U.S. Fiscal Policies and Priorities for Long-Run Sustainability

Martin Muhleisen and Christopher Towe, Editors

with

Roberto Cardarelli

Paula De Masi

Iryna Ivaschenko

Michael Kell

Ayhan Kose

Jim Prust

Dominique Simard

INTERNATIONAL MONETARY FUND

Washington DC

2004

© 2004 International Monetary Fund

Production: IMF Multimedia Services Division

Composition: Julio R. Prego

Figures: Theodore F. Peters, Jr.

Cataloging-in-Publication Data

U.S. Fiscal Policies and Priorities for Long-Run Sustainability / Martin Mühleisen and Christopher Towe, editors; with Roberto Cardarelli … [et al.]—Washington, D.C.: International Monetary Fund, 2004.

p. cm. — (Occasional paper / International Monetary Fund; 227)

ISBN 1-58906-295-7

Includes bibliographical references.

1. Fiscal policy — United States 2. Budget — United States. 3. Social security — United States. 4. Energy policy — United States. I. Mühleisen, Martin. II. Towe, Christopher M., 1957- III. Cadarelli, R. (Roberto) IV Series: Occasional paper (International Monetary Fund); no. 227

HJ2381.U8 2004

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Contents

• Preface

• I Overview: Returning Deficits and the Need for Fiscal Reform

  • Martin Mühleisen

  • The Fiscal Deficit: Back to Square One

  • Costs and Consequences of Tax Cuts and Deficits

  • Long-Run Insolvency of Social Security and Medicare

  • The Policy Challenge

  • State and Federal Fiscal Relations

  • Concluding Remarks

  • References

• II Economic Impact of U.S. Budget Policies

  • Roberto Cardarelli and Ayhan Kose

  • Simulations of the FY2004 Budget Proposal

  • Fiscal Deficits and Real Interest Rates

  • International Implications of Higher U.S. Public Debt

  • References

• III Social Security, Medicare, and U.S. Fiscal Prospects

  • Paula De Masi, Iryna Ivaschenko, and Christopher Towe

  • Fiscal Consequences of Social Security and Medicare

  • President’s Social Security Reform Commission

  • Medicare Reform

  • Concluding Remarks

  • References

• IV Long-Run U.S. Fiscal Imbalance: An Intergenerational Analysis

  • Roberto Cardarelli and Christopher Towe

  • Constructing Intergenerational Fiscal Accounts

  • Debt Dynamics and Fiscal Sustainability

  • Conclusions

  • References

• V U.S. Energy Policy: Role of Taxation

  • Jim Prust and Dominique Simard

  • Energy Use in the United States

  • Energy Policy

  • Taxation and Other Instruments to Reduce Energy Consumption

  • Macroeconomic Effects of Energy Taxation

  • References

• VI Budget Enforcement Act and Options for Reform

  • Michael Kell

  • Background

  • Assessing the BEA Rules

  • Options for Reform

  • Conclusion

  • References

• VII Will the State and Local Budget Crisis Hinder Economic Growth?

  • Iryna Ivaschenko

  • State and Local Government Finances

  • Recent Developments in State and Local Government Finances

  • Balanced Budget Rules and Fiscal Adjustment

  • How Much of a Drag on Growth?

  • References

• Boxes

  • 1.1. Recent U.S. Tax Initiatives

  • 1.2. Fiscal Transparency in the United States

  • 3.1. Social Security and Medicare Systems

  • 5.1. U.S. Energy Excise Taxes

  • 6.1. Main Provisions of the BEA

• Tables

  • 1.1. Factors Explaining the Budget Turnaround

  • 2.1. Change in Real GDP Growth Before and After Large Fiscal Expansions

  • 2.2. Estimates from Large-Scale Models

  • 2.3. Estimates from Small-Scale Models

  • 2.4. Selected Studies on the Impact of Deficits on Real Interest Rates

  • 2.5. Correlations of G-7 Real Interest Rates (1977–2002)

  • 2.6. Selected Studies on the Impact of World Fiscal Variables on Real Interest Rates

