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In Part 1 of this essay, I demonstrated with incontrovertible data that the US government budget cannot realistically be balanced, or even be made sustainable, through either spending cuts alone or revenue increases alone. In Part 2 of this essay, I will elaborate further on why a two-pronged approach is required.

Fact #3: Outlays as A Percent of GDP Must Rise In the Next 20 Years

The demographic "bulge" caused by the baby boom generation helped boost the growth in government revenues for the past 30 years. But as this particular generation retires, the bulge effect reverses, causing a decrease in revenues and an increase in outlays for retirement and medical benefits.

Furthermore, Americans have decided that they wish to have universal health care coverage (as possessed by every other major industrialized country in the world and most middle income countries such as those in Latin America).

All of this means that, all else being equal, outlays as a percent of GDP must rise relative to the historical average of 21.2% between 1980 and 2007.

Sure, outlays as a percent of GDP don't have to rise, theoretically. But in practical terms, the clock cannot be turned back on Americans' expectations regarding the responsibilities of a modern state. Americans have decided that they want government to provide certain services and to honor certain commitments such as Medicare and Social Security. The inevitable implication is that outlays as a percent of GDP must rise relative to historical averages

Furthermore, an inexorable corollary of this is that government revenues as a percent of GDP must rise to meet these requirements.

Fact #4: A Balanced Approach To Fiscal Sustainability Is Not Optional; It is Required.

I have previously shown in Part 1 that it is simply impossible today to balance the US federal deficit, or even to bring the deficit down to a sustainable level by reducing outlays alone or by increasing receipts alone.

One way to come to grips with this is to ponder the following data outlined in Part 1: If outlays as a percent of GDP were immediately brought down to the historical average between 1980 and 2007, the US fiscal deficit would decline by 3.5% of GDP. At the same time, if receipts as a percent of GDP were instantly brought up to the historical average for the same period, the US fiscal deficit would be reduced by a further 2.5%. Given that the budget deficit in 2012 is projected to be equivalent to 8.5% of GDP, the net result of combining the aforementioned spending cuts and revenue increases would still be a budget deficit of 2.5% of GDP.

Fortunately, a budget deficit of 2.5% of GDP is sustainable indefinitely by the US government.

It would be nice if the analysis of the US fiscal situation could end here. Alas, it cannot. The problem is that given the projected growth in federal spending in the next 20 years (under current law), in order to bring the budget deficit down to 2.5% of GDP - or even to 4.0% which would still be sustainable - it will not be sufficient to raise revenues and reduce outlays as a percent of GDP to average historical levels.

Clearly, the very nature of this problem is such that it will be necessary to restrict this aforementioned projected growth of government spending. However, it must also be acknowledged by all parties that given demographic realities and manifest political priorities, some level of spending growth relative to GDP is inevitable. And once this basic fact is acknowledged, it also becomes imperative, to this same extent, to raise government revenues as a percent of GDP.

Having said this, the need to raise receipts as a percent of GDP need not be a cause of excessive worry. History in the US has proven that federal receipts as a percent of GDP can rise to at least 20.6% of GDP without significantly hindering economic growth. Indeed, history in other nations proves that receipts as a percent of GDP can even go substantially higher without significantly restricting economic growth. Major negative effects on economic growth do not start kicking in until both receipts and outlays as a percent of GDP rise to levels that are substantially above 20.6%.

Conclusion

Anybody who tells you that the US fiscal problem can be solved through spending cuts alone or tax increases alone is either lying or misinformed. The US fiscal situation requires a two-pronged Grand Bargain.

The Grand Bargain that the US needs must simultaneously accomplish two objectives: First, given the astronomical rise in future spending projected under current law, a Grand Bargain must limit this projected growth of future government outlays, and entitlements in particular. Second, given the inevitability of some modicum of growth in government outlays as a percent of GDP in the next 20 years, revenues as a percent of GDP must be raised from the current historically low thresholds to levels that are above historical averages. Both of these objectives must be accomplished together; achieving one or the other alone will simply not be sufficient.

Fortunately, and contrary to what many (if not most) believe, achieving a Grand Bargain of this sort is both economically feasible and politically viable.

The requisite cost control can mostly be achieved by limiting the growth of spending projected under current law on Medicare and Social Security; actual cuts in nominal dollar terms are not needed. The rest of the cost control can come from freezing defense spending and other domestic spending items. Again, at this stage, outright cuts in government expenditures are not absolutely necessary (though some would be advisable due to the inefficiency of many government expenditures).

In terms of the requisite revenue increases, tax rates need not be raised at all; the rise in revenues as a percent of GDP can come from eliminating deductions, tax breaks and loopholes. Raising revenue in this way has the additional advantage of making the overall tax burden substantially more progressive than what President Obama's proposed increase in income tax rates would achieve. Simplification of the tax code would also improve overall economic efficiency (i.e. growth).

So, a Grand Bargain is both economically sound and politically viable.

However, before you uncork the bottle of Champagne, I've got news for you: A Grand Bargain is not a free lunch. A Grand Bargain presages significant pain. Implementing the sort of deficit control outlined in this essay will necessarily exert a considerable drag on GDP growth and corporate earnings in the coming decade. There is no way around this basic fact.

This fact is one of the primary reasons why I remain cautious regarding US equities represented in index ETFs such as (NYSEARCA:SPY), (NYSEARCA:DIA) and (NASDAQ:QQQ) and stocks such as Apple (NASDAQ:AAPL), Oracle (NYSE:ORCL) and Amazon (NASDAQ:AMZN). On the one hand, I am somewhat sanguine because I do not believe the general investing public has begun to understand the potential for reaching Grand Bargain. But overall, my caution overrides my optimism due to the fact that I am even more certain that the general investing public understands even less about the consequences of a Grand Bargain - or any other alternative resolution of the US fiscal situation for that matter. A Grand Bargain will entail a significant amount of pain, including below-trend GDP growth and corporate earnings growth for a very long time. Just as significantly, any scenario that does not involve a Grand Bargain would only pose even greater dangers for stocks.

Source: Fiscal Grand Bargain: Are Spending Cuts And Revenue Increases Both Needed? Part 2