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5 budget assumptions that won't happen

February 21, 2012: 9:21 AM ET

From Medicare savings to tax revenues, the latest budget from President Obama includes scenarios that almost certainly will never play out.


FORTUNE -- President Obama's budget for fiscal 2013 -- covering the twelve months ending in September of next year -- is attracting boos from Republicans for proposing large increases in spending, taxes and debt, and praise from Democrats for lowering future deficits. The budget's supporters stress that the gap between spending and revenues would shrink from 8.5% this year to just 2.8% in 2022. Its critics pan the big rise in debt that happens as deficits supposedly shrink from gigantic to manageable.

By the president's own projections, federal borrowing would rise to 76.5% of GDP by 2022, almost twice the historical average of 40%.

The swelling debt load would require interest payments that absorb 14.4% of all outlays in 2022. That's one dollar in every seven America will spend, matching the entire projected budget for defense. "The interest payments are essentially wasted, because it doesn't pay for government services," says David Walker, former US Comptroller General and chief of non-partisan watchdog group the Comeback America Initiative.

It's well accepted that a burden of almost 80% of national income is nearing the danger zone, where borrowers doubt a nation's ability repay and demand ruinously high rates to keep buying sovereign bonds. Given how close the president's official plan comes to the fiscal edge, it's important to carefully weigh its assumptions on revenues and spending. If the forecasts for the former are unrealistically high, and the latter unreasonably low, the debt and the interest burden will grow to disastrous levels.

Here are five deficit-and-debt-lowering measures that are either virtually certain not to happen, or highly unlikely. The view is more or less non-partisan: Although the budget's critics and supporters vary on how far each measure will fall from the mark, they agree that these revenue and tax projections are unlikely to produce a budget that's heading for balance.

Discretionary spending down, by not by this much

This category comprises all spending on the military, foreign intelligence and homeland defense, a category called "security," as well as all appropriations that Congress votes on each year. "Discretionary" now accounts for 35% of total outlays.

The budget projects that discretionary spending will fall 22% from 2013 levels, adjusted for inflation, to 3.4% of GDP, by 2022. That's far below the 40-year average of 4.7%, and a figure only reached or breached in seven years over that period. In effect, the President is pledging that spending for both the military and two-dozen major branches of government, from the Agriculture to Energy to Commerce to Education departments, drop by one-fifth, adjusted for inflation.

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It's indeed possible that rigorous budgeting can hold increases in discretionary spending below the upward march of prices. That's especially likely because many of the measures that swelled the category under the "stimulus" plan are expiring. Says Walker, "Discretionary spending will drop in real terms, but a decrease on the scale the president is promising will not happen."

By contrast, the budget balances the freeze in "discretionary" with a large increase in entitlement or "mandatory" spending, plus interest on the debt. Those two areas combined rise 84% over the next nine years, or 7% annually, five points higher than projected inflation. One reason discretionary looks so good, and "mandatory" appears such a problem is that the president has shifted one of his top spending priorities, outlays on high-speed rail, from the discretionary to the mandatory budget. Cost: $125 billion over ten years.

Walker, who is even-handed in blaming both parties for mishandling budgets, is alarmed by the trend in mandatory spending. "With measures like moving transportation to the mandatory category, spending on autopilot would rise to 78% of total outlays by 2022," he says. "That's unsustainable and irresponsible."

Phantom savings from Medicare

The 2013 budget forecasts Medicare savings of around $48 billion a year by the end of the 10-year window. The projections correctly assume that the famous "doc fix," which is scheduled to lower physician payments by around 30% each year, will not occur, Congress always kills the provision. Instead, the $48 billion comes from reducing payments to clinics and hospitals, and by lowering spending on training and education for physicians. The number is big: Savings on that order would lower projected outlays from $956 billion in 2022 to $908 billion, a reduction of 5%.

Once again, it won't happen. In fact, it's likely that the entire number is an illusion. The Medicare actuary warns that cuts to providers would cause long waits and rationing of care, an outcome the administration rejects.

Tax receipts heading up, but don't count on this windfall

The Obama administration is counting on a gigantic increase in income tax receipts to help tame the deficit. From 2013 to 2022, the budget forecasts a 92% rise in what's far and away the biggest revenue-raiser.

