Straight From The IMF – The U.S. Is Broke

August 2010

Economists are known for their dry writing style. Consequently, International Monetary Fund (IMF) reports are difficult to read, and are largely ignored by most news agencies. For example, the evening news certainly did not report the understated IMF comment that “a larger than budgeted adjustment would be required to stabilize debt-to-GDP”. Nevertheless, if one carefully parses a recent IMF report, the result is anything but boring.

Simply put, the IMF says the U.S. is bankrupt. Solving this problem will require an immediate and permanent doubling of all current U.S. taxes. If this massive tax increase is not feasible, the U.S. will need to close the gap through dramatic reductions of existing entitlement programs (i.e., Social Security and Medicare) and other federal spending.

To put the following in context, current U.S. taxes are around 14% of U.S. gross domestic product (GDP). The “fiscal gap” is the value today (aka the present value) of the difference between projected spending and revenue in all future years. The IMF report states:

“The U.S. fiscal gap associated with today’s federal fiscal policy is huge. …. Using the same discount rate (3 percent) used by the Trustees of the Social Security Administration (2009) in their own Social Security-specific fiscal gap analysis and by CBO [the Congressional Budget Office], and the infinite horizon definition, the U.S. fiscal gap is about 14 percent of the present discounted value of U.S. GDP under the Staff’s Scenario. This implies that closing the fiscal gap requires a permanent annual fiscal adjustment equal to about 14 percent of U.S. GDP, that is to say that fiscal revenues and spending would need to change so that the primary balance predicted under that scenario improves by this amount every year into the indefinite future starting next year.”

Recent deficit spending and health care legislation play a part in the current problem. But the larger culprit is future spending for Social Security and Medicare. One might initially think that the IMF’s amounts cannot possibly be correct since the existing record government deficits are still not equal to the entire U.S. tax intake. However, the U.S. actually needs to run a “surplus” immediately (at least as how the government defines it) if the U.S. is to meet all the entitlement spending currently promised. If a change does not occur now, the size of the future solution will need to be even greater. The annual cost of these expected entitlements is around $4 trillion in today’s dollars.

Stated otherwise, the U.S. government has been running a Ponzi or pyramid scheme ever since Social Security started in 1935. Younger workers and their employers paid taxes, and the government made payments to their elders. As with anyone on the lower levels of a pyramid scheme, the young were promised that they would get their chance later at having future younger generations do the same. As occurs for all Ponzi schemes, what will actually happen is that the pyramid becomes too large for the younger generation to continue to support.

Absent changing U.S. spending, sizable tax increases will be required. According to the IMF:

“Sizeable fiscal actions would be needed to close the U.S. fiscal and generational imbalances. Under current policies, the United States federal debt is projected to grow rapidly due to a combination of large budget deficits before and during the crisis, as well as, over the medium term, demographic factors and healthcare inflation. As part of the medium term adjustment, the authorities would need to raise taxes and/or cut transfers [spending] substantially to avoid an undesirable escalation of the debt-to-GDP ratio. The longer the wait, the larger the necessary adjustment will be and the greater the burden on future generations.”

The IMF’s projections are based on the assumption that the U.S. is able to achieve a consistent 3% real growth rate. This is a fairly optimistic assumption, so the problem will not likely disappear based on the U.S. economy performing better than the IMF assumes.

At the risk of being obvious, changing the spending programs that have caused this significant increase in government spending is one part of a possible solution. Assuming spending reductions do not occur, the IMF provided interesting and controversial suggestions (controversial to Americans, that is) regarding preferable tax policy changes. In recent comments outside the current report, the IMF suggested that taxes be raised on gasoline, where the U.S. has considerably lower taxes than other developed countries. The IMF also suggested a consumption tax (aka a value added tax), which the IMF thought could be reasonably set at 10%.

The IMF did not suggest income tax increases. There is a limit as to how much the income tax can reasonably affect the huge problem that the U.S. faces, since a mere 2% of Americans already pay 40% of all income taxes. Without causing a serious disincentive to upper-income Americans, further increasing the progressive income tax rate structure is not a solution.

The IMF further suggested changes in the U.S. policy of supporting home ownership, both in terms of eliminating the income tax deduction for home-related interest, and the elimination of public support of interest rates through the government-sponsored entities (GSEs) such as the Federal National Mortgage Association (FNMA or Fannie Mae) and the Federal Home Mortgage Corporation (FMAC or Freddie Mac). Describing these existing large subsidies and their usefulness, the IMF wrote:

“These large fiscal costs end up benefiting middle- to high- income households. The majority of the tax measures are not well targeted, and they are largely enjoyed by upper income households that itemize deductions. The richer households benefit disproportionately since they face higher marginal income tax rates and usually have larger mortgages. However, their decision to buy a house is little influenced by government financial incentives.”

“It is thus unclear whether subsidies affect homeownership rates, although they raise housing consumption. Data suggest that there is no strong correlation between homeownership rates and subsidies to housing, both across time and in cross country comparisons. … It appears on the other hand, that the mortgage interest deduction affects housing consumption (i.e., the size of the house). … In addition, Lehnert et al. (2008) find little evidence that GSEs [such as Freddie Mac and Fannie Mae] lower interest rate spreads or raise homeownership. “

For related advice, we address how Americans need to change their retirement savings and expectations in light of these gloomy circumstances.

Fulcrum Inquiry performs financial investigations, business valuations, and economic analyses.