Facing the 2025 Fiscal Cliff: Reduce Deficits with Spending Cuts or Risk Inflation and Voter Backlash
A winning fiscal strategy to deal with the return of the debt limit and expiring Trump tax cuts, budget caps, and Obamacare subsidies
All eyes are on the Department of Government Efficiency, or DOGE—a Trump initiative to cut wasteful government spending spearheaded by Elon Musk and Vivek Ramaswamy. With dire fiscal projections threatening the American dream, efforts to curb spending and rein in administrative excess should be welcomed. But before DOGE is scheduled to report recommendations no later than July 4 of 2026, the new administration and 119th Congress will face four critical fiscal deadlines in 2025—the return of the statutory debt limit and the expiration of discretionary spending caps, key provisions of the 2017 Tax Cuts and Jobs Act (TCJA), and expanded Obamacare subsidies. Each deadline is an opportunity to reshape the fiscal landscape and set America on a sustainable path. Without decisive action, the mounting deficit will fuel inflation, drive up interest rates, and push homeownership and aspirations of a more prosperous future further out of reach for millions of Americans.
The previous administration’s disregard for fiscal sustainability, marked by excessive spending, contributed to sharp increases in inflation (see figure below), one of the major factors costing them the election. As my Cato colleague, Ryan Bourne noted:
”I think that they thought the public would reward them more for a fast recovery, in terms of jobs, than they would punish them for inflation […] I think that proved a huge miscalculation.”
To avoid repeating these mistakes, Congress and the Trump administration should adopt a comprehensive fiscal strategy to respond to each of these impending deadlines by reducing spending significantly, with the goal of putting the budget on a path to balance (see Table 1).
The Debt Limit Returns
On January 1, 2025, the statutory debt limit—suspended under the Fiscal Responsibility Act of 2023 (FRA)—will be reinstated. Without action, the Treasury Department will deploy so-called extraordinary measures to continue meeting federal obligations until those resources are exhausted. Congress must use the debt limit as an opportunity to implement a credible fiscal stabilization plan, pairing any increase with major spending reforms.
Key recommendations:
Establish clear fiscal targets, such as achieving primary balance or stabilizing the debt-to-GDP ratio at no more than 100 percent over the next decade.
Tie debt limit increases to significant spending reductions, particularly through discretionary spending cuts and entitlement reform.
Empower an independent fiscal commission modeled on the BRAC process to insulate entitlement reforms from political pressures.
Expiring Discretionary Spending Caps
The binding statutory caps on discretionary spending, reinstated under the FRA for Fiscal Year (FY) 2024 and FY 2025, expire after FY 2025. This will remove a key constraint on discretionary spending, increasing the risk of higher deficits and unchecked growth in non-essential programs.
Key recommendations:
Reinstate discretionary spending caps with a 2 percent annual growth limit over a 10-year period to encourage fiscal discipline.
Close loopholes incentivizing abuse of emergency designations to bypass caps, requiring offsets and stricter budget rules to stop phony emergency spending.
Reduce wasteful or duplicative discretionary programs, such as outdated subsidies and federal funding for state and local responsibilities.
The Expiration of Key TCJA Provisions
At the end of 2025, most individual tax provisions from the TCJA will expire, triggering automatic tax increases averaging $400 billion annually over the next decade. Extending these provisions without offsetting spending cuts would worsen already unsustainable deficits.
Key recommendations:
Extend pro-growth provisions within a deficit-neutral framework, including lower individual tax rates and business tax incentives.
Eliminate inefficient tax loopholes and corporate welfare to offset revenue losses and promote economic efficiency.
Pair tax cuts with long-term spending reductions to ensure fiscal sustainability and avoid future tax increases driven by rising deficits.
The Expiration of Expanded Obamacare Subsidies
Expanded Affordable Care Act (ACA) subsidies, initially enacted under pandemic relief legislation and extended through 2025 by the Inflation Reduction Act, are set to lapse. These subsidies have increased federal spending significantly without addressing the underlying drivers of high health care costs.
Key recommendations:
Allow Obamacare subsidies to expire, rejecting permanent expansions of temporary programs that contribute to long-term fiscal challenges.
Focus healthcare reforms on reducing government intervention and fostering market competition to improve health care quality and reduce health care prices.
