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2016 Financial Report of the United States Government


United States Government Required Supplementary Information (Unaudited) For the Years Ended September 30, 2016, and 2015

The Sustainability of Fiscal Policy

One of the important purposes of the Financial Report is to help citizens and policymakers assess whether current fiscal policy is sustainable and, if it is not, the urgency and magnitude of policy reforms necessary to make fiscal policy sustainable. A sustainable policy is one where the ratio of debt held by the public to GDP (the debt-to-GDP ratio) is ultimately stable or declining.

As discussed below, the projections in this report indicate that current policy is not sustainable. If current policy is left unchanged, the projections show the debt-to-GDP ratio will fall about 6 percentage points between 2016 and 2024 before commencing a steady rise, exceeding its 2016 level by 2030, exceeding 100 percent by 2039, and reaching 252 percent in 2091. For comparison, under 2015 projections, the debt-to-GDP ratio fell about 6 percentage points between 2015 and 2025 before commencing a steady rise, exceeding its 2015 level (74 percent) by 2031, exceeding 100 percent by 2043, and reaching 223 percent in 2090.

These conclusions are rooted in the projected trends in receipts, spending, and surpluses/deficits in the context of current law and policy, although, as described in the following pages, there is considerable uncertainty surrounding these projections. The projections are on the basis of policies currently in place and are neither forecasts nor predictions.

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Current Policy Projections for Primary Deficits

A key determinant of growth in the debt-to-GDP ratio and hence fiscal sustainability is the primary deficit-to-GDP ratio. The primary deficit is the difference between non-interest spending and receipts, and the primary deficit-to-GDP ratio is the primary deficit expressed as a percent of GDP. As shown in Chart 1, the primary deficit-to-GDP ratio grew rapidly in 2009 due to the financial crisis and the recession and the policies pursued to combat both. The ratio remained high from 2010 to 2012 despite shrinking in each successive year, and fell significantly in 2013 and 2014. The primary deficit is projected to shrink in the next few years as the discretionary spending limits called for in the Budget Control Act of 2011 (BCA) remain in effect and the economy continues to recover. Starting in 2020, receipts are projected to exceed non-interest spending, and this primary surplus is projected to peak at 0.3 percent of GDP in 2021. After 2022, however, increased spending for Social Security and health programs due in part to the continued retirement of the baby boom generation is expected to cause the primary surplus to steadily deteriorate and become a primary deficit in 2025 that reaches 1.0 percent of GDP in 2029. The primary deficit peaks at 1.6 percent of GDP in 2038, gradually decreases beyond that point as the aging of the population continues at a slower pace, and reaches 0.2 percent in 2091.

The receipt share of GDP fell substantially in 2009 and 2010 and remained low in 2011 and 2012 because of the recession and tax reductions enacted as part of the 2009 American Recovery and Reinvestment Act (ARRA) and the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. The share was 17.6 percent in 2016, exceeding its 30-year average of 17.3 percent due to continued economic growth and the higher tax rates enacted under the American Tax Relief Act (ATRA) of 2012. Receipts are projected to grow slightly more rapidly than GDP as increases in real (i.e., inflation-adjusted) incomes cause more taxpayers and a larger share of income to fall into the higher individual income tax brackets. Other possible paths for the receipts-to-GDP ratio and the implications for projected debt are analyzed in the “Alternative Scenarios” section.

On the spending side, the non-interest spending share of GDP is projected to stay at or below its current level of about 19 percent until 2026, and to then rise gradually to 21.2 percent of GDP by 2041 and 21.7 percent of GDP by 2091. The reductions in the non-interest spending share of GDP over the next few years are mostly due to the expected reductions in spending for overseas contingency operations (OCO), caps on discretionary spending and the automatic spending cuts mandated by the BCA, and the subsequent increases are principally due to faster growth in Medicare, Medicaid, and Social Security spending (see Chart 1). The aging of the baby boom generation over the next 25 years, among other factors, is projected to increase the Social Security, Medicare, and Medicaid spending shares of GDP by about 1.1 percentage points, 1.6 percentage points, and 0.6 percentage points, respectively. After 2041, the Social Security spending share of GDP remains relatively stable, while the combined Medicare and Medicaid spending share of GDP continues to increase, albeit at a slower rate, due to projected increases in health care costs.

The Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act of 2010 (ACA), significantly affects projected spending for both Medicare and Medicaid. That legislation expands health insurance coverage, including Medicaid, includes many measures designed to reduce health care cost growth, and significantly reduces Medicare payment rates. On net, the ACA is projected to substantially reduce the annual increases in Medicare payment rates over the next 75 years. The Medicare spending projections in the long-term fiscal projections are based on the projections in the 2016 Medicare trustees’ report, and those projections show a substantial slowdown in Medicare cost growth. The projections assume that Medicaid enrollment increases in line with demographic trends and that Medicaid cost per beneficiary grows at the same reduced rate as Medicare cost growth per beneficiary. As discussed in Note 22 to the U.S. Government’s Financial Statements, these projections are subject to much uncertainty about the ultimate effects of the ACA’s provisions to reduce health care cost growth. Even if those provisions work as intended and as assumed in this projection, Chart 1 shows that there is still a long-term gap between projected receipts and projected total non-interest spending.

Current Policy Projections for Debt and Interest Payments

The primary deficit projections in Chart 1, along with projections for interest rates and GDP, determine the projections for the debt-to-GDP ratio that are shown in Chart 2 (right axis). That ratio was 77 percent at the end of fiscal year 2016.  Under current policy the ratio is projected to be 71 percent in 2026, 122 percent in 2046, and 252 percent in 2091. The continuous rise of the debt-to-GDP ratio after 2026 indicates that current policy is unsustainable.

The change in debt held by the public from one year to the next is approximately equal to the unified budget deficit, the difference between total spending and total receipts.1 Total spending is non-interest spending plus interest spending. Chart 2 (left axis) shows that the rapid rise in total spending and the unified deficit is almost entirely due to projected interest payments on the growing debt. As a percent of GDP, interest spending was 1.3 percent in 2016, and under current policy is projected to reach 4.7 percent in 2036 and 12.8 percent in 2091.

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Another way of viewing the change in the financial outlook in this year’s report relative to previous years’ reports is in terms of the projected debt-to-GDP ratio in 2089, the last year of the projection period in the FY 2014 report. This ratio is projected to reach 246 percent in the fiscal year 2016 projections, which compares with 220 percent projected in the fiscal year 2015 projections and 321 percent projected in the fiscal year 2014 projections.2

The Cost of Delay in Closing the 75-Year Fiscal Gap

The longer policy action to close the fiscal gap is delayed, the larger the post reform primary surpluses must be to achieve the target debt-to-GDP ratio at the end of the 75-year period. This can be illustrated by varying the years in which reforms closing the fiscal gap are initiated while holding the ratio of debt to GDP in 2091 equal to its level in 2016. Three reforms are considered, each one beginning in a different year, and each one increasing the primary surplus relative to current policy by a fixed percent of GDP starting in the reform year. The analysis shows that the longer policy action is delayed, the larger the post-reform primary surplus must be to bring the debt-to-GDP ratio to the target level in 2091. Future generations are harmed by delays in policy changes because delay necessitates higher primary surpluses during their lifetimes, and those higher primary surpluses must be achieved through some combination of lower spending and higher taxes and other receipts.

As previously shown in Chart 1, under current policy, primary deficits occur in much of the projection period. Table 1 shows primary surplus changes necessary to make the debt-to-GDP ratio in 2091 equal to its level in 2016 under each of the three policies. If reform begins in 2017, then it is sufficient to raise the primary surplus share of GDP by 1.6 percentage points in every year between 2017 and 2091 in order for the debt-to-GDP ratio in 2091 to equal its level in 2016. This policy raises the average 2017-2091 primary surplus-to-GDP ratio from -0. 8 percent to +0. 8 percent.

