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How Important Is The Debt Level To Future U.S. Economic Health?

During this year’s first quarter, U.S. investors were heartened by improving economic indicators at home and by Europe’s efforts to contain its sovereign debt crisis. Yet that good news, which helped fuel the recent stock market rally, may overlook a larger, more persistent weakness—a ballooning federal deficit that independent economist Fritz Meyer describes as a “debt bomb.” Whether Congress finally deals with the issue could go far in determining the nation’s long-term economic health.
Meyer points to the possibility that U.S. debt levels could leapfrog current projections—of a rise to $4 trillion during the next decade—and surge to as high as $11 trillion. A critical measure of economic viability is the level of debt relative to gross domestic product (GDP), and the higher the percentage of debt to GDP, the more the United States may begin to resemble Greece, Spain, Portugal, and other nations at the center of the European sovereign debt crisis. And although the current percentage of U.S. debt relative to GDP is better than in some other countries, that level could be on a trajectory to a danger point, depending on which of two possible projected scenarios actually occurs.

The two possibilities are contained in a Congressional Budget Office (CBO) report produced each January that describes what may happen during the following decade based on current tax laws. This year, there were two sets of projections because there are two starkly different scenarios for taxes and federal spending beyond the end of 2012.

One projection is based on what will happen under laws now on the books. This “baseline” scenario assumes that several tax cuts enacted during the past 11 years will expire on schedule at the end of the year. Those laws, which reduced tax rates across the board—for income, capital gains, dividends, estates and gifts—and have limited the number of people subject to the alternative minimum tax (AMT), were supposed to “sunset” in 2010 but got a last-minute, two-year extension.

The CBO’s baseline scenario assumes that this time all of those taxpayer-friendly provisions indeed will expire, resulting in a rush of new tax revenue beginning in 2013. If that happens, the CBO projects that federal revenue could increase by as much as $800 billion during the next two years, rising to 16.3% of GDP in 2013 and 20% of GDP the following year. This surge in tax collection would be helped not only by higher tax rates but also by a sharp increase in the percentage of taxpayers subject to the AMT. The level of US debt would be impacted by a scheduled 30% reduction in fees that Medicare uses to reimburse physicians for their services.

The baseline scenario also factors in the impact of another current law, the Budget Control Act of 2011. Passed last August to allow the U.S. debt limit to rise, the legislation calls for broad, automatic spending cuts if Congress fails to achieve major deficit reduction.

The baseline scenario shows the federal deficit for fiscal year 2012 dropping to $1.1 trillion, or 7% of GDP, and projects that the shortfall will continue to decline steadily to less than $200 billion and will average just 1.5% from 2013 through 2022.

Because neither spending cuts nor tax increases are ever popular, the CBO report also includes an alternative fiscal scenario based on the notion that Congress once again will give taxpayers a reprieve. If the current tax breaks continue rather than expire, payments to doctors remain at current levels, and the Budget Control Act spending cuts are somehow averted, the level of U.S. debt could skyrocket.

Under the CBO’s alternative fiscal scenario, the annual U.S. budget deficit would remain high, averaging 5.4% of GDP during the next 10 years rather than the 1.5% average projected under the baseline scenario. Meanwhile, total public debt would approach 94%, the highest level since just after World War II.

Meyer considers the CBO’s alternative fiscal scenario to be the more realistic of the two projections, and he believes the long-term impact of failing to reduce U.S. debt would be a weaker economy. Though further postponing tax increases and spending cuts would spur economic growth in the short run, leading to higher rates of GDP expansion and reduced unemployment, unchecked deficits ultimately would reduce private investment and cause GDP growth to fall below levels predicted under the baseline scenario.

This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice


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