Irresponsibility Is Costing Americans Their Future
The US is on an unsustainable fiscal trajectory. With the public debt nearly at 100 percent of GDP and growing rapidly, excessive spending and high debt will produce severe economic consequences, including reduced growth, higher inflation, higher interest rates, and the possibility of severe and sudden austerity when debt financing becomes too expensive. Policymakers must achieve about $8 trillion in deficit reductions over the next 10 years to stabilize the debt at current levels and achieve primary balance (the government’s budget balance excluding interest payments)—and that’s under the assumption that none of the expiring Trump tax cuts will be extended, or if they would be extended that Congress will do so in a deficit-neutral manner.
Addressed irresponsibly, the coming fiscal deadlines outlined above could result in the addition of trillions of dollars to the deficit. Full extension of the TCJA without offsets, for example, is projected to increase deficits by around $4.5 trillion over a 10-year period. Likewise, extending temporarily expanded Obamacare subsidies could cost an additional $335 billion, not including associated interest costs.
On the flip side, even modest discretionary spending caps that increase 2 percent annually could save roughly $500 billion over a 10-year window. More aggressive caps, akin to the Limit, Save, Grow Act of 2023, could save $3 trillion or more. Add a few hundred billion more in additional discretionary savings if Congress can offset just a fraction of the various emergency plus-ups it now passes regularly.
To truly commit to a credible fiscal stabilization plan over the long term, though, policymakers must address the government’s vast network of social transfers, especially old-age entitlement programs like Medicare and Social Security. These programs are projected to grow rapidly due to demographic changes and benefit design, yet they are some of the most politically challenging to reform.
Here, the administration and Congress might harness the positive momentum behind DOGE, establishing an independent fiscal commission with real power akin to the Base Realignment and Closure process used to close outdated military bases. A BRAC-like process could overcome gridlock by providing legislators with sufficient political cover, as it would leave the details of entitlement program reform to outside experts and the approval mechanism to the executive. This could help Congress make meaningful changes to entitlement programs before a fiscal crisis forces draconian austerity.
A Winning Fiscal Strategy for American Prosperity
President Trump and Congress have a choice: stabilize America’s finances or risk leaving future generations a legacy of economic ruin. By cutting spending and lowering deficits, policymakers can restore economic growth, keep living costs manageable, and increase the odds that Americans’ dreams to achieve career success, attain homeownership, and start or expand their families are within reach. Failure to address runaway deficits will not only hurt American families—it could lead to political fallout as voters despise inflation.
The stakes couldn’t be higher. It’s time to do the right thing.
We will delve deeper into each of these issues in a new policy analysis to be published on January 7.
Your emphasis on the middle class doing well under our welfare system is telling. I imply from it that you know welfare is insufficient for the lowest SES strata. Homelessness and hunger is high amongst the poor, which is the right metric to measure the adequacy of a nation's welfare system. I agree that all welfare should be means tested (except child benefits like school lunches because of peer pressure considerations), which would ease our mutual concern over the middle class consuming too much of our total welfare budget.
Speaking of metrics, the right measure of progressive taxation is the individual tax burden, and not the percentage of total taxes paid by SES strata. That the top 10% pay 76% of all collected taxes is a reflection of grievous wealth disparity. America's wealthiest SES strata are not individually burdened at all. At our wealth disparity, the wealthiest should be paying 90%+ of taxes to call our tax schedule progressive. Even at that level, they would not be burdened.
This type of progressive taxation is justified because individual capitalist wealth is largely unearned. Billions of dollars are made off the shoulders of thousands of others. Elon Musk, for instance, is not so brilliant that we can say he earned his fortune. American society earned the greatest part of his billions, so we should increase his tax burden. It's a canard to suggest that slight burden would diminish any capitalist drives for wealth accumulation.
The greatest risk to the economy and social tranquility is continuing tax rates that are too low and insufficiently progressive. While government fraud and waste are extensive, necessitating budget cuts, we must strengthen, not diminish the "welfare state."
American capitalism is the envy of the world, but continuing that success requires a healthy, educated, housed, well fed and internationally defended society; elements of the welfare state. America lags far behind our industrial peers in all of these bedrocks except the last. National defense expenditures are grossly excessive, with inefficiencies and ineffectiveness rampant. At the same time as these necessities are falling short, American capitalists are enjoying unprecedented wealth.
Budgets should be "zeroed out" every decade, and then reset by imagining the minimum needed for the welfare state in a fully effective and efficient manner. Then taxes need to be raised to meet that budget. Effectively and efficiently providing for the welfare state is a challenge that has not been met, but continuing with inadequate tax revenue while those problems are solved is a recipe for eventual social unrest that will damage capitalist fortunes.