Faced with large and growing deficits, U.S. President Barack Obama struck a commission earlier this year to find a way for the U.S. to grapple with its looming budgetary problems. But just a few days after the commission published its recommendations, he announced a deal that will extend tax cuts and expand benefits — good news for the economy, but bad news for long-term fiscal sustainability.

For governments, the only way to eradicate deficits and control debt is to cut spending, raise taxes, or some combination of both. On Dec. 1, 2010, the U.S. National Commission on Fiscal Responsibility and Reform proposed both spending cuts and tax hikes to grapple with the country’s growing fiscal burden. As the commission noted: “The problem is real. The solution will be painful. There is no easy way out … If the U.S. does not put its house in order, the reckoning will be sure and the devastation severe.”

That devastation surely would not stop at the U.S. border. A growing U.S. government debt burden that becomes a serious drag on U.S. economic growth would also weigh heavily on the Canadian economy. It could hurt U.S. equities as well as the stocks of companies around the world that rely on the U.S. market. The possible impact on the U.S. dollar would also affect cross-border trade and investors’ returns. And it could leave the U.S. unable to combat future negative economic shocks, such as the next financial crisis.

However, it appears that no one is ready to hear the deficit commission’s message just yet. A few days after the commission released its report, Obama and congressional Republicans announced that they had reached a compromise to extend tax cuts that were introduced under former president George W. Bush along with various other costly measures, including cutting payroll taxes by two percentage points, extending emergency jobless benefits for an additional 13 months, along with expanding various other tax credits and allowances. In effect, these measures will provide further fiscal stimulus to a flagging U.S. economy.

Indeed, in response to the announcement, some economists raised their forecasts for gross domestic product growth in the U.S. this year. For example, economists with Morgan Stanley & Co. Inc. boosted their forecast for U.S. GDP growth in 2011 by a full percentage point, to 4% from 3%, as a result.

Here in Canada, Toronto-based BMO Capital Markets Corp. hiked its U.S. GDP growth forecast for 2011 to 3% from 2.3%. It also suggested that the effect would likely spill over into Canada, so it boosted its forecast for Canadian GDP growth to 2.7% from 2.4%.@page_break@However, some analysts also caution that these measures may not prove as effective as hoped. Furthermore, Morgan Stanley suggests that the measures that bolster growth in 2011 could then reduce growth in 2012 by about half a percentage point.

Additionally, this package will add further weight to the U.S. deficit. Morgan Stanley estimates that it would bump up its deficit forecasts for both fiscal 2011 and 2012 by about US$160 billion, pushing the projected deficit to US$1.23 trillion, or 8.6% of GDP in 2011, and US$1.1 trillion in 2012.

BMO Capital Markets says that although this fiscal stimulus is needed now, future deficit reduction “will not be easy.” In fact, it predicts that the 2012 presidential election will be fought on the subject of deficit reduction. “The deficit-reduction plan will be hotly debated as the new year progresses and the expanding economy will make the eventual spending cuts, tax hikes and the increase in the retirement age more palatable,” it says.

Indeed, those sorts of measures appear inescapable given the U.S.’s current fiscal situation. The deficit commission reports that the U.S. federal debt has ballooned to 62% of GDP in 2010 from 33% of GDP in 2001. “The escalation was driven in large part by two wars and a slew of fiscally irresponsible policies, along with a deep economic downturn,” its report states.

And although economic recovery will help the deficit situation in the short term, it indicates that even after the economy recovers, federal spending is expected to increase faster than revenue. The Congressional Budget Office projects the U.S is currently on track to push its debt to 90% of GDP by 2020. Population aging will rapidly make the situation far worse, it notes, possibly pushing debt as high as 185% of GDP by 2035.

To fight this threat, the commission proposes a plan that aims to achieve US$4 trillion in deficit reduction by 2020, taking the deficit down to 2.3% of GDP by 2015, and reducing the debt to 60% of GDP by 2023 and 40% by 2035.

The plan involves serious spending cuts; tax reforms that would lower rates, but do away with loopholes, thereby raising overall tax revenue; and reforms of the social security program, including raising the retirement age further still (it’s scheduled to reach 67 in 2027, and the plan would hike it to 68 by 2050 and to 69 by 2075); among other things.

In a report on the commission’s proposals, UBS Financial Services Inc. says that it doesn’t expect to see many of these ideas adopted in the next couple of years. “However, the proposal could inform budgets going forward and could bring some previously off-limits topics into the mainstream debate,” it suggests.

UBS notes that tax reform and changes to the social security progam will be some of the commission’s most controversial recommendations. IE