Imagining Balanced Budgets—What Kind of Changes Would It Take?

In recent weeks we have seen again that bond markets do respond negatively to projections of big government deficits. How difficult will it be for the world's leading economies to confront plunging confidence in the bond markets by balancing their government budgets? A comparison of the challenges faced by different members of the Organization for Economic Cooperation and Development (OECD) is instructive.

In simple terms, governments can balance their budgets by cutting spending or raising government revenues (or any combination of the two). Typically incumbent leaders, fearful of voters' reactions, do too little of each, and then cross their fingers in the hope that accelerating economic growth will restore budgetary balance. This is what happened in the United States in the 1990s: Congress and the Clinton administration agreed in the early 1990s to move tentatively in the direction of a balanced federal budget and then the Internet boom added to their actions, delivering the budget surpluses of the late 1990s.

Let's imagine that sovereign OECD governments are suddenly unable to raise more debt in the bond markets and, as a result, abruptly become effectively subject to the same annual balanced budget requirements that apply to most US state government budgets.¹ In other words, imagine that OECD governments would have to eliminate their 2009 deficits, as projected by the International Monetary Fund (IMF) in the April 2009 World Economic Outlook,² by the end of this year. How big an adjustment from the fiscal policies of 2008 would that require?³

For illustrative purposes, it is easiest to concentrate only on the two policy options of cutting government spending or raising taxes. (It is important to note up front that this is a thought experiment and that actually balancing fiscal deficits in a demand crisis in one year would be extremely damaging economically for any country attempting it, so this is decisively not a policy prescription)

Let's call the spending cut option the "Bundesbank" scenario, in which Bundesbank staff (or their equivalent) assume total control of OECD economic policies in mid-2009 and declare that all governments must cut spending sufficiently to restore budgets to balance by year's end. And let's call the second scenario, the "Future Generations Get to Vote" scenario, in which the unborn (but no longer silent) future generations of OECD voters actually get to vote and demand that current generations pay fully for the government services they enjoy by raising tax rates.

Table 1 illustrates the scale of the fiscal policy changes required of OECD governments to balance their budgets from 2008 to the end of 2009 under the two scenarios. Table 1 also indicates the relative scope of the political challenges for different OECD governments in balancing their budgets. From these figures one can see the intensity of the political discussion that would occur over the tradeoff between sustainable government services and acceptable levels of taxation. In many respects, this is precisely the debate occurring today in state capitals around the United States over the struggle to balance their 2009 budgets.⁴

The first column shows the IMF's 2009 projected general government (i.e., including all levels of government) deficits in the OECD countries.⁵ Column 2 shows how much OECD general government revenues would have to increase in 2009 over 2008 levels in the Future Generations Get to Vote scenario, while column 3 shows how much OECD general government revenues would have to be cut in 2009 from 2008 levels in the Bundesbank scenario.⁶

Several things are clear from table 1. It can be seen in column 1 how oil-rich Norway is projected to be the only OECD country in general government surplus in 2009, while the average general government deficit in the OECD will be close to 5 percent of GDP. The deficits are close to, or in excess of, 10 percent of GDP in the United Kingdom, Japan, Iceland, the United States, and Ireland. As an addendum, it is shown at the bottom that most of the general US government deficit is at the federal level, reflecting the requirement for balanced budgets at the US state and local government level.⁷

In column 2, it is clear that the required percentage increase in government revenues to balance the budget in the Future Generations Get to Vote scenario is far higher when measured as a percentage of the previous year's revenues than when the projected deficits are simply estimated as a share of GDP. This follows directly from the fact that OECD government revenues in 2008 were only a fraction of total GDP. After Norway, the country with the lowest required increase in government revenues in 2009 is Finland, where the 1.6 percent projected deficit can be covered by raising general government revenues by just 3.1 percent over 2008 levels.⁸ Meanwhile, covering Switzerland's similar-sized 2009 projected deficits through increases in revenues would require a 4.6 percent increase in government revenues over 2008 levels, reflecting the far smaller size of government in Switzerland (33.7 percent of GDP in general government revenues in 2008) compared with Finland.

The striking finding in column 2, however, is the scale of the fiscal policy changes required in countries with high deficits and relatively small government. The United States and Ireland would both require an increase of more than 40 percent in government revenues from 2008 to 2009 to balance their budgets. In other words, when measured as a percentage of the previous year's government revenues, their political fiscal policy challenge would be more than 10 times the scale of the challenge in Finland or Denmark, which have larger government sectors and smaller deficits than the United States and Ireland. The same logic applies to Iceland, which at 13 percent of GDP has IMF-projected 2009 general government deficits almost as large as the United States and Ireland. But with a Scandinavian-size government sector—that is, a larger government sector as a proportion of GDP—it faces a substantially smaller relative fiscal policy change in order to balance the budget.

