Could Faster Growth Solve Our Debt Woes?
A number of commentators have suggested recently that our budget problems could be solved if only we focused more on promoting economic growth. Economic growth, they argue, would generate more revenue and thus make painful tax increases and spending cuts unnecessary.
We've taken on this claim before, demonstrating that even a significant improvement in long-term growth would not be enough to prevent debt from growing faster than the economy. Over the medium term, the story is similar. Still, while faster growth cannot solve our medium-term debt problems, it certainly can help.
Rules of Thumb for Growth and Deficits
The actual impact of economic growth on budget deficits will depend on the source of the growth, but a broad rule of thumb suggests that every dollar increase in GDP will produce 20 to 25 cents more in revenue. For 2023, when GDP is projected to be nearly $27 trillion, a one percent increase in the size of the economy will yield about $60 billion in revenue.
Of course, the ten-year deficit impact will depend on how that 1 percent increase is achieved, both because there could be interim savings (or costs) and because of savings on net interest. For example, if the economy grew by 0.1 percentage point faster per year, that growth would produce about $315 billion of deficit reduction over ten years. On the other hand, if the economy grew 1 percentage point faster in 2014 and grew at the same rate after that, economic growth would produce $560 billion of savings. And if the economy started by growing 1 percentage point slower and then growing to 1 percent above projections by 2023, there would be barely any ten-year deficit reduction, though there would be in subsequent years.
|Savings/Costs (-) of Different Growth Scenarios Resulting in 1% Higher GDP by 2023 (billions)
|First Five Years
||Second Five Years||Ten Years|
|0.1% Annual Faster Growth
|Immediate 1% Increase
|1% Fall Followed by Faster Growth||-$120||$130||$10|
Source: CRFB calculations
Note: Numbers include interest savings/costs.
These ten-year estimates can serve as an important guide to understanding the effects of larger or smaller growth scenarios. Importantly, however, these estimates may be overly optimistic on the deficit impact, since they assume that there will be no feedback between economic growth and either health care spending or interest rates (both could be higher, leading to higher spending). They are also unlikely to be very predictive of long-run impact, over which higher growth is likely to result in higher spending -- like Social Security benefits, which grow with wages -- as well as revenue.
Economic Growth and The Debt
Faster economic growth can help improve debt projections in at least two ways. First, faster growth produces more revenue -- enough to result in $315 billion of deficit reduction for every 0.1 percentage point increase in the annual growth rate. But in addition, faster growth increases the economy's capacity to carry debt. Thought of another way: when we measure debt as a share of GDP, a higher GDP can help lower debt-to-GDP the same as lower nominal debt levels can lower the ratio.
As a result, even small improvements in growth can help slow debt accumulation. If growth were 0.1 percentage point higher annually, for example, debt levels would reach 71 percent of GDP by 2023, compared to 73 percent under the CRFB Realistic Baseline. Even just a faster economic recovery that brings GDP back to its potential sooner would bring debt levels to 72 percent of GDP by 2023.
Still, it would take a pretty significant improvement in growth to put the debt on a clear downward path as we have called for in the past. In fact, by our estimates, doing so would require the economy to grow nearly 0.5 percentage points faster each year. This would mean annual productivity growth nearly 40 percent faster than what is projected and inconsistent with what most analysts think could be generated through government policy changes alone. Even under this scenario, CBO expects that debt would bottom out in the mid-2020s and begin to rise again thereafter.
Source: CBO, CRFB calculations
Growth Isn't the Solution, But It Can Help
At the end of the day, no reasonably achievable increase in economic growth can solve all of our fiscal woes. Even if we could permanantly increase productivity growth from the 1.3 percent projected by CBO to 1.8 percent annually -- a scenario which seems highly unlikely -- debt would still begin to grow as share of GDP by the middle of next decade.
Yet while growth cannot be the whole solution, it certainly can help. That's why policymakers should focus not only on the size of whatever deficit reduction they do, but also the composition. Replacing the anti-growth sequestration with more targeted and gradual cuts can improve growth by increasing demand and reducing the squeeze on public investments. Reforming the tax code can promote growth by encourage work and investment and reducing various distortions. Raising retirement ages can improve growth by encouraging more savings and longer working lives. And deficit reduction itself can encourage growth by reducing the "crowd out" of private investment.
Ultimately, a comprehensive plan to replace the sequester and reduce long-term debt could go a long way to improving economic growth in both the short and long term. And that improved growth can further help us to put our fiscal house in order.