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Fairy tales are heartwarming because the main characters usually possess a special power and something magical appears, allowing everyone to live happily ever after. Across Europe and the United States, governments manage their budgets in imaginary worlds. You don’t have to have a particularly Germanic view of public finances to know that this probably won’t end well.
The Congressional Budget Office warned last week that the U.S. government’s finances were on an unsustainable trajectory. The independent watchdog forecasts that U.S. government borrowing will remain relatively stable over the next ten years, at about 6 percent of gross domestic product. This level would far exceed the 3.7 percent average of the previous 50 years, a period that included the global financial crisis and the coronavirus pandemic. To give a more stark comparison, potential US borrowing is also around 50% higher than that proposed by former UK Chancellor Kwasi Kwarteng in his 2022 “mini” budget, which sent the UK bond market into a tailspin.
This would be worrying enough if we could take the CBO numbers at face value. But we shouldn’t do that, because Congress’s watchdog has been too optimistic in recent years, in part because it must base its projections on current U.S. government policy. This implausibly assumes that most of Donald Trump’s 2017 tax cuts will expire at the end of 2025. It also assumes that the restrictions on government spending contained in the Fiscal Responsibility Act of 2023 will continue after 2025. This suggests that discretionary spending by the US government, including defense, will decline. from 6.4 percent of GDP last year to 5.1 percent in 2034. Over the past 50 years, this spending has averaged 8 percent of GDP. These hypotheses are also not credible.
Add to this the slightly optimistic assessment that the US government will be able to borrow permanently in the short term at a rate below 3 percent and the true fantastical nature of these forecasts becomes evident. Even though the CBO’s main projection is that U.S. public debt is not on a sustainable trajectory and will rise from 97.3 percent of GDP in 2023 to an all-time U.S. record in 2028 and 116 percent in 2034, the outlook is much worse.
Although not as extreme, similar fairy tales about public finances dominate European debates. Following the Kwarteng debacle and subsequent fiscal U-turns, independent forecasts from the UK’s Office for Budget Responsibility show that UK debt will stabilize as a percentage of GDP towards the end of the decade. But these predictions are based on the UK’s own fictions that the government will start increasing fuel taxes in line with inflation, that the financial benefits of immigration will have no implications for public spending, that The restriction on public spending will come at a time of enormous dissatisfaction in the country. public services and that significant reductions in public investment spending are consistent with accelerated progress towards net zero.
We still do not know how the new European fiscal framework will work in practice, but the debt sustainability analyzes that will guide its work will be subject to the same Panglossian forecasting assumptions evident in the US and UK. The situation will not be any easier if we add the two structural difficulties of the euro zone: the European Central Bank seems likely to delay easing its monetary policy, which inhibits European growth, and the budgetary differences between Europe Northern and Southern Europe remain marked.
The bad news for all Western countries is that in addition to overly optimistic forecasting assumptions, maintaining the quality of health and social security programs in a context of rapid population aging will require higher taxes without perspective of improving services. This is a tough election bid.
The good news is that the necessary consolidation of budgets is far from impossible until we start getting caught up in new budget fantasies.
On the political left, the most widespread fiction is that all the necessary funds can be collected from the “rich” with almost no consequences for the rest of the population. To raise the necessary sums, tax increases must extend much further across the distribution of income and wealth. The more concentrated they are, the more tax evasion activities will be encouraged, thereby limiting revenues.
The greatest illusion of centrists is that there is a way to persuade the public that higher taxes and more public investment are necessary and in the best interests of all our collective interests. Examples of open, honest, and successful revenue-raising programs that minimize distortions by also reforming taxes are notable for their rarity. Even classic attempts, such as the increase in British national insurance in 2002, have chosen the tax least visible to the public, but also the one which costs the most on the labor market.
On the right, the long-standing fairy tale is that tax cuts raise revenue. Even if this is true in rare specific cases, the overwhelming evidence is that across-the-board tax cuts, such as those implemented in the United States in 2017, have deteriorated public finances, even if they have been positive for growth.
But perhaps the biggest fantasy of all is the hope that anything will happen to resolve unsustainable budgets without a crisis. We are much more likely to continue to muddle through, pretending everything is fine until something cracks. The problem is that the tax system will collapse and there will be no happy ending.