Macroeconomic and Welfare Costs of U.S. Fiscal Imbalances

Macroeconomic and Welfare Costs of U.S. Fiscal Imbalances. By Bertrand Gruss and Jose L. Torres
IMF Working Paper No. 12/38
http://www.imf.org/external/pubs/cat/longres.aspx?sk=25691.0

Summary: In this paper we use a general equilibrium model with heterogeneous agents to assess the macroeconomic and welfare consequences in the United States of alternative fiscal policies over the medium-term. We find that failing to address the fiscal imbalances associated with current federal fiscal policies for a prolonged period would result in a significant crowding-out of private investment and a severe drag on growth. Compared to adopting a reform that gradually reduces federal debt to its pre-crisis level, postponing debt stabilization for two decades would entail a permanent output loss of about 17 percent and a welfare loss of almost 7 percent of lifetime consumption. Moreover, the long-run welfare gains from the adjustment would more than compensate the initial losses associated with the consolidation period.

The authors start the paper this way:

“History makes clear that failure to put our fiscal house in order will erode the vitality of our
economy, reduce the standard of living in the United States, and increase the risk of economic and financial instability.”
Ben S. Bernanke, 2011 Annual Conference of the Committee for a Responsible Federal Budget

Excerpts

Introduction

One of the main legacies of the Great Recession has been the sharp deterioration of public finances in most advanced economies. In the U.S., the federal debt held by the public surged from 36 percent of GDP in 2007 to around 70 percent in 2011. This rise in debt, however impressive, gets dwarfed when compared to the medium-term fiscal imbalances associated with entitlement programs and revenue-constraining measures. For example, the non-partisan Congressional Budget Office (CBO) foresees the debt held by the public to exceed 150 percent of GDP by 2030 (see Figure 1). Similarly, Batini et al. (2011) estimate that closing the federal “fiscal gap” associated with current fiscal policies would require a permanent fiscal adjustment of about 15 percent of GDP.

While the crisis brought the need to address the U.S. medium-term fiscal imbalances to the center of the policy debate, the costs they entail are not necessarily well understood. Most of the long-term fiscal projections regularly produced in the U.S. and used to guide policy discussions are derived from debt accounting exercises. A shortcoming of such approach is that relative prices and economic activity are unaffected by different fiscal policies, and that it cannot be used for welfare analysis. To overcome those limitations and contribute to the debate, in this paper we use a rational expectations general equilibrium framework to assess the medium-term macroeconomic and welfare consequences of alternative fiscal policies in the U.S. We find that failing to address the federal fiscal imbalances for a prolonged period would result in a significant crowding-out of private investment and drag on growth, entailing a permanent output loss of about 17 percent and welfare loss of almost 7 percent of lifetime consumption. Moreover, we find that the long-run welfare gains from stabilizing the federal debt at a low level more than compensate the welfare losses associated with the consolidation period. Our results also suggest that the crowding-out effects of public debt are an order of magnitude bigger than the policy mix effects: Reducing promptly the level of public debt is significantly more important for activity and welfare than differences in the size of government or the design of the tax reform.

The focus of this study is on the costs and benefits of fiscal consolidation for the U.S. over the medium-term to long-term. In this sense, we explicitly leave aside some questions on fiscal consolidation that, while very relevant for the short-run, cannot be appropriately tackled in this framework. One example is assessing the effects of back-loading the pace of consolidation in the near term—while announcing a credible medium-run adjustment—in the current context of growth below potential and nominal interest rates close to zero. A related relevant question is what mix of fiscal instruments in the near term would make fiscal consolidation less costly in such context. While interesting, these questions are beyond the scope of this paper.

The quantitative framework we use is a dynamic stochastic general equilibrium model with heterogeneous agents, and endogenous occupational choice and labor supply. In the model, ex-ante identical agents face idiosyncratic entrepreneurial ability and labor productivity shocks, and choose their occupation. Agents can become either entrepreneurs and hire other workers, or they can become workers and decide what fraction of their time to work for other entrepreneurs. In order to make a realistic analysis of the policy options, we assume that the government does not have access to lump sum taxation. Instead, the government raises distortionary taxes on labor, consumption, and income, and issues one period non-contingent bonds to finance lump sum transfers to all agents, other noninterest spending, and service its debt. Given that the core issue threatening debt sustainability in the U.S. is the explosive path of spending on entitlement programs, the heterogeneous agents assumption is crucial: Our model allows for a meaningful tradeoff between distortionary taxation and government transfers, as the latter insure households from attaining very low levels of consumption. The complexity this introduces forces us to sacrifice on some dimension: Agents in our model face individual uncertainty but have perfect foresight about future paths of fiscal instruments and prices. Allowing for uncertainty about the timing and composition of the adjustment would be interesting, but would severely increase the computational cost.