Table 1:
Cost of Delaying Fiscal Reform
Timing of Reforms Required Change in Average Primary Surplus
Reform in 2017 (No Delay) 1.6 percent of GDP between 2017 and 2091
Reform in 2027 (Ten-Year Delay) 1.9 percent of GDP between 2027 and 2091
Reform in 2037 (Twenty-Year Delay) 2.4 percent of GDP between 2037 and 2091

Note: Reforms taking place in 2016, 2026, and 2036 from the 2015 Financial Report were 1.2, 1.5,
and 1.9 percent of GDP, respectively.

In contrast to a reform that begins immediately, if reform begins in 2027 or 2037, then the primary surpluses must be raised by 1.9 percent and 2.4 percent of GDP, respectively, in order for the debt-to-GDP ratio in 2091 to equal its level in 2016. The difference between the primary surplus increase necessary if reform begins in 2027 and 2037 (1.9 and 2.4 percent of GDP, respectively) and the increase necessary if reform begins in 2017 (1.6 percent of GDP) is a measure of the additional burden policy delay would impose on future generations. The costs of delay are due to the additional debt that accumulates between 2016 and the year reform is initiated, in comparison to the scenario in which reform begins immediately.

These projections likely understate the cost of lengthy policy delays because they assume interest rates will not rise as the debt-to-GDP ratio grows. Under the current projections, the debt-to-GDP ratio is stable through 2025 and then grows rapidly. If a higher debt-to-GDP ratio causes the interest rate on government borrowing to rise, thus making it more costly for the government to service its debt and simultaneously slowing private investment, then the primary surplus required to return the debt-to-GDP ratio to its 2016 level would also increase. This dynamic may accelerate with higher ratios of debt to GDP, potentially resulting in there being no feasible level of taxes and spending that would reduce the debt-to-GDP ratio to its 2016 level. The potential impact on the projections of interest rates rising as the debt-to-GDP ratio rises is explored in the “Alternative Scenarios” section.

Alternative Scenarios

The long-run outlook for the budget is extremely uncertain. This section illustrates this inherent uncertainty by presenting alternative scenarios for the growth rate of health care costs, interest rates, discretionary spending, and receipts. (Not considered here are the effects of alternative assumptions for long-run trends in birth rates, mortality, and immigration.)   

The population is aging rapidly and will continue to do so over the next several decades, which puts pressure on programs such as Social Security, Medicare, and Medicaid. A shift in projected fertility, mortality, or immigration rates could have important effects on the long-run projections. Higher-than-projected immigration, fertility, or mortality rates would improve the long-term fiscal outlook. Conversely, lower-than-projected immigration, fertility, or mortality rates would result in deterioration in the long-term fiscal outlook.

Effect of Changes in Health Care Cost Growth

One of the most important assumptions underlying the projections is the projected growth of health care costs. Enactment of the ACA in 2010 reduced the projected long-run growth rates of health care costs, but these growth rates are still highly uncertain. As an illustration of the dramatic effect of variations in health care cost growth rates, Table 2 shows the effect on the size of reforms necessary to close the fiscal gap of per capita health care cost growth rates that are one percentage point higher or two percentage points higher than the growth rates in the base projection, as well as the effect of delaying closure of the fiscal gap.3 As indicated earlier, if reform is initiated in 2017, eliminating the fiscal gap requires that the 2017-2091 primary surplus increase by an average of 1.6 percent of GDP in the base case. However, that figure increases to 4.6 percent of GDP if per capita health cost growth is assumed to be 1 percentage point higher, and 9.6 percent of GDP if per capita health cost growth is 2 percentage points higher. The cost of delaying reform is also increased if health care cost growth is higher, due to the fact that debt accumulates more rapidly during the period of inaction. For example, the lower part of Table 2 shows that delaying reform initiation from 2017 to 2027 requires that 2027-2091 primary surpluses be higher by an average of 0.3 percent of GDP in the base case, 0.9 percent of GDP if per capita health cost growth is 1 percentage point higher, and 1.8 percent of GDP if per capita health cost growth is 2 percentage points higher. The dramatic deterioration of the long-run fiscal outlook caused by higher health care cost growth shows the critical importance of managing health care cost growth, including through effective implementation of the ACA.

