Why Don't Those Darn Politicians Just Balance the Budget?!

Balancing the U.S. Federal Budget:

Why It Is SOOOOOO Much Harder than You Think

Disclaimer: Nothing in this essay should be viewed as advocating any ideological or policy position on proper strategies for reducing the federal budget deficit.  All I’ve done in this essay is use official data to illustrate the great difficulties, and hard choices, that we will have to make if we are to balance the federal budget.  In the interests of full disclosure, however, I should tell you that in general I favor balanced budgets. 

The Current Debate over Balancing the Federal Budget

In my last post I pointed out that large numbers of American citizens are concerned about the federal budget deficit.  Public opinion polls show large majorities of Americans are in favor of balancing the federal budget.  In this election season, both parties – but especially the Republican Party – are promising to reduce the federal budget deficit if elected.  And, as we have seen, Tea Party activists and others have mobilized around the idea of reducing the federal budget deficit.

Balancing the federal budget, or even substantially reducing the federal budget deficit, will be extraordinarily difficult.  Since budget deficits are caused by revenues that are too low and expenditures that are too high, reducing these deficits will require both raising taxes and cutting expenditures.  Moreover, the magnitude of these tax increases and budget cuts are far larger than most citizens realize.  How large?  Let’s take a look at the data.

A Tale of Two Budgets: Discretionary and Non-Discretionary

Before we begin, it’s important to point out that there are really two federal government budgets.  The one we hear about most is the official budget, which includes all (or almost all) federal expenditures.  In 2010, the official budget had the US federal government spending $3.72 trillion and running a budget deficit of $1.29 trillion.

Let’s say we want to reduce this budget deficit by cutting spending.  It turns out that some federal spending is very difficult to cut, because levels of funding are determined by preexisting formulas or are required to fulfill legal requirements.  Examples of this non-discretionary funding include:

·        Social Security                                             $721 billion in 2010

·        Medicare                                                      $457 billion in 2010

·        Federal Employee Pensions                    $121 billion in 2010

·        Interest on Federal Debt                          $425 billion in 2010

It’s not that we can’t reduce these expenditures.  It’s just that doing so is very difficult, and can’t be done by simply tinkering with the federal budget.  For example, reducing Social Security payments will require a fundamental restructuring of the Social Security system, and this restructuring will have to take place outside of the system for crafting the federal budget.  Federal employee pensions are legal obligations, and reducing these pensions faces serious legal obstacles (they are contracts, and the government can’t simply ignore contracts).  Reducing interest payments means renegotiating debt payment schedules with the individuals and countries that hold US government debt.  Or we could simply default on this debt, plunging the world economy into ruin.  Like I said, reducing these expenditures will be very, very tough.

If we’re going to reduce the federal deficit by simply “cutting the federal budget,” rather than by fundamentally restructuring large programs and legal obligations, we’re really talking about cutting the federal discretionary budget, or levels of federal spending that Congress and the President actually decide upon every year.  The federal discretionary budget in 2010 is $1.40 trillion.  Recall that the federal budget deficit in 2010 is predicted to be $1.29 trillion.  So balancing the budget by spending cuts alone will require near complete elimination of all federal discretionary spending.   You read that right – balancing the federal budget through spending cuts alone will require eliminating almost all federal discretionary spending. 

Stark Choices for Balancing the Federal Budget

Discussing discretionary and non-discretionary budgets probably seems pretty theoretical.  Instead, let’s talk about balancing the federal budget in terms of actual federal programs.  The discussion here assumes that we want to balance the federal budget in a single year, which is very unrealistic.  Still, this simplification helps identify the tough choices we face.    

How Much Do We Have Available to Spend?

Before looking at how much we have to cut spending to balance the federal budget, let’s look at the revenue side – how much do we have available to spend?  We saw in my first blog post that total federal revenues in 2010 will be equal to 14.8% of GDP (about $2.26 trillion), a 60 year low.  A large percentage of this revenue, however, is earmarked for special non-discretionary program.  Revenue raised through these sources cannot be used for other federal programs.  Some examples include:

·        FICA (Social Security)

·        Medicare

·        Federal fuel taxes (pays for most transportation projects)

When we talk about balancing the federal budget, looking at all federal revenue isn’t too useful, since much of this revenue is unavailable to be spent on most federal programs.  Most discretionary federal programs – that is, the programs that Congress and the President choose to fund every year – are funded by personal and corporate income taxes.  Here is how much revenue was generated by these taxes in 2010:

·        Personal income tax=       6.4% of GDP (roughly $980 billion)

·        Corporate income tax=    1.1% of GDP (roughly $168 billion)

So in 2010 personal and corporate income taxes generated revenue equal to about $1.15 trillion, or 7.5% of GDP.  This is the revenue that the federal government has to fund most programs.