We compare model simulations from four alternative fiscal scenarios. The benchmark scenario maintains current fiscal policies for about twenty years. More precisely, in this scenario we feed the model with the spending (noninterest mandatory and discretionary) and revenue projections from CBO’s Alternative Fiscal scenario (CBO 2011)—allowing all other variables to adjust endogenously—until about 2030, when we assume that the government increases all taxes to stabilize the debt at its prevailing level. Three alternative scenarios assume, instead, the immediate adoption of fiscal reform aimed at gradually reducing the federal debt to its pre-crisis level. There are of course many possible parameterizations for such reform reflecting, among other things, different views about the desired size of the public sector and the design of the tax system. We first consider an adjustment scenario assuming the same size of government and tax structure than the benchmark one in order to disentangle the sole effect of delaying fiscal adjustment—and stabilizing the debt ratio at a high level. We then explore the effect of alternative designs for the consolidation plan by considering two alternative adjustment scenarios that incorporate spending and revenue measures proposed by the bipartisan December 2010 Bowles-Simpson Commission.

This paper is related to different strands of the macro literature on fiscal issues. First, it is related to studies using general equilibrium models to analyze the implications of fiscal consolidations. Forni et al. (2010) use perfect-foresight simulations from a two-country dynamic model to compute the macroeconomic consequences of reducing the debt to GDP ratio in Italy. Coenen et al. (2008) analyze the effects of a permanent reduction in public debt in the Euro Area using the ECB NAWM model. Clinton et al. (2010) use the IMF GIMF model to examine the macroeconomic effects of permanently reducing government fiscal deficits in several regions of the world at the same time. Davig et al. (2010) study the effects of uncertainty about when and how policy will adjust to resolve the exponential growth in entitlement spending in the U.S.

The main difference with our paper is that these works rely on representative agent models that cannot adequately capture the redistributive and insurance effects of fiscal policy. As a result, such models have by construction a positive bias towards fiscal reforms that lower transfers, reduce the debt, and eventually lower the distortions by lowering tax rates. Another unappealing feature of the representative agent models for analyzing the merits of a fiscal consolidation is that, in steady state, the equilibrium real interest rate is independent of the debt level, whereas in our model the equilibrium real interest rate is endogenously affected by the level of government debt, which is consistent with the empirical literature.

Second, the paper is related to previous work using general equilibrium models with infinitively lived heterogeneous agents, occupational choice, and borrowing constraints to analyze fiscal reforms, such as Li(2002), Meh (2005) and Kitao (2008). Differently from these papers, that impose a balanced budget every period, we focus on the effects of debt period of time we augment our model to include growth. Moreover and as in Kitao (2008), we explicitly compute the transitional dynamics after the reforms and analyze the welfare costs associated with the transition.  dynamics and fiscal consolidation reforms. Also, since we focus on reforms over an extended period of time we augment our model to include growth. Moreover and as in Kitao (2008), we explicitly compute the transitional dynamics after the reforms and analyze the welfare costs associated with the transition.

Results:The long-run effects


What is the effect of delaying fiscal consolidation on...?

Capital and Labor. The high interest rates in the delay scenario imply that for those entrepreneurs that do not have enough internal funding, the cost of borrowing sufficient capital is too high for them to compensate for their income under the outside option (i.e.  wage income). As a result, the share of entrepreneurs in the delay scenario is roughly one half the share under the passive adjust scenario and the aggregate capital stock is about 17 percent lower. The higher share of workers in the delay scenario implies a higher labor supply. Together with a lower labor demand (due to a lower capital stock), this leads to a real wage that is more than 19 percent lower. Total hours worked are similar in the two steady states as lower individual hours offset the higher share of workers.

Output and Consumption. The crowding-out effect of fiscal policy under the delay scenario leads to large permanent losses in output and consumption. The level of GDP is about 16 percent lower in the delay than in the passive adjust scenario and aggregate consumption is 3.5 percent lower. Moreover and as depicted in Figure 4, the wealth distribution is significantly more concentrated under the delay scenario.

Welfare. The effect of lower aggregate consumption and more concentrated wealth distribution under the delay scenario implies that welfare is significantly lower than in the passive adjust scenario. Using a consumption equivalent welfare metric we find that the average difference in steady state welfare across scenarios would be equivalent to permanently increasing consumption to each agent in the delay scenario economy by 6 percent while leaving their amount of leisure unchanged. We interpret this differential as the permanent welfare gain from stabilizing public debt at its pre-crisis level. A breakup of the welfare comparison of steady states by wealth deciles, shown in Figure 5, suggests that all agents up to the 7th deciles of the wealth distribution would be better off under fiscal consolidation.

What are the effects of alternative fiscal consolidation plans?

Capital and Output. The smaller size of government in the two active adjust scenario relative to the passive one translates into higher capital stocks and higher output, increasing the gap with the delay scenario. Regarding the tax reform, the comparison between the two active adjust scenarios reveals that distributing the higher tax pressure on all taxes, including consumption taxes, lowers distortions and results in a higher capital stock and in a growth friendlier consolidation: The difference in the output level between the delay and active (1) adjust scenario stands at 17.7 percent—while this difference is 17.1 and 15.7 percent for the active (2) adjust and passive adjust scenarios respectively.

