The Deficit: Background Information

One of the most annoying things I come across as I talk about the economy is just how little the average voter knows about it. We are asked to form opinions and then vote of policy options based upon a very flimsy understanding of what the situation is. In the current fraught political atmosphere, and in the even more dangerous economic circumstances we have created for ourselves, opinions need to be supported by more fact. There will always be differences of opinion with respect to policy choices, at least I hope so, but we should all have a common grounding in the situation we are trying to fix.

“Credible conversations about cutting the deficit have to focus on the long term problem. It is unfortunate that our current crisis came after a period in which our long term situation had already deteriorated very badly. The crisis clearly aggravated an existing very serious problem. But it did not create that problem.”

In the spirit of neutrality I want this week to distribute some simple facts about the federal budget. The need for this is simple: there is a great deal of public talk about our ‘awful’ deficit, and a growing urgency to close the gap. If this is to be a serious discussion we all need to start from the same place:

What do we spend our money on?

The latest figures for federal spending are these:

1. The largest single item in the budget is defense spending, at $625 billion. This is 21% of all spending. It includes the costs of all the wars we are waging, plus the operations of the defense department generally.
2. Next largest is Social Security, at $617 billion, which also rounds out to 21% of the budget. The average monthly payment in 2008 was $1,041 and was paid to about 35 million retirees.
3. Medicare, Medicaid, and CHIP – the three government run health care programs – account for $599 billion or 20% of the budget. Approximately 45 million receive Medicare supported health care and cost about $391 billion. The rest of the money goes to the Medicaid and CHIP programs that cover about a further 55 million people at any given time.
4. The next largest category of spending in the budget is a group of ‘safety net’ programs such as child care assistance, food stamps, supplemental income programs and so on. Together these amount to an annual $313 billion or 11% of the total.
5. The next largest item in the budget, and on being much discussed, is the interest paid on the national debt. In 2008 this amounted to $253 billion or about 8% of the total budget.
6. The remaining 20% of spending is spread across a wide variety of smaller programs: veterans benefits – 6%; scientific and medical research – 3%; transportation infrastructure – 3%; education -2%; and non-security international spending such as aid – 1%. The final 5% is made up of things like the justice system and government offices.

All the above figures are drawn from the 2008 budget and give a glimpse into what we spend our money on.

A more interesting insight is the change within the budget over the last few years.

The fastest growing category in the list above is defense spending which has been growing at an average annual rate of 9.1% since 2001. Other categories have grown much less rapidly: Social Security, Medicare and Medicaid combined grew 3.8% over the same time; other mandatory programs grew 3.0%; and the discretionary programs grew only 1.3%. The average for all categories was 4.6%, so we can see that only defense has grown at a rate above average.

Finally we should look at the revenue side which in this case I will do by noting federal revenues as a percentage of GDP. Because of the recession and the huge drop in taxable incomes caused by it, federal revenues plunged in 2009 to below 15% of GDP which is almost an all time low. This drop was ‘cyclical’ in that it will automatically go away – without any policy changes – once taxable incomes recover as the economy starts to grow again. Remember that government spending tends to increase, not decline, in recessions as many of the safety net programs kick into gear as people lose jobs etc. So as revenues decline spending increases making the deficit widen dramatically. Of the current deficit about 35% to 40% of it is due to this cyclicality.

The remainder of the current deficit – in fact more than half of it – comes from ‘structural’ or long term problems in the budget. The government takes in less than it spends on a regular basis. This problem has been particularly pernicious since the mid 2000’s.

Let me give you some comparative data:

In 2000, government spending was 18.4% of GDP while revenues were 20.9%. This produced a budget surplus of 2.5% of GDP. By 2004 this situation had changed dramatically: spending has crept up to 20.0% of GDP – with the onset of the Iraq war – but revenues had dropped to 15.8% creating a deficit of 4.2% of GDP. In other words in just four years the budget had swung from solid surplus to growing deficit.

The federal revenues recorded in 2004 were the lowest as a percentage of GDP since 1950 and the drop is entirely accounted for by the two waves of tax cuts introduced in 2001 and 2003. The philosophy behind those tax cuts was that the stimulus of the tax refunds would generate sufficient GDP growth that normal tax rates on that extra growth would offset the drop in revenues caused by the tax cut. Thus, the theory was, growth would eliminate any deficit caused by dropping federal revenues.

This has not happened. So we are left with a structural funding gap that we fill currently through borrowing.

In the light of these facts it is important for us all to separate the two sources of deficit:

• The current crisis management or cyclical deficit
• The longer term or structural deficit

Credible conversations about cutting the deficit have to focus on the long term problem. It is unfortunate that our current crisis came after a period in which our long term situation had already deteriorated very badly. The crisis clearly aggravated an existing very serious problem. But it did not create that problem.

Consequently the discussion we now need to have should have two basic themes:

1. How much of GDP should flow through the government? This is a vital part of any discussion. We need to settle on a rough range within which we can contain government spending. By comparison with other industrial countries the portion of GDP we allocate to the government budget is quite small – much less than, say France or Japan. But there are clearly pressures on the budget that keep it growing.
2. Which is the second theme. We need to make choices, not avoid them. The main problem with recent fiscal policy is that it tried to have it both ways: cut taxes and yet not cut spending. We fell into a huge hole because of that avoidance of the issue. If we are to get out of a long term deficit problem, and I think it wise we do, then we need to be straight forward with ourselves about what the implications are for each choice.

I tend towards a fiscally conservative position: I would advocate getting the budget as close to balance as possible within a medium term period – say five to ten years. The reason that the adjustment cannot be achieved more quickly is the disruption caused by closing the gaps. Any solution to our difficulty will entail new taxes, and that will slow growth in the short term, so they need to be phased in gradually. Similarly program cuts need to be deep in some areas, and that is also anti-growth since it means taking government spending out of the economy. Obviously in our current weak state doing either is risky, so both need to be phased in properly so everyone has time to adjust with minimal impact. Hence the medium term focus.

Finally for the record: there is no data I am aware of that says a low tax environment automatically implies faster growth. Indeed all the recent evidence is the exact opposite. The fastest post war growth periods have all been associated with higher taxes! Since I don’t like paying taxes, I would dispute the cause and effect in these cases, but advocates of tax cuts have an even harder case to prove: they have no evidence at all on which to base their case.

In any case we are about to enter a vital discussion. We all need to be well versed on the facts, and the real causes of our problems. It will be tempting for some to focus on short term political point scoring and thence to make the case that the current deficit is entirely the result of profligate bail-outs and stimulus spending. This is categorically not the case. I wish it were, because that would make solving our problems more easy.

As it is we need to be grown up and recognize the real issues and their long term and deep rooted nature. Only then can we get the budget under control and back to a modest surplus, which is where it should be in years of growth.

Addendum:

Here is a good discussion – at the Baseline Scenario site – of the budget. The chart halfway down the post tells the entire story. The big problem is the lost revenue from 2001 and 2003. If you cut revenue that much you need to have the courage to cut spending too. The Republicans don’t have that courage. Instead they punted the problem forward, making it worse. That was an act of extraordinary cynicism and frankly was, to use one of their favorite words, ‘unpatriotic’. Fiscal conservatives should be revolted at the distemper and lack of ideas coming from the right.

The country is in crisis and we need leadership not smug naysaying.