate of insurance contributions and reviewing the ratio of the federal budget allocated to medical care, measures to curb the cost of medical care itself, such as revising treatment fees, are urgently required.

・Identifying new sources of tax revenue
Measures to help make up the unprecedented federal budget deficit must not be confined to a review of existing taxation; efforts should be made to find new sources of tax revenue. One possibility would the introduction of a value added tax (VAT), corresponding to Japan's consumption tax. Estimates by the private think-tank Tax Policy Center suggest that a basic levy would bring a net increase in tax revenues of more than $250 billion. Simulations of the change in federal government fiscal revenue and expenditure after the introduction of a VAT suggest that it would go some way to improving government finances. Using VAT revenue to fund a reduction in payroll taxation would help to reduce the regressivity that is one of the demerits of VAT.

However, putting the above measures into practice is likely to be quite difficult. Closing the substantial GDP gap is likely to take a long time and there is a risk that introducing large-scale tax increases in the midst of an economic recession will lead to a further slowdown. Moreover, Obama's Democratic administration, which is already suffering from a decline in popular support in the lead up to the mid-term elections, is expected to face a difficult campaign in the lead up to the mid-term elections, and if the Republican Party gains control of Congress, Obama will find it still more difficult to stay in control of government. For these reasons, the path to restoring sustainability in US government finances is highly uncertain.

For more information on the content of this report, please contact Yusuke Shimoda, the Japan Research Institute, Limited.

E-mail:report@jri.co.jp

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