Question

Discuss the history of US government debt and deficits over time, with specific attention to our current situation. Looking forward should we expect deficits to increase or decrease, and what are some of the factors that will be driving them in the future? Do you think this is an issue we need to worry about? Explain why or why not?

Answer 1

Sol:

The national debt level has been a significant subject of U.S. domestic policy controversy. Given the amount of fiscal stimulus pumped into the U.S. economy over the past couple of years, it is easy to understand why many people are starting to pay close attention to this issue. Unfortunately, the manner in which the debt level is conveyed to the general public is usually very obscure. Couple this problem with the fact many people do not understand how the national debt level affects their daily lives, and you have a centerpiece for discussion.

Before addressing how the national debt affects people, it is important to understand the difference between the federal government's annual budget deficit, and the country's national debt. Simply explained, the federal government generates a budget deficit whenever it spends more money than it brings in through income-generating activities such as taxes. To operate in this manner, the Treasury Department has to issue treasury bills, treasury notes and treasury bonds to make up the difference. By issuing these types of securities, the federal government can acquire the cash it needs to provide governmental services.

The national debt is simply the net accumulation of the federal government's annual budget deficits.

The U.S. federal budget deficit for the fiscal year 2021 is $966 billion. FY 2021 covers October 1, 2020, through September 30, 2021. The deficit occurs because the U.S. government spending of $4.829 trillion is higher than its revenue of $3.863 trillion. The deficit is lower than last year. The FY 2020 budget created a $1.083 trillion deficit. Spending at $4.79 trillion was more than the estimated $3.706 trillion in revenue. It is unknown at this time what the impact of COVID-19 federal relief will be to the budget deficit; however, these relief packages will increase the deficit in 2020 and beyond.

Three Reasons for the Current Budget Deficit

Many people blame the deficits on entitlement programs. But that's not supported by the budget. These enormous deficits are the result of three factors.

War on Terror

First, the attacks on 9/11 led to the War on Terror. It's added $2.4 trillion in Overseas Contingency Operations (OCO) to the debt since 2001. As a result, defense spending rose to a record $855 billion in 2012. That includes the defense department budget OCO, and increases for the Department of Veterans Affairs, Homeland Security, and the National Nuclear Security Administration.

The Trump administration will continue to have high defense spending. It is estimated to reach $936 billion in FY 2020.1 That also includes OCO, the VA, Homeland Security, and the NNSA.

U.S. military spending is greater than the next 10 largest government expenditures combined. It's almost three times greater than China's military budget, and 10 times bigger than Russia's defense spending.2 It's difficult to reduce the budget deficit without cutting U.S. defense spending.

Tax Cuts

Second is the impact of tax cuts. They immediately reduce revenue for each dollar cut. Proponents of supply-side economics argue that the government will recoup that loss over the long term by boosting economic growth and the tax base. But the National Bureau of Economic Research found that only 17% of the revenue from income tax cuts was regained.3 It also found that 50% of the revenue from corporate tax cuts was lost.

For example, the Bush tax cuts added $2.023 trillion to the debt between 2011 and 2020. The Congressional Research Service estimated that service cost on that debt would add another $450 billion.4

Going forward, the Trump tax cut will reduce revenue. It's reducing the personal income tax rate, corporate taxes, and small business taxes. These cuts total $1.5 trillion over the next 10 years. But the Joint Committee on Taxation said the cuts would stimulate growth by 0.7% annually. The increased growth will add revenue, offsetting some of the tax cuts. As a result, the deficit will increase by $1 trillion over the next decade.

Unfunded Mandatory Spending

Lastly is unfunded elements of mandatory spending. Some people point to the $1 trillion cost of Social Security as a contributor to the deficit. But it's funded through payroll taxes and the Social Security Trust Fund until 2034.

Medicare will cost $722 billion in FY 2021. Around 60% of it is paid for by payroll taxes and premiums.5

The rest of the mandatory budget adds to the deficit. This includes Medicaid, which will be $448 billion in FY 2021. Medicaid provides health care to those with low incomes.

The mandatory budget also includes $645 billion in income support programs for those who can't provide for themselves. This includes welfare programs like TANF, EITC, and Housing Assistance. It also includes unemployment benefits for those who were laid off. Student loans help create a more highly skilled workforce. Other retirement and disability programs are for those who were former federal employees. These include civil servants, the Coast Guard, and the military.