How Much Do We Spend? National Security

We’ll begin looking at federal spending by examining national security.  Protecting citizens is the fundamental purpose of government, so a good argument could be made that national security spending is essential (I am not making this argument, but it is commonly made by others).  Here is how much the US spent on national security related programs in 2010:

·        Department of Defense:              $692 billion              4.5% GDP

·        Civil Defense                                    $54 billion                0.4% GDP

·        Veterans Benefits                           $125 billion              0.8% GDP

·        Homeland Security                         $53 billion                0.3% GDP

A little quick addition will show that federal spending on national security in 2010 was $924 billion, or 6.0% of GDP.  To place this number in context, this means that 80% of all federal income taxes – both personal and corporate – are required to fund national security. Personal and corporate income taxes raised $1.15 trillion in 2010, and we spent $924 billion on national security.  This leaves only $226 billion, or 1.5% of GDP, to fund everything else government does outside of the earmarked programs discussed above.

How Much Do We Spend? Interest on the Debt

In an earlier blog post I discussed the large federal deficit.  Adding up all deficits for all years gives us the national debt.  The US has to borrow to cover this debt, and the US government has to pay interest on this borrowed money.  This is called debt service, or interest on the debt.  This is mandatory spending.  The government cannot refuse to pay this debt service, but there is no special tax or fund to pay for this.  Debt service must be paid for using revenue from personal and corporate income taxes (we’re ignoring the short-term strategy of paying this interest by borrowing from the Social Security program).  In 2010, interest on the national debt was equal to $425 billion, or 2.8% of GDP.

What Do We Need to Cut to Balance the Federal Budget?

Some more quick addition shows that in 2010 federal spending on national security and debt interest equaled $1.35 trillion, or 8.8% of GDP.  But remember, total federal revenue from personal and corporate income taxes in 2010 was only $1.15 trillion, or 7.5% of GDP.  This means that if the federal government did nothing in 2010 but pay for national security and interest on the debt, we would have run a budget deficit of $200 billion, or 1.3% of GDP.  Stated differently, if we eliminated spending on all federal discretionary programs except for national security, we would still not balance the federal budget. In fact, if the federal government ONLY spent money on the Department of Defense and debt service, these expenditures would equal $1.12 trillion.  So, if we want to balance the federal budget through cuts in discretionary spending alone, this means eliminating all federal spending except debt service and the Department of Defense.  We would even need to eliminate spending on homeland security, civil defense, and veterans benefits.

OK, so maybe we can’t completely balance the federal budget through spending cuts.  Can’t we make good progress toward a balanced budget by cutting other government programs?  The short answer is, no.  Here is how much the federal government spent on several programs in 2010:

·        Environmental protection                                   $11 billion

·        Education and training                                         $143 billion

·        International Aid                                                    $24 billion

·        Justice and Law Enforcement                             $30 billion

·        Agriculture                                                               $21 billion

·        Food stamps and food support                          $99 billion

·        Housing assistance                                                 $77 billion

·        NASA                                                                         $18 billion

·        Energy                                                                       $19 billion

·        Science and Technology                                       $15 billion

·        Conservation, Recreation, and Parks               $36 billion

·        Economic and community development        $12 billion

·        Cash welfare assistance                                        $30 billion

·        Disaster Assistance                                                $17 billion

·        Congress and the Courts                                      $13 billion

Federal spending for all of these programs adds up to $565 billion.  This may be too much to spend on these programs.  I don’t know.  Remember that the budget deficit in 2010 is expected to be $1.29 trillion.  So, completely eliminating every one of these federal programs would still leave us with a budget deficit of $725 billion.  Stated differently, the complete elimination of federal spending for all of these programs would reduce the budget deficit by less than half.

The Take Away

Eliminating the federal budget deficit in the short term will be extraordinarily difficult.  Some key points to take away from this essay include:

1.     All federal personal and corporate income taxes are consumed by federal spending on the Department of Defense and debt service.  If we are going to balance the federal budget using cuts to discretionary spending alone, we will have to eliminate all federal discretionary spending except for these two items.

2.     The complete elimination of 14 large (and popular) federal programs, plus the elimination of Congress and the Federal Courts, will reduce the budget deficit by only 44%. 