Table 2
Impact of Alternative Health Cost Scenarios on Cost Of Delaying Fiscal Reform
  Primary Surplus Increase (% of GDP)
Starting in:
Scenario 2017 2027 2037
Base Case 1.6 1.9 2.4
1% pt. higher per person health cost growth 4.6 5.5 6.9
2% pt. higher per person health cost growth 9.6 11.4 14.1
   
Change in Primary Surplus Increase if
Reform is Delayed From 2016 to:
 
2027
2037
Base Case 0.3 0.8
1% pt. higher per person health cost growth 0.9 2.2
2% pt. higher per person health cost growth 1.8 4.6
NOTE: Increments may not equal the subtracted difference of the components due to rounding.

Effects of Changes in Interest Rates

A higher debt-to-GDP ratio is likely to increase the interest rate on Government debt, making it more costly for the Government to service its debt. Table 3 displays the effect of several alternative scenarios using different nominal (and real) interest rates than assumed in the base case on the size of reforms to close the fiscal gap as well as the effect of delaying closure of the fiscal gap. If reform is initiated in 2017, eliminating the fiscal gap requires that the 2017-2091 primary surplus increase by an average of 1.6 percent of GDP in the base case, 1.9 percent of GDP if the interest rate is 0.5 percentage point higher in every year, and 1.3 percent of GDP if the interest rate is 0.5 percentage point lower in every year. The cost of delaying reform is also increased if interest rates are higher, due to the fact that interest paid on debt accumulates more rapidly during the period of inaction. For example, the lower part of Table 3 shows that delaying reform initiation from 2017 to 2027 requires that 2027-2091 primary surpluses be higher by an average of 0.3 percent of GDP in the base case, 0.4 percent of GDP if the interest rate is 0.5 percentage point higher in every year, and 0.2 percent of GDP if the interest rate is 0.5 percentage point lower in every year.

Table 3
Impact of Alternative Interest Rate Scenarios on Cost Of Delaying Fiscal Reform
  Primary Surplus Increase (% of GDP)
Starting in:
Scenario 2017 2027 2037
Base Case: Average of 5.4 percent over 75 years 1.6 1.9 2.4
0.5 percent higher interest rate in each year 1.9 2.3 3.0
0.5 percent lower interest rate in each year 1.3 1.5 1.8
   
Change in Primary Surplus Increase if
Reform is Delayed From 2016 to:
 
2027
2037
Base Case: Average of 5.4 percent over 75 years 0.3 0.8
0.5 percent higher interest rate in each year 0.4 1.1
0.5 percent lower interest rate in each year 0.2 0.5
NOTE: Increments may not equal the subtracted difference of the components due to rounding.

Effects of Changes in Discretionary Spending Growth

The growth of discretionary spending has a large impact on long-term fiscal sustainability. The current base projection for discretionary spending assumes that after 2021, discretionary spending keeps pace with the economy and grows with GDP. The implications of two alternative scenarios are shown in Table 4. The first alternative scenario allows discretionary spending to grow with inflation and population after 2021 so as to hold discretionary spending constant on a real per capita basis. (This growth rate assumption is still larger than the standard 10-year budget baseline assumption, which assumes that discretionary spending grows with inflation but not with population.) The second alternative scenario sets discretionary spending in 2022 to levels consistent with the path established prior to the sequestration required by the failure of the Joint Select Committee on Deficit Reduction, and then grows discretionary spending with GDP from that point forward. As shown in Table 4, the fiscal gap is eliminated if discretionary spending grows with inflation and population. Conversely, if discretionary spending rises to the levels prior to Joint Committee sequestration in 2022 and then grows with GDP, the fiscal gap increases from 1.6 percent of GDP to 1.9 percent of GDP. The cost of delaying reform is greater when discretionary spending levels are higher. Initiating reforms in 2027 requires that the primary surplus increase by an average of 0.3 percent of GDP per year in the base case, and also increase by 0.4 percent of GDP if discretionary levels return to pre-Joint Committee sequestration levels. If delayed until 2037, the primary surplus must increase by an average of 0.8 percent of GDP in the base case, and increase by 0.9 percent of GDP at pre-sequestration levels.