Debt has been a part of this country's operations since its economic founding. However, the level of national debt spiked up significantly during President Ronald Reagan's tenure, and subsequent presidents have continued this upward trend. Only briefly during the heydays of the economic markets in the late 1990s has the U.S. seen debt levels trend down in a material manner.

From a public policy standpoint, the issuance of debt is typically accepted by the public so long as the proceeds are used to stimulate the growth of the economy in a manner that will lead to the country's long-term prosperity. However, when debt is raised simply to fund public consumption, such as proceeds used for Medicare, Social Security, and Medicaid, the use of debt loses a significant amount of support. When debt is used to fund economic expansion, current and future generations stand to reap the rewards. However, debt used to fuel consumption only presents advantages to the current generation.

The national debt has to be paid back with tax revenue, not GDP, although there is a correlation between the two. Using an approach that focuses on the national debt on a per capita basis gives a much better sense of where the country's debt level stands. For example, if people are told debt per capita is approaching $40,000, it is highly likely they will grasp the magnitude of the issue. However, if they are told the national debt level is approaching 70% of GDP, the magnitude of the problem will not be properly conveyed.

Comparing the national debt level to GDP is akin to a person comparing the amount of their personal debt to the value of the goods or services they produce for their employer in a given year. Clearly, this is not the way one would establish their own personal budget, nor is it the way the federal government should evaluate its fiscal operations.

Given that the national debt has recently grown faster than the size of the American population, it is fair to wonder how this growing debt affects average individuals. While it may not be obvious, national debt levels directly affect people in at least five ways.

First, as the national debt per capita increases, the likelihood of the government defaulting on its debt service obligation increases, and therefore the Treasury Department will have to raise the yield on newly issued treasury securities to attract new investors. This reduces the amount of tax revenue available to spend on other governmental services because more tax revenue will have to be paid out as interest on the national debt. Over time, this shift in expenditures will cause people to experience a lower standard of living, as borrowing for economic enhancement projects becomes more difficult.

Second, as the rate offered on treasury securities increases, corporations operating in America will be viewed as riskier, necessitating an increase in the yield on newly issued bonds. This, in turn, will require corporations to raise the price of their products and services to meet the increased cost of their debt service obligation. Over time, this will cause people to pay more for goods and services, resulting in inflation.

Third, as the yield offered on treasury securities increases, the cost of borrowing money to purchase a home will increase because the cost of money in the mortgage lending market is directly tied to the short-term interest rates set by the Federal Reserve and the yield offered on treasury securities. Given this established interrelationship, an increase in interest rates will push home prices down, because prospective home buyers will no longer qualify for as large of a mortgage loan since they will have to pay more of their money to cover the interest expense on the loan they receive. The result will be more downward pressure on the value of homes, which in turn will reduce the net worth of all homeowners.

Fourth, since the yield on U.S. Treasury securities is currently considered a risk-free rate of return, and as the yield on these securities increases, risky investments such as corporate debt and equity investments will lose appeal. This phenomenon is a direct result of the fact it will be more difficult for corporations to generate enough pre-tax income to offer a high enough risk premium on their bonds and stock dividends to justify investing in their company. This dilemma is known as the crowding out effect and tends to encourage the growth in the size of the government and the simultaneous reduction in the size of the private sector.

Fifth, and perhaps most importantly, as the risk of a country defaulting on its debt service obligation increases, the country loses its social, economic and political power. This, in turn, makes the national debt level a national security issue.

You Should Be Concerned

A budget deficit is not an immediate crisis. In moderation, it increases economic growth. It puts money in the pockets of businesses and families. Their spending creates a stronger economy. That makes other countries happy to lend to the U.S. government. It has always paid the debt back.

The World Bank found that if the debt-to-GDP ratio exceeds this tipping point for an extended period of time, it slows the economy. Every percentage point of debt above this level costs the country 1.7% in economic growth.

When the debt is excessive, owners of the debt become concerned. They worry that the United States won't pay them back. They had reason to be concerned in 2011 and 2013. That's when tea party Republican congressmen threatened to default on the U.S. debt.

You should also be concerned when the economy is doing well. The government should be reducing the deficit in an effort to lower the debt. Deficit spending in a healthy economy will make it overheat. An economy that's churning too fast creates a boom and bust cycle. It always leads to a recession.

The Bottom Line

The national debt level is one of the most important public policy issues. When debt is used appropriately, it can be used to foster the long-term growth and prosperity of a country. However, the national debt must be evaluated in an appropriate manner, such as comparing the amount of interest expense paid to other governmental expenditures or by comparing debt levels on a per capita basis.