Saturday, May 27, 2006

How will the fiscal gap be closed?

At a dinner a few days ago, some students and I were discussing how the long-term fiscal imbalance in the United States would be resolved. I opined, as I have on this blog before, that the place I would start is by considering a gradual but significant increase in the age of eligibility for government retiree benefits, including both Social Security and Medicare. I noted, however, that this solution is not very popular in polls, and no major political figure has advocated it in recent years. (Commentators: Please correct me if I am overlooking someone.)

A student then asked my prediction about whether we would see the correction on the spending side or on the tax side. That is, of course, a positive question rather than a normative one. I said, some of both, but my answer was more in the nature of a shrug than an analysis.

This morning, however, I recalled an old paper of Henning Bohn, which probably gives the best analysis of the topic. Here is a summary of the paper, which was published in the Journal of Monetary Economics:
The paper provides a historical perspective on the issue of whether budget deficits are typically eliminated by increased taxes or by reduced spending. By examining U.S. budget data from 1792–1988, I conclude that about 50–65% of all deficits due to tax cuts and about 65–70% of all deficits due to higher government spending have been eliminated by subsequent spending cuts, while the remainder was eliminated by subsequent tax increases.
That seems like a reasonable forecast: about 2/3 of the adjustment on the spending side, 1/3 on the tax side.