  • 2.7. OLS Regressions of Real Interest Rates on World Fiscal Variables

  • 2.8. Joint GMM Estimation of National Real Interest Rates Imposing Equality of Coefficients Across Equations

  • 4.1. Long-Term Projections as a Share of GDP

  • 4.2. Indicators of Fiscal Imbalance in Alternative Economic and Policy Scenarios

  • 5.1. Simulated Impact of Energy Taxes on the Economy

  • 6.1. Adjustments to Discretionary Spending Caps

  • 7.1. Government Revenues, Spending, and Investment

  • 7.2. State and Local Governments: Composition of Receipts

  • 7.3. State and Local Governments: Composition of Spending and Investment, 2002

  • 7.4. Fiscal Impulse by Level of Government

• Figures

  • 1.1. International Comparisons: Fiscal Balance and Net Debt

  • 1.2. Federal Budget Balance Adjusted for Cyclical Factors and Capital Gains Taxes

  • 1.3. Federal Expenditures

  • 1.4. Unified Budget Balance

  • 1.5. Revenue and Expenditure Projections

  • 1.6. Social Security and Medicare Outlays

  • 1.7. Debt Held by the Public and Social Security/Medicare Trust Funds

  • 1.8. Health Expenditures and Life Expectancy in OECD Countries

  • 2.1. Two-Year Changes in Structural Fiscal Variables

  • 2.2. Impact of 2003 Tax Cuts on Labor Productivity

  • 2.3. World Government Net Debt-to-GDP Ratio and World Real Interest Rate

  • 3.1. Social Security and Medicare Projections

  • 3.2. Budget Projections

  • 4.1. Tax Revenues

  • 4.2. Social Transfers

  • 4.3. Health Care Spending

  • 5.1. Energy Intensity of GDP: International Comparison

  • 5.2. Energy Intensity of GDP and Real Motor Gasoline Price

  • 5.3. Real Prices of Premium Unleaded Gasoline

  • 5.4. Prices and Taxes of Premium Unleaded Gasoline

  • 5.5. Carbon Dioxide Emissions per GDP

  • 5.6. Shares of Energy Consumption by Type of Fuel

  • 5.7. Net Petroleum Imports

  • 6.1. Federal Budget Deficit

  • 6.2. Federal Outlays and Revenues

  • 6.3. Discretionary Spending

  • 6.4. Mandatory Spending

  • 6.5. Projection Errors Due to Economic Factors

  • 7.1. State and Local Governments: Current Balances

  • 7.2. Revenues and Expenditures of State and Local Governments

  • 7.3. State and Local Governments: Credit Market Debt

  • 7.4. State and Local Governments: Budget Balances and Spreads on SLG Debt

  • 7.5. Dynamic Responses of the Output Gap to Fiscal Variables

Preface

This paper presents an overview of recent U.S. fiscal developments and discusses possible implications of the sharp turnaround in the government’s fiscal position. Against this background, it also reviews key policy challenges that will need to be addressed to cope with the mounting pressures on public retirement and health care systems during the next decade. U.S. Fiscal Policies and Priorities for Long-Run Sustainability draws principally on background papers that were prepared for the IMF staff’s annual consultation discussions with the U.S. authorities in 2002 and 2003. Charles Collyns, Deputy Director of the Western Hemisphere Department, led the staff team and provided considerable guidance in compiling this volume. Anoop Singh, Director of the Western Hemisphere Department, also actively participated in the consultation discussions and directed the staff’s background work.

The authors would like to thank the U.S. authorities for their cooperation and support during the policy discussions and technical meetings. They are indebted to Gustavo Ramirez and Victor Culiuc for first-rate research assistance and to Asegedech WoldeMariam for her excellent contribution to Section V. The authors are especially grateful to Alfred S. Go, Modupeh B. Williams, Joan F. McLeod-Tillman, and Mary Kelley for coordination and general assistance and to Archana Kumar of the External Relations Department for editing the paper and coordinating its production.

The opinions expressed are solely those of the authors and do not necessarily reflect the views of the International Monetary Fund, the Executive Directors, or the U.S. authorities.

Except where otherwise indicated, the paper reflects information available through end-September 2003.