Table 4
Impact of Alternative Discretionary Spending Growth Scenarios on Cost of Delaying Fiscal Reform
  Primary Surplus Increase (%of GDP)
Starting in:
Scenario 2017 2027 2037
Base Case: Discretionary spending growth with GDP after 2021 1.6  1.9  2.4 
Growth with inflation and population after 2021 - (0.1) (0.1)
Reversion in 2022 to pre-Joint Committee sequester levels and growth with GDP 1.9  2.3  2.8 
   
Change in Primary Surplus Increase if Reform is
Delayed From 2017 to:
 
2027
2037
Base Case: Discretionary spending growth with GDP after 2021 0.3  0.8 
Growth with inflation and population after 2021 (0.1) (0.1)
Reversion in 2022 to pre-Joint Committee sequester levels and growth with GDP 0.4  0.9 
NOTE: Increments may not equal the subtracted difference of the components due to rounding.

Effects of Changes in Individual Income Receipt Growth

The growth rate of receipts, specifically individual income taxes, is another key determinant of long-term sustainability. The base projections assume growth in individual income taxes over time to account primarily for the slow shift of individuals into higher tax brackets due to real wage growth (“real bracket creep”). This assumption approximates the long-term historical growth in individual income taxes relative to wages and salaries and is consistent with current tax code policy without change, as future legislation would be required to prevent real bracket creep. As an illustration of the effect of variations in individual income tax growth, Table 5 shows the effect on the size of reforms necessary to close the fiscal gap and the effect of delaying closure of the fiscal gap if long-term receipt growth as a share of wages and salaries is 0.1 percentage point higher, than the base case, as well as 0.1 percentage point lower than the base case. If reform is initiated in 2017, eliminating the fiscal gap requires that the 2017-2091 primary surplus increase by an average of 1.6 percent of GDP in the base case, only 0.5 percent of GDP if receipt growth is 0.1% higher, but 2.7 percent of GDP if receipt growth is 0.1% lower. The cost of delaying reform is also affected if receipt growth assumptions change, much as was the case in the previous alternative scenarios.

Table 5
Impact of Alternative Revenue Growth Scenarios on Cost of Delaying Fiscal Reform
  Primary Surplus Increase (%of GDP)
Starting in:
Scenario 2017 2027 2037
Base Case: Individual income tax bracket creep of 0.1% of wages and salaries per year 1.6 1.9 2.4
0.2% of wages and salaries per year after 2025 0.5 0.6 0.7
0.0% of wages and salaries per year after 2025 (no bracket creep) 2.7 3.2 4.0
   
Change in Primary Surplus Increase if Reform is
Delayed From 2017 to:
 
2027
2037
Base Case: Individual income tax bracket creep of 0.1% of wages and salaries per year 0.3 0.8
0.2% of wages and salaries per year after 2025 0.1 0.2
0.0% of wages and salaries per year after 2025 (no bracket creep) 0.5 1.3
NOTE: Increments may not equal the subtracted difference of the components due to rounding.

Fiscal Projections in Context

In this report, a sustainable policy has been defined as one where the Federal debt-to-GDP ratio is stable or declining. However, this definition does not indicate what a sustainable debt-to-GDP ratio might be. Any particular debt ratio is not the ultimate goal of fiscal policy. Rather, the goals of fiscal policy are many, including: financing public goods, such as infrastructure and government services; a strong and growing economy; and managing the national debt so that it is not a burden to future generations. These goals are interrelated, and readers should consider how policies intended to affect one might depend on or affect another.

This report shows that current policy is not sustainable. In evaluating policies that could make policy sustainable, note that national debt may play roles in both facilitating and hindering a healthy economy. For example, Government deficit spending may support demand and allow economies to emerge from recessions more quickly. Debt may also be a cost-effective means of financing capital investment, promoting economic growth, which may in turn make debt levels more manageable in the future. However, economic theory also suggests that high levels of national debt may contribute to higher interest rates, leading to lower investment and a smaller capital stock which the economy can use to grow. Unfortunately, it is unclear what debt-to-GDP ratio would be sufficiently high to produce these negative outcomes, or whether the key concern is the level of debt per se, or a trend that shows debt increasing over time.

