Upgrading the U.S.A.

How to fix the country's debt-to-GDP ratio


This summer, for the first time in history, Standard & Poor's downgraded the United States from AAA to AA+. Whether or not we think the country deserved it, whether or not S&P holds any credibility, whether or not the move will have long-term consequences, the rating agency's rationale for the reduction boils down to a legitimate fear: that America will fail to get its financial act together in time.

But how do we put our house in order? Even if lawmakers allow the Bush tax rates to expire at the end of 2012, the debt-to-GDP ratio is still projected to increase dramatically over the next decade. And then the real problems kick in with the explosion of spending on Social Security, Medicare, and Medicaid. You could make the deficit situation look better by refusing to soften the blow of the alternative minimum tax through the types of "patches" that are passed each year, but that is both unlikely and unwise. And it would be very helpful if we got all the savings promised by boosters of the recent health care overhaul, but that too is highly doubtful.

The bottom line is that the debt problem in the United States will not go away as long as we don't reform Social Security, Medicare, and Medicaid. The coming explosion in entitlement spending will blow apart any possibility  of an equilibrium between revenue (no matter how high marginal tax rates get) and expenditures.

Unfortunately, the debt-limit deal passed this summer failed even to fake a solution. And things can get much worse. S&P has served notice that a further downgrade is likely if more progress is not made at upcoming deficit-reduction meetings to reduce the debt-to-GDP ratio within the next few months. Prior to the debt-limit deal, you may recall, S&P had talked about wanting a long-term plan in place by October. And that means doing precisely what our representatives refused to do over the past seven months: moving decisively off this unsustainable path.  

Thankfully, we are not the first nation to struggle with a dangerous debt-to-GDP ratio, and thankfully, the academic world has already produced great insights into what can be done to help the problem without hurting the economy.

Take Alberto Alesina and Silvia Ardagna, two Harvard economists. In an October 2009 working paper published by the National Bureau of Economic Research, the duo look at 107 efforts to reduce debt in 21 OECD nations between 1970 and 2007. Several countries were successful, among them Austria in 2005, Finland in 2005, and Sweden from 1997 to 2004. Spending cuts, the scholars found, are more effective than tax increases in reducing the ratio of debt to GDP. With successful fiscal adjustments, spending as a share of GDP fell by an average of 2 percent while revenue also fell by half a percentage point. Unsuccessful fiscal-adjustment packages involved smaller spending reductions (only about eight-tenths of a percentage point, on average) and large revenue increases.

Following and building on the work of Alesina and Ardagna, American Enterprise Institute economists Andrew Biggs, Kevin Hassett, and Matthew Jensen published a working paper in December 2010 covering more than 100 instances in which countries took steps to address their budget gaps. They identify successful consolidations as those in which the ratio of debt to potential GDP three years following the first year of the consolidation has declined by at least 4.5 percentage points.

Their conclusion: "Countries that addressed their budget shortfalls through reduced spending were far more likely to reduce their debt than countries whose budget-balancing strategies depended upon higher taxes." What's more, "the typical unsuccessful fiscal consolidation consisted of 53 percent tax increases and 47 percent spending cuts. By contrast, the typical successful fiscal consolidation consisted of 85 percent spending cuts."

Alas: Even (or especially) in a time of crisis, lawmakers are driven more by politics than by good public policy. Countries in fiscal trouble generally got there through years of catering to pro-spending constituencies, be they senior citizens or the military-industrial complex, and their fiscal adjustments tend to make too many of these same mistakes. As a result, failed fiscal consolidations are more the rule than the exception. Eighty percent of the adjustments that Biggs, Hassett, and Jensen studied were failures.

The United States cannot afford to follow this pattern. Those who are not ideologically inclined toward austerity measures should remember that all this research is consistent with the work of the Berkeley economists David and Christina Romer—the same Christina Romer who used to chair Obama's Council of Economic Advisers. In a paper published in the June 2010 American Economic Review, the Romers show that increasing taxes by 1 percent of GDP for deficit-reduction purposes leads to a 3 percent reduction in GDP. Alesina and Ardagna discuss Romer and Romer's paper, noting that while their methodology is different enough to make it hard to compare the two results formally, the studies are consistent in their conclusions. 

Finally, Biggs, Hassett, and Jensen look at how successful different kinds of spending cuts are at reducing the debt ratio. Consistent with other studies, they find that winning fiscal consolidations tend to focus spending cuts in two areas: social transfers, which largely means entitlements in the American context, and the government-wage bill, which means the size and pay of the public-sector workforce.

I can't stress enough the importance of these findings. At a time when many politicians and pundits are calling for a "balanced" solution that features an equal mix of revenue increases and spending cuts to address our debt crisis, we must remember that this path has systematically failed in the past.

It may not be "balanced," but what works is a package that mostly cuts spending. In the short term, that could mean means-testing Social Security and Medicare, increasing the programs' eligibility age, and/or block-granting Medicaid. In the longer term, we must rethink the system on a fundamental level. A system that assumes an entitlement due to the simple fact of being American and over 65 cannot be sustained.  

Contributing Editor Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.