Consumption and Welfare. While all adjust scenarios reveal a significant difference in long-run per-capita consumption and welfare with respect to postponing fiscal consolidation, the relative performance among them also favors a smaller size of government and a balanced tax reform. The difference in per-capita consumption with the delay scenario is 3.5, 5.8 and 5.4 percent respectively for the passive, active (1) and active (2) adjustment scenarios. The policy mix under the active (1) adjust scenario also ranks the best in terms of welfare, with the welfare differential with respect to the delay scenario being more than 7 percent of lifetime consumption.

Overall Welfare Cost of Delaying Fiscal Consolidation

In the long-run the average welfare in the adjust scenario is higher than in the delay scenario by 6.7 percent of lifetime consumption. However, along the transition to the new steady state the adjust scenario is characterized by a costly fiscal adjustment that entails a lower path for per capita consumption, so it might not be necessarily true that an adjustment is optimal.

To assess the overall welfare ranking of the alternative fiscal paths, we extend the analysis of section III.A. by computing, for the delay and adjust scenarios, the average expected discounted lifetime utility starting in 2011. We find that even taking into account the costs along the transition, the adjust scenario entails an average welfare gain for the economy. The infinite horizon welfare comparison suggests that consumption under the delay scenario should be raised by 0.8 percent for all agents in the economy in all periods to attain the same average utility than under the adjust scenario (while leaving leisure unchanged). A breakup of this result by wealth deciles (see Figure 9) suggests that, as in the long-run comparison, the wealthiest decile of the population is worse off under the adjust scenario. Differently from the steady state comparison, however, the first four deciles also face welfare losses in the adjust scenario.

A few elements suggest that the average welfare gain reported (0.8 percent in consumptionequivalent terms) can be considered a lower bound. First, the calibrated subjective discount factor from the model used to compute the present value of the utility paths entails a yearly discount rate of about 9.9 percent.20 With such a high discount rate, the long-run benefits from the delay scenario are heavily discounted. Using a discount rate of 3 percent, the one used by CBO for calculating the present value of future streams of revenues and outlays of the government’s trust funds, would imply a consumption-equivalent welfare gain of 5.9 percent (instead of 0.8 percent). Second, the model we are using has infinitely lived agents, so we are not explicitly accounting for the distribution of costs and benefits across generations.

Conclusions

We compare the macroeconomic and welfare effects of failing to address the fiscal imbalances in the U.S. for an extended period with those of reducing federal debt to its precrisis level and find that the stakes are quite high. Our model simulations suggest that the continuous rise in federal debt implied by current policies would have sizeable effects on the economy, even under certainty that the federal debt will be fully repaid. The model predicts that the mounting debt ratio would increase the cost of borrowing and crowd out private capital from productive activities, acting as a significant drag on growth. Compared to stabilizing federal debt at its pre-crisis level, continuation of current policies for two decades would entail a permanent output loss of around 17 percent. The associated drop in per-capita consumption, combined with the worsening of wealth concentration that the model suggests, would cause a large average welfare loss in the long-run, equivalent to about 7 percent of lifetime consumption. Our results also suggest that reducing promptly the level of public debt is significantly more important for activity and welfare than differences in the size of government or the design of the tax reform. Accordingly, even under consensus on the desirability to increase primary spending in the medium-run, it would be preferable to start from a fiscal house in order.

The model adequately captures that the fiscal consolidation needed to reduce federal debt to its pre-crisis level would be very costly. Still, extending the welfare comparison to include also the transition period suggests that a fiscal consolidation would be on average beneficial.  After taking into account the short-term costs, the average welfare gain from fiscal consolidation stands at 0.8 percent of lifetime consumption.

We argue that our welfare results can be interpreted as a lower bound. This is because, first, we abstract from default so our simulations ignore the potential effect of higher public debt on the risk premium. However, as the debt crisis in Europe has revealed, interest rates can soar quickly if investors lose confidence in the ability of a government to manage its fiscal policy. Considering this effect would have magnified the long-run welfare costs of stabilizing the debt ratio at a higher level. Second, the high discount rate we use in the computation of the present value of utility exacerbates the short-term costs. If we recomputed the overall welfare effects in our scenarios using a discount rate of 3 percent, the welfare gain from a consolidation would be 5.9 percent of lifetime utility, instead of 0.8 percent. An argument for considering a lower rate to compute the present value of welfare is that by assuming infinitely lived agents we are not attaching any weight to unborn agents that would be affected by the permanent costs of delaying the resolution of fiscal imbalances and do not enjoy the expansionary effects of the unsustainable policy along the transitional dynamics.

The results in this paper are not exempt from the perils inherent to any model-dependent analysis. In order to address features that we believe are crucial for the issue at hand, we needed to simplify the model on other dimensions. For example, given the current reliance of the U.S. on foreign financing, the closed economy assumption used in this paper may be questionable. However, we believe that it would also be problematic to assume that the world interest rate will remain unaffected if the U.S. continues to considerably increase its financing needs. Moreover and as mentioned before, the model ignores the effect of higher debt on the perceived probability of default, which would likely counteract the effect in our results from failing to incorporate the government’s access to foreign borrowing. The model also abstracts from nominal issues and real and nominal rigidities typically introduced in the new Keynesian models commonly used for policy analysis. However, we believe that while these features are particularly relevant for short-term cyclical considerations, they matter much less for the longer-term issues addressed in this paper.