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The Budget Challenge
By Nayyer Ali MD
In the fiscal year just ended October 31, the federal government ran a budget deficit of 1.7 trillion dollars, amounting to 6.3% of GDP. This is an extremely high deficit for an economy that is near full employment, and far from a major recession.
In fact, the deficit actually increased compared to last year’s 5.4% of GDP. The Congressional Budget Office (CBO) projects that deficits will run about 6% of GDP for the next decade, increasing the total debt of the country at a pace much faster than economic growth and inflation, which means that the debt burden will be rising instead of falling. Typically, when economic times are good, the debt burden should be falling as the government collects more taxes and has less need to spend on relief programs such as unemployment insurance and food stamps.
So, what is driving this poor budget outlook and what can be done? One should always be at least a bit skeptical about 10-year forward projections. Looking up what the CBO projected in 2013 for 2023, they presumed that spending would be 19.5% of GDP, tax collection would be 19.1% of GDP, and interest on the debt would be 3.2% of GDP, yielding a total deficit of 3.5% GDP. But in the interim we had the large Trump tax cuts followed by massive spending and borrowing to deal with COVID disruptions. In reality in 2023, spending was 21.2% of GDP, taxes only 17.4%, and interest payments were smaller at 2.6% of GDP.
One big factor that is affecting the budget outlook is the rise in interest rates. Much of the national debt comes due over the next few years and will have to be refinanced at the higher interest rates we are seeing since 2022. It’s unclear how long such high interest rates will last. Currently the 10-year note is commanding an interest rate of 4.5%, but if inflation continues to decline back down to 2%, the 10-year note should fall to under 3.5%.
What’s more important than the interest bill is the wide gap between taxes and spending. No one likes paying taxes, but a responsible government should tax the amount needed to fund the level of spending the public wants.
There is an old joke that the Federal government is old-age home with a police station. This refers to the fact that 75% of government spending (not including interest payments on debt) is either for old age pensions and healthcare, or the defense department. If the people want to shrink the budget gap by cutting spending, this is where the real money is.
But Social Security is extremely popular, and keeps tens of millions of seniors out of poverty. The system is mostly self-funded, meaning that dedicated Social Security payroll taxes fund the program and keep it solvent. While it is true that there will be a shortfall in the late 2030’s, even then the program will have enough revenue to pay 75% of its obligations. Slashing social security does not seem like a reasonable solution.
Healthcare spending does offer some room for cuts. But even there the two main government health programs, Medicare for the elderly and Medicaid for the poor are pretty efficient. Medicare in fact over the last ten years has kept per beneficiary spending stable in real terms. This is remarkable given the advances in medicine. Medicare has actually been a pleasant surprise in the budget. Perhaps this positive trend will continue, and healthcare spending will not rise as much as predicted. Medicaid is even stingier and is the cheapest health insurance program in the country. Patients sometimes have trouble finding doctors willing to see Medicaid patients because the payments are so low.
The final area where cuts could be made is defense spending. Currently it amounts to 3% of GDP. But if Russia is defeated and neutralized by the Ukraine war, it may be possible to reduce defense spending as the only major competitor the US would then have to face is China. There may be a peace dividend of 0.5% of GDP that could fall into American laps in the wake of the total defeat of Putin.
If we cannot close the budget deficit with spending cuts alone, then we have to look at taxes. For Social Security, when the program was first set up payroll taxes applied to 90% of total earned income. Because it stops taxing at high income levels, and due to widening income inequality, Social Security now only applies to about 80% of earned income. If we raised taxes to cover 90%, that would substantially cut the shortfall in Social Security. Even more boldly, we could apply Social Security taxes to all income, including capital gains, over 1 million dollars per year, a move that would pretty much close the shortfall completely.
Two other options also remain on the table. The Trump corporate tax cuts could be reversed, and taxes on corporations raised from 1% of GDP at present back to about 1.5% of GDP. A final option would be to raise income and estate taxes on the extremely wealthy by about 0.5% of GDP.
A combination of tax increases amounting to about 1.5% of GDP and spending cuts of 1% of GDP would reduce annual budget deficits to about 3.5% of GDP, in line with long term historical averages. The lower budget deficits will mean lower total amount of government debt, and interest payments would shrink from their current massive projections. These modest changes in taxes and spending would result in budget deficits under 3% of GDP by 2033, numbers low enough that economic growth and inflation would mean that the debt burden, the total debt as a percent of GDP, would be on a long-term downward trajectory.
The US has a budget problem, but it is not insurmountable. It is fundamentally a political problem driven by the Republican Party’s unwillingness to ever increase taxes or significantly cut spending. Their childish approach to governance is why there is always a threat of a government shutdown when they control any aspect of government. Ultimately, they have no agenda they can articulate. Twice Democratic Presidents took over from Republicans who had run up massive debt, and put the nation’s fiscal house in order, once with Clinton in the 1990’s and again with Obama. Biden is now tasked with doing the same. As the remedies are politically unpopular, he will have to wait until he is reelected and tackle these issues in 2025.