It is difficult to discern a definite relationship between national debt and economic growth from the past experience of countries. The historical experience, while valuable, is filled with confounding events and circumstances. Some countries with high debt-to-GDP ratios have been observed to experience lower-than-average growth, while other countries with similarly high debt ratios continue to enjoy robust growth. Analogously, low debt-to-GDP ratios are no guarantee of strong economic growth. Moreover, the direction of causality is unclear. High debt may undermine growth; low growth may contribute to high debt.

Nevertheless, to put the current and projected debt-to-GDP ratios in context, it is instructive to examine how the United States experience compares with that of other countries. The United States Government’s debt as a percentage of GDP is relatively large compared with central government debt of other countries, but far from the largest among developed countries. Based on historical data as reported by the International Monetary Fund (IMF) for 27 select countries, the debt-to-GDP ratio in 2014 ranged from 14 percent of GDP to 199 percent of GDP.4 The United States is not included in this set of statistics, which underscores the difficulty in calculating debt ratios under consistent definitions, but the IMF does report a similar debt statistic for the United States as 83 percent of GDP.5  Despite using consistent definitions where available, these debt measures are not strictly comparable due to differences in the share of government debt that is debt of the central government, how government responsibilities are shared between central and local governments, how current policies compare with the past policies that determine the current level of debt, and how robustly each economy grows.

The historical experience of the U.S. may also provide some perspective. As Chart 3 shows, the debt-to-GDP ratio was highest in the 1940s, following the debt buildup during World War II. In the projections in this report, the U.S. would reach the previous peak debt ratio in 2041. However, the origins of current and future Federal debt are quite different from the wartime debt of the 1940s, which limits the pertinence of past experience.

As the cross-country and historical comparisons suggest, there is a very imperfect relationship between the current level of central government debt and the sustainability of overall government policy. Past accrual of debt is certainly important, but current policies and their implications for future debt accumulation are as well. The U.S. has made progress towards sustainability in recent years. The projections in this Financial Report show the relative stability in the U.S. Federal debt-to-GDP ratio for the next decade under current policies, followed by a rising trend that implies current policies are unsustainable in the long run.

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Conclusion

The United States took a potentially significant step towards fiscal sustainability in 2010 by reforming its system of health insurance through enactment of the ACA. The legislated changes for Medicare, Medicaid, and other health coverage hold the prospect of lowering the long-term growth trend for health care costs and significantly reducing the long-term fiscal gap. Furthermore, enactment of the BCA in August 2011 placed limits on future discretionary spending, while enactment of ATRA in January 2013 increased receipts under current policy. With these laws in place, the debt-to-GDP ratio is projected to remain relatively stable for the next decade. However, the projections beyond the next decade in this Financial Report indicate that if policy remains unchanged the debt-to-GDP ratio will continually increase over the next 75 years and beyond, which implies current policies are not sustainable and must ultimately change. Subject to the important caveat that policy changes are not so abrupt that they slow continued economic growth, the sooner policies are put in place to avert these trends, the smaller are the receipt increases and/or spending decreases necessary to return the Nation to a sustainable fiscal path, and the lower the burden of the national debt will be to future generations.

Footnotes

1The change in debt each year is also affected by certain transactions not included in the unified budget deficit, such as changes in Treasury’s cash balances and the non-budgetary activity of Federal credit financing accounts. These transactions are assumed to hold constant at about 0.4 percent of GDP each year, with the same effect on debt as if the primary deficit was higher by that amount. (Back to Content)

2For further information on changes from the 2014 projections, see Note 24 in the 2015 Financial Report. (Back to Content)

3The base case health cost growth rates are derived from the projections in the 2016 Medicare trustees’ report. These projections are summarized and discussed in Note 22 (see Table 1B in particular) and the “Medicare Projections” section of the RSI for the SOSI. (Back to Content)

4Government Finance Statistics Yearbook, Main aggregates and Balances, available at http://data.imf.org - Data is for D1 debt liabilities for the central government, excluding social security funds (Back to Content)

5Data is for D1 debt liabilities for the central government, including social security funds. For the few countries where both central government debt ratios (excluding and including social security funds) are reported, the values are similar. (Back to Content)

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