While the administration and others have criticized S&P for downgrading U.S. debt, there are at least three reasons it makes sense.
Reason 1: The debt ceiling deal fails to address long term debt, which is mainly coming from healthcare entitlement spending.
The following graph shows the severity of the problem. According to CBO projections, spending on healthcare entitlement programs alone will exceed the entire discretionary budget by 2019.
Medicare and Medicaid are the two largest components of healthcare spending, but “other healthcare” starts to kick in substantially in 2014, which is mainly attributable to Obama’s health insurance subsidies and exchanges.
Healthcare entitlement spending is the one part of the budget that is exploding, and yet the debt deal specifically puts it off the table, outside of Medicare reimbursement rates which current law would reduce drastically anyway. Further, Democrats are sending strong signals that they intend to protect entitlement spending at all costs. It all portends a long term debt explosion and distinguishes us from AAA rated countries like the U.K. and France whose debt levels will peak in the next couple of years and decline afterwards, according to S&P.
Reason 2: Many OECD countries spend more than we do on welfare programs, but they also have the VAT.
The U.S. is in fact the only OECD country left without a VAT, or value-added taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. . As explained here, taxes on goods and services, particularly the VAT, provides the largest source of revenues for OECD countries, making their relatively generous welfare programs more sustainable. Of course, it is not a panacea, as evidenced by the debt crisis now gripping many European countries, but it helps explain why Germany, France, Canada, and the U.K. in particular continue to maintain their AAA ratings. Neither is the VAT costless, as it would lead to a much higher level of taxation than Americans are accustom to — roughly 10 percentage points more in taxes as a share of GDP — and this would significantly lower the long term growth trend.
Reason 3: In a world where healthcare spending is not addressed, and we do not have the VAT, interest payments will become a dangerously large share of tax revenues.
Mark Joffe, a former senior director at Moody’s Analytics, recommends using the ratio of interest payments to tax revenues as an intuitive and easily calculated measure of default risk. Unlike the more standard measure, Debt-to-GDP, it directly accounts for both interest rates and the ability to tax the economy. He figures based on the history of the U.S., which has actually defaulted three times, default happens when interest payments get to about 30 percent of revenues. The following graph shows this will happen in 2025, based on the CBO’s “alternative fiscal scenario”, which is generally considered the most realistic. Also, shown is (publicly held) Debt-to-GDP, which reaches 100 percent in 2021.
Joffe notes that the unpredictability of both interest rates and politics over such a long time frame means there is plenty of room for disagreement. For example, the CBO assumes interest rates will return to historic levels (about 5 percent on the 10 year T-note). This depends on many things, including worldwide growth, inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. , and the willingness of China to continue accepting low returns on treasuries. Politics is equally unpredictable, and it is well within the realm of possibility that the current market turmoil and downgrade will eventually spur politicians to pursue more substantive deficit reduction efforts.
Conclusion
In the U.S., our politicians have for years promised us European style welfare benefits and yet promised we won’t have to pay for it. If we are to avoid a default, i.e. missing a payment or hyper-inflating the currency, we have but two options: significantly reduce our future promises to healthcare entitlement recipients, or join the community of high-tax and low-growth social democracies via a VAT.
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