The expected windfall would help raise all tax revenues to 20.1% of GDP in ten years, 1.6 points over the historical average. Given the opportunities Americans have to shelter income, it's always been difficult to surmount the 18% or 19% level with higher rates, except in periods of rapid expansion.

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The administration promises to break that traditional ceiling by imposing far higher taxes on high-earners. The problem is that two of the major new levies it proposes are more wish list than real cash. The first and biggest is a measure that would limit all itemized deductions to a maximum of 28% of income for families earning over $250,000 a year. This provision appears to echo the "Buffett rule" that advocates minimum taxes on the wealthy.

The second change would shift all dividends for high-earners from the current special 15% rate to regular income, scheduled to be taxed next year at as much as 39.5%, plus an additional Medicare levy that would bring the total to around 45%.

Together, the limitations on exemptions and new rate on dividends would raise $104 billion in additional taxes by 2012. That's an increase of between 4% and 5% in most future years, a huge boost to the revenue side.

Once again, it won't happen. Leaders of both parties are determined to eliminate the hated Alternative Minimum Tax. Congress has no appetite to complicate the code add another AMT-like levy before it addresses the AMT itself. Tripling the tax on dividends stands no chance of passing the Republican controlled House, and hence is strictly theoretical.

An optimistic forecast for growth 

The budget reckons that GDP will expand at 2.7% this year, and 3% next year, then cruise at around 4% from 2015 to 2017. But those numbers are a lot higher than the scenario most forecasters expect. The CBO predicts far lower growth for 2012 and 2013. Over the 10-year window, the budget reckons that GDP will increase by a total of 41%, adjusted for inflation. The CBO says 37%.

"The administration's forecasts are the most aggressive since the early 1980s," observes J.D. Foster, an economist with the conservative Heritage Foundation. "It's assuming an extra year of growth compared with most forecasts, and a very good year at that."

If GDP is indeed 4% lower than the budget's forecast in 2022, tax receipts will also be a lot lower -- causing a shortfall on the order of $300 billion. That would raise the deficit from a projected $704 billion to over $1 trillion.

Interest rates need to stay low, but will they? 

Today, the U.S. is paying an average interest rate of just 2.1% on the $11.6 trillion in debt in the hands of investors. That's one-third of the average of 6.5% since 1986. To keep interest payments down, the Treasury has systematically reduced the average maturity on its bonds to benefit from the extremely low yields on short-term notes. Today, almost 60% of all U.S. debt needs to be repaid within four years.

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The forecast on rates is the most difficult of the five areas to assess. But it's also one of the most important if the forecast is incorrect. The administration does foresee a sharp increase in short-term rates, with the 90-day Treasury bill hitting 4.1% by 2017.

What's far less convincing is the forecast for longer-term rates. The budget sees ten-year bond yields rising gradually to 5.3% over ten years. That's 0.5 points below the 30-year average. It's also highly possible, if not probable, that future rates will be above the norm because of America's elevated level of debt, even the level that the budget predicts.

If the average rate on America's mountainous, $19.5 trillion in debt is one point above the prediction, add $200 billion to the deficit. At two points, it's $400 billion, and the budget gap jumps far over $1 trillion once again. If rates rise more rapidly than predicted, the debt will also be far higher, compounding the problem.

The Obama budget attempts to balance conflicting goals: Advocating major spending initiatives at the same time it attempts to curb dangerous deficits. On paper, it gets there by assuming revenues that are unlikely to materialize and cuts that won't happen. It wouldn't be such a problem if the blueprint left plenty of room for error by projecting balanced budgets or surpluses. But it's flirting with danger even if its numbers play out. And it's non-partisan to predict that they won't.

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About This Author
Shawn Tully
Shawn Tully
Senior EDITOR-AT-LARGE, Fortune

Shawn Tully has been writing feature stories for Fortune since 1980. He's covered stories as varied as the Vatican's finances, the exile of fugitive commodities trader Marc Rich, and the disastrous merger between Guidant and Boston Scientific. He specializes in banking, federal budget and spending issues, and health care. Tully holds a B.A. in English from Princeton University, an M.B.A. from the University of Chicago, and a master's in Applied Economics from the Universite Catholique de Louvain in Belgium.

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