3.     If we cut taxes further, as many Congressional candidates recommend, balancing the federal budget deficit will require even greater cuts in federal spending. (And no, tax cuts do not “pay for themselves.”  All tax cuts reduce revenues).

4.     If citizens are serious about wanting a balanced federal budget, this will require significant increases in federal taxes (which, as we have seen, are at a 60 year low) and very, very large reductions in many popular government programs.  In short, to reach a balanced budget, be prepared to make large sacrifices. 

5.     Any politician that tells you we can make meaningful progress toward a balanced federal budget by simply trimming federal spending is either lying to you or does not know what they are talking about.

Deficits, Deficits, Everywhere Deficits

U.S. Federal Budget Deficit:

How Big Is It and Where Did It Come From?

Disclaimer: Nothing in this essay should be viewed as advocating any ideological or policy position on proper levels for federal budgets or deficits.  All I’ve done in this essay is evaluate the accuracy of political complaints about the size and source of federal budget deficits by comparing these criticisms with official data and information from public records. 

The Current Debate Over the Federal Budget Deficit

Government budget deficits occur when the amount of money the government spends (expenditures) exceeds the amount of money the government accumulates from taxes (revenues).  So budget deficits can occur because taxes are too low, because government spending is too high, or both.  Since 1960, the US federal government has run a budget deficit in all but five years (in 1969, 1998, 1999, 2000, and 2001 the federal government ran a budget surplus).

While the US federal government almost always runs a budget deficit, citizens rarely pay much attention to this fact.  Things are different today.  For the first time in 25 years, significant numbers of American citizens appear to be concerned about the federal budget deficit.  Much of the rhetoric surrounding the 2010 Congressional Elections focuses on the budget deficit.  In addition, Tea Party activists are mobilized by the dramatic increase in the federal budget deficit.  In this essay we will take a look at the size of the federal budget deficit (it’s really, really big), and try and figure out where this budget deficit came from. 

How Big is the Federal Budget Deficit?

In three words, the federal budget deficit is “really, really big.”  But what do we mean by big?  Think about when people incur debt.  If your neighbor incurs a debt of $1 million, is this a large debt?  This depends upon how wealthy your neighbor is.  If I’m your neighbor, this is a huge debt.  If your neighbor is Brett Farve, the debt isn’t quite so big.  If your neighbor is Warren Buffett (or even Jimmy Buffett), the debt is trivial.  The same thing is true of government budget deficits.  Whether they are “big” depends upon the wealth of the government.  The best way to measure the size of the budget deficit is by looking at these deficits as a percentage national wealth, or Gross Domestic Product (GDP).  

The 2009 federal budget deficit was 9.9% of GDP.  The 2010 federal budget deficit is estimated to be 8.9% of GDP.  These are very big numbers.  To put this in perspective, between 1960 and 2009, the largest federal budget deficit was 6% of GDP (in 1983 under President Reagan).  So, the current federal budget deficit is 50% larger than the previous record.  

New Presidents and Budget Deficits

Since the 1970s, budget deficits have tended to get larger during the first couple of years of a new presidential administration.  I’m not sure why this is the case, but the data are pretty clear.  Here I report the percentage increase in the federal budget deficit between the last year of an outgoing President and the second year of a new President:

Jimmy Carter’s First 2 Years:       Deficit decreased 36% compared to Ford

Ronald Reagan’s First 2 Years:    Deficit increased 48% compared to Carter

G.H.W. Bush’s First 2 years:        Deficit increased 26% compared to Reagan

Bill Clinton’s First 2 Years:            Deficit decreased 38% compared to Bush

G.W. Bush’s First 2 Years:            Deficit increased 163% compared to Clinton

Barack Obama’s First 2 Years:    Deficit increased 178% compared to Bush

Sources of the Federal Budget Deficit

Even in this historic context, the current growth of the federal budget deficit is very large.  In short, during the Presidency of Barack Obama we have seen historic increases in the federal budget deficit.  Why is this?  Where did these huge budget deficits come from?  Let’s take a look.

The Legacy Budget Deficit

New Presidents don’t come into office facing a balanced budget.  Reagan inherited a budget deficit from Carter.  Clinton inherited a budget deficit from George H.W. Bush.  George W. Bush inherited a budget surplus from Clinton. Therefore, budget deficits are caused by something more than the policy decisions of new Presidents.    