By far the biggest challenge in balancing the budget is faced by the US federal government, which, if it were to finance the projected $1.825 trillion 2009 deficit projected by the Congressional Budget Office, would have to raise federal government revenues by more than 72 percent over their 2008 levels of $2.524 trillion.⁹ By table 1's metric, which statically measures the required change in fiscal policy over the previous year to reach a balanced federal budget, the political battle over reaching that goal would be more intense than any other budgetary battle in the OECD. Historically, the unwillingness to raise taxes (in the face of huge deficits) is seemingly more deeply rooted in the US Congress than anywhere else in the OECD.

Column 3 shows many of the same relative country results for OECD countries as column 2. The Bundesbank scenario thus reveals how Finland would have to cut general government expenditures by 3.4 percentage points in 2009, relative to 2008, to balance the budget, while Switzerland would require a 5 percent cut in general government expenditures. That these countries require slightly larger expenditure cuts than revenue increases (relative to their bases) to balance their 2009 budgets indicates that they ran government surpluses in 2008.

At the other end, governments in the United States and Ireland would have to slash general government spending by over a third from 2008 levels in order to restore general budgets to balance in 2009.

Again, however, it is the US federal government that is facing the worst situation, as it would have to cut 2009 spending by more than half—actually more than 61 percent—from 2008 government expenditure levels (of $2.983 trillion) to restore balance. As was the case above, table 1 illustrates that the unwillingness to cut government spending (in the face of huge deficits) is seemingly stronger in the US Congress than among any other parliamentarians in the OECD.

In the OECD therefore, it is incontrovertibly the US Congress that will have to have the most earnest discussion with voters about the sustainable scale of government or the level of their in the years ahead. One could easily argue that no other elected OECD politicians have shown as much fiscal irresponsibility as US presidents and members of the US Congress.

"There is a moment where you cannot spend more and accumulate more debts. We are at that moment" Jean-Claude Trichet—June 21, 2009¹⁰

Notes

1. A 2004 survey from the National Conference of State Legislators showed that all US states, except Vermont, had constitutional or statutory balanced budget rules in place. US states typically follow "fund accounting" (in which all revenues and expenditures are designated a particular fund), meaning that state balanced-budget requirements distinguish between the general fund and other funds (usually for items such as highways or general transportation). State balanced-budget requirements most often pertain to the general funds, which account for the vast majority of states' spending.

2. International Monetary Fund World Economic Outlook Database, April 2009.

3. This is a simplified and completely static exercise, and all dynamic effects, such as declines in tax revenues as a result of cuts in government expenditures, are ignored.

4. See, for instance, New York Times, "States Turning to Last Resorts in Budget Crisis," June 22, 2009.

5. Comparing general government deficits is preferable, as it allows one to ignore both country-size differences and historical organizational disparities in government sectors. In the United States for instance, the government sector is split into federal, state, and local government, while in other, smaller OECD countries governments are often organized in a far more centralized manner.

6. Column 2 is computed by taking the 2009 projected deficit as a share, not of GDP, but of the country's 2008 general government revenues, as estimated in the OECD's Economic Outlook 84. Computing with ratios is necessary, as the IMF 2009 projected deficits are not available in absolute dollar terms. As such, two data points are used with GDP denominators from 2008 and 2009, respectively, which generally biases the data in columns 2 and 3 upward (as 2009 GDP data will be lower than in 2008 in almost all OECD countries). Similarly, these computations do not take inflation into account. However, these biases are not large enough to materially impact the conclusions drawn from these computations here.

7. Table 1's addendum combines IMF general government deficits with the most recent Congressional Budget Office (CBO) estimates for the US federal government. Since this utilizes two separate data sources, the data—13 percentage points for the federal government deficit out of a total of 13.6 percentage points for the general government deficit—should be taken as an approximation.

8. Correspondingly, Finland's general government revenues in 2008 amounted to 51.9 percent of GDP.

9. In fact, the federal government would have to raise revenues by fully 83 percent over the projected (lower) 2009 federal government revenues of $2.186 trillion.

10. "Europe bank chief warns on debt," BBC News, June 21, 2009.