Implications of the Looming
Budget Adjustments for
Macroeconomic Activity
Alan J. Auerbach
University of California,
Berkeley
December 2, 2005
Outline
What We Face
Policy Changes to Expect
The Impact of These Changes
How We Could Do Better
What We Face
Huge Long-Run Imbalance
Using CBO 10-year baseline:
– 4.6% of GDP through 2080
– 7.9% of GDP permanently
Using Adjusted 10-year baseline:
– 7.3% through 2080
– 10.6% permanently
What We Face
Long-run gap substantially larger than five
years ago
– January 2001: 3.3% - 4.1%
– Now: 7.9% - 10.6%
What happened?
– Spending growth
– Tax cuts
– The end is near(er)
– The economy (very little over long run)
Policy Changes to Expect
Three places to look (in decreasing order
of importance):
– Health Care (Medicare, Medicaid)
– General Revenue (i.e., not dedicated) Taxes
– Social Security
Policy Changes to Expect
Primary focus has been on potential
effects of current deficits (crowding out,
interest rates, current account, etc.).
But what about effects of necessary policy
adjustments?
– What will happen to the economy when the
music stops?…or when people realize that it
will stop?
Coming Policy Changes: Taxes
Taxes as a share of GDP lower than at
any time since the 1950s
The current share is even lower if one
excludes payroll taxes, which have risen
as a share of GDP along with Social
Security and Medicare, to which they are
dedicated
Trends in Tax Revenues
Percent of GDP
20
Total
15
10
Total, Excluding Payroll Taxes
5
0
1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002
Fiscal Year
Coming Policy Changes: Taxes
Taxes as a share of GDP lower than at
any time since the 1960s
The current share is even lower if one
excludes payroll taxes, which have risen
as a share of GDP along with Social
Security and Medicare, to which they are
dedicated
Given history and current gap, an eventual
tax increase of 4% of GDP plausible
How Would Taxes Change?
Likely a mix of base broadening and
marginal tax rate increases
Base broadening: look at recent tax reform
panel report:
– housing
– state and local taxes
– So, expect shifts in spending patterns from
these sectors
What Would Tax Changes Do?
Sectoral shifts aside, what effects should
we expect from higher tax burdens and
higher marginal tax rates?
Higher future tax burdens 
– higher private saving
– higher labor supply
Higher future marginal tax rates 
– lower private saving
– higher labor supply
What Would Tax Changes Do?
Overall effects of impending tax changes:
– sectoral shifts away from activities currently
tax-favored
– increases in labor supply (employment/hours)
– uncertain impact on private saving
Coming Policy Changes:
Entitlements
Consider recent responses to Social
Security and Medicare problems
Medicare: in face of huge long-run gap,
increase long-run cost by 1/3 with
unfunded prescription drug benefit
Social Security: no progress at addressing
this “easy” problem
Implication: nothing will happen without a
crisis
Coming Policy Changes:
Entitlements
A crisis will be characterized by the need
for immediate action
– gap too big to be closed by increased payroll
taxes alone
– but sizable benefit cuts unlikely for less
affluent retirees, so
Means testing of entitlements is in our
future
What Would Means Testing Do?
Mixed incentives to accumulate retirement
wealth
– positive, if benefits reduced
– negative, if reducing assets wards off benefit
cuts
In first scenario, increased incentive to
work and save; in second scenario, the
opposite: save less, and therefore need to
work less
What Would Means Testing Do?
Overall effects of impending entitlement
changes: unclear
Further Effects: Trade
Adjustment will eventually involve trade
surpluses, to service accumulating
international obligations
Should lead to relative growth in tradesensitive industries
Further Effects: Uncertainty
Until we know what will happen, there
should be a higher equity premium
– …once we realize that something must
happen
Summary
Policies outlined are costly to economic
well-being
– sharp marginal tax rate increases
– means-testing and its disincentives
– uncertainty about future policy
Costs could be reduced by more gradual,
systematic plans, but recent policy actions
not promising