The 2009 federal budget deficit was 9.9% of GDP, or $1.41 trillion.  This is a huge figure.  Why is the budget deficit so large?  In January 2009, before President Obama took office, the US Congressional Budget Office predicted that with no new policy changes, the 2009 federal budget deficit would be $1.2 trillion, or 8.3% of GDP (CBO contains the nonpartisan budget experts in the federal government).  That is, if President Obama or President McCain would have simply continued the policies of President Bush, the federal budget deficit would have been $1.2 trillion.  This figure is often called a “legacy deficit”.  The difference between this projection and the actual 2009 budget deficit of $1.41 trillion -- $201 billion – can plausibly be attributed to the policies of President Obama. 

The same CBO report predicted that the 2010 budget deficit would be $717 billion, or 4.9% of GDP.  Projections get less accurate as they move farther into the future, but let’s assume this estimate was on target.  The actual budget deficit in 2010 will probably be $1.29 trillion.  The difference between the CBO projection and the actual 2010 budget deficit is $573 billion. 

In total, then, the difference between the CBO’s 2009-2010 estimates of budget deficits and actual budget deficits add up to $774 billion.  This increase in the total 2009-2010 budget deficit can plausibly be attributed to the policies of President Obama.  This is a very large number, equal to roughly 5.3% of GDP.  

The Deficit and the Stimulus Plan

What policy actions did President Obama (and the Democratic Congress) take to create this $774 billion increase in the federal budget deficit?  It turns out that this increase in federal debt is almost exactly the same size as the 2009 “stimulus plan” (the American Recovery and Reinvestment Act, or ARRA).  ARRA increased federal spending by $499 billion and included tax cuts of $288 billion.  Together, these increased expenditures and reduced revenues added $787 billion to the federal budget deficit (this back of the envelope calculation ignores the more complicated ways in which the ARRA affected revenues and expenditures).  It’s fair to say, then, that President Obama’s “stimulus plan” is largely responsible for the $774 billion increase in the federal budget deficit in 2009 and 2010 above the legacy deficit.

Why did President Obama push so hard for a stimulus plan that increased federal debt by over 5% of GDP?  Lots of explanations have been offered, but the fact is that Presidents don’t make these decisions on their own.  They respond to the input of experts and representatives of important interests that are affected by these decisions.  In late 2008 and early 2009 the US economy was in the midst of the largest economic downturn since the Great Depression.  There was real fear that a second Depression was right around the corner.  Faced with this situation, the overwhelming majority of experts and many powerful interest groups argued that the stimulus plan was essential if we were to avoid this Depression.  This recommendation is also consistent with the dominant theory of how economies work.  Here are some examples of experts and groups asserting that the stimulus plan was needed:

·        Paul Krugman, George Stiglitz, Ken Arrow, Dan McFadden, and Robert Solow, all winners of the Nobel Prize in Economics

·        Private economists Alan Sinai (chief economist for Decision Economics), Mark Zandi (chief economist for Moody’s), and David Wang

·        Paul Volker and Ben Bernanke, past and present chairmen of the Federal Reserve Board

·        Economists who advise politicians from both parties, including Alice Rivlin (Budget Director for President Clinton), Laura Tyson (Chair of the Council of Economic Advisors under President Clinton), Greg Mankiw (Chair of the Council of Economic Advisors under President Bush), and Mark Zandi (economic advisor to Presidential candidate John McCain).

·        A majority of Democratic state governors and a majority of Republican state governors

·        The U.S. Chamber of Commerce

To be sure, not all economists thought the stimulus plan was a good idea.  But on balance, a large majority of experts supported the stimulus plan, and the majority was even larger among the “more famous” economists and analysts.  Couple this with support from a majority of Governors of both parties and strong support from representatives of the business community, and it would have been tough for President Obama to ignore this advice and not push for the ARRA.

One final note.  While no Republican members of the US House of Representatives voted for the ARRA, they did offer an alternative $490 billion “stimulus plan” that would have increased the federal budget deficit by this amount.  The ARRA, then, increased the federal budget deficit roughly $300  billion more than the Republican proposal.  Had the Republican proposal carried the day, the federal budget deficit would still be above 8% of GDP – a record.

The Real Story on Federal Taxes

 Welcome to my blog!  I'll be posting a small handful of short essays in advance of the Congressional elections on November 2.  I should have begun posting these essays awhile ago, but (1) I've been really busy and (2) I just figured out how to get Excel files onto my blog (turns out Blogger doesn't interface well with MS Office products.  Go figure).  If this first blog post looks a little funny, it's because the original post was first translated into a .pdf file, then re-translated into a .jpg file in order to get it on to blogger.  I know, you don't care . . . .   This first post focuses on federal taxes.  The next couple will focus on the US federal budget deficit (which is very scary) and US federal government spending.  I hope you find these posts informative, helpful, or entertaining.