U.S. Government Spending: Champagne Taste (On a Beer Budget)
The U.S. government debt is on the minds of many, including President Trump’s, who recently released a proposed budget for the federal government. If his first term spelled tax cuts for corporations and the ultra-wealthy, his proposed agenda going forward marks a steep cut in social safety nets, medicare, and medicaid, while increasing military spending and NASA’s budget.
Given that the House is controlled by the Democrats and bipartisanship would be needed to pass the budget in the Senate, it’s safe to assume the final budget will look nothing like the one currently on the table. Still, the proposed budget clearly indicates what another term of a Trump presidency would look like.
President Trump is right about one thing — the U.S. must address its debt problem. With the government’s obligations expected to reach $30 trillion by 2025, it’s clear that like many of its citizens, the federal government is living beyond its means. If the proposal makes one painful point, it is that the 2018 tax cuts did not pay for themselves and certainly did nothing to help close the deficit. Instead, President Trump is looking to offset the cuts by reducing services low income communities rely on.
To better understand what feasible solutions to debt problem look like, below is deep dive into tax revenue and government spending data and insights as to the causes of the debt, the magnitude of the problem, and importantly, possible solutions.
What’s Causing the Debt to Grow?
While it’s convenient to blame the growing debt burden on the 2018 tax reforms, in reality, this crisis has been in the making for a long time. Certainly the tax cuts did nothing to help the situation, but they are hardly the sole cause.
Government debt accumulates when there’s a discrepancy between the government’s income, which mainly comes from taxes, and spending levels. In the fiscal year 2019, the U.S. government ran a deficit of 4.64% of GDP, meaning it spent $984 billion more than it collected.
Starting with the income side, there is no doubt that the U.S. government collects less tax as a percentage of GDP than its developed peers do. As Chart 1 shows, at 15.4%, the U.S. ratio is well below Germany’s 33.2% and Spain’s 34.9%, and far closer to Argentina’s 11.0%.
Chart 1 also shows that the 2018 tax reforms only exacerbated an ever growing low tax burden. As I’ve written before, U.S. corporations rarely pay the statutory tax rates, and instead benefit from a myriad of subsidies and tax breaks.
Clearly, the U.S. brings in significantly less tax revenue than other countries do. But then again, it also provides its citizens with comparatively fewer services, namely in areas of public education, healthcare, and welfare programs. The real question then is whether government spending is proportionally low enough to compensate for the lower tax revenue.
To answer this question, we can look at the ratio of public spending to tax income, and compare it to that of other countries’. Chart 2 shows that the U.S. was historically roughly in line with its peers, and the ratio was trending downward since the fiscal stimulus plans of 2008. But that changed in 2016 — as other developed countries continued to reduce their spending to income ratios, the U.S.’s started trending upward.
Starting in 2016, the U.S. deficit began growing again. But it’s not so much that our spending has gone up, it’s that our tax revenues, as a percentage of GDP, have gone down.
That tax revenues started declining in 2016, before the passing of the tax reforms that went into effect on January 1, 2018, is a surprising finding, and one that does not have a simple explanation. Reduced corporate earnings played a role, but that’s only part of the story. As Chart 4 shows, tax revenue as a percentage of GDP took the largest hit from individual income taxes. Thus, it is the lower revenues that are the main drivers of the deficit.
How Bad is the Situation?
The federal government currently owes its creditors $22.7 trillion, a sum that is equal to 107% of our GDP. This is certainly not great, but it’s not catastrophic either; Chart 5 shows the U.S. debt is definitely higher than many of its peers’, but it is still well below the alarming levels of 150% that are associated with sovereign defaults.
Defaults usually take place when lenders refuse to lend additional money to a government, especially when outstanding bonds are coming due and the borrower needs to refinance or ‘roll’ the debt. While this could theoretically happen to the U.S., it is unlikely given Treasury securities’ role as the risk-free asset and the USD’s role as the world’s base currency.
With the U.K leaving the European Union and the Coronavirus shaking the confidence in China, it’s doubtful that the U.S. will be replaced in these roles any time soon. This alleviates another potential issue with large government debt: the fear that there will be less capital available for the private sector. The U.S., currently, has no shortage of capital inflows.
The larger question is just how far can the U.S. push the debt boundaries when we hit the next recession? As Chart 6 shows, while other countries are using this time of relative economic stability to shrink their deficits, with some even running a surplus and reducing their borrowing levels, this is not the case at home.
All this means is that during the next inevitable recession, or a national emergency like a full blown pandemic, the government might struggle with using fiscal stimulus to jumpstart the economy. As the GDP contracts, the deficit and debt-to-GDP ratios will get worse even before intervention can take place. The end of the economic cycle is no time to be increasing our deficit, but this is exactly what the current administration is doing.
What Happens Next?
At some point (and hopefully sooner rather than later) we’re going to have to actively address the deficit, and there are a finite number of ways to do so. They include:
1. Growing Faster — our current growth rate of 2.1% is not enough to stem increases in, let alone reduce the budget deficit. In order to do so, we would need to grow at 9% per year, at least. This seems unlikely at best, given the last ten years have an average annual growth of 3.4%, and especially given that we have little workforce capacity to enable such growth.
2. Print Money, aka Inflate — despite President Trump’s claims that the U.S. could print money to pay down its debt, this is a highly unlikely and undesirable solution. For one, the Federal Reserve is purposely set up as an independent body governed by Congress, so that the executive branch cannot use it in that suggested manner. True, the Fed has bought treasury bonds as part of the quantitative easing program, but this was not done at the administrations’ request and the goal was not to alleviate U.S. debt.
Beyond the practical questions of Fed oversight, and on a conceptual level, inflating the debt away by printing money would be disastrous to the U.S. Treasuries’ position as a risk-free asset and to its global standing. It’s simply not something a developed economy that wants to continue receiving investments does.Furthermore, a large portion of U.S. obligations, namely Social Security and Medicare, are ‘Real’ obligations; Social Security is inflation adjusted (and good luck changing that) and Medicare pays for medical services, the cost of which goes up with inflation. You can inflate away nominal debt — at a high price to your credibility as a borrower — but not real obligations.
3. Ask Creditors to Take a Haircut — another solution recently suggested by President Trump (and then later denied) is to negotiate with lenders to accept a lower payback than the value of their notes. While this may work with hotels in Atlantic City, it’s hard to imagine creditors ever agreeing to this for U.S. sovereign debt, and woe to our credibility if they did.
4. Cut Spending — this is the solution suggested by fiscal conservatives, though of course not implemented while the GOP is in power. A review of the U.S. government spending (Chart 7) suggests this is going to be very difficult. To touch the largest expenses, social security and medicare, would be political harakiri. Sure, it would be nice if we could lower healthcare costs across the board and thus reduce the cost of Medicare, but even with a ‘Medicare for all’ plan, significant cost reductions without addressing the social determinants of health are unlikely.
Defense, the other uniquely large item in our budget, may seem more politically feasible to cut. However, the U.S. has long been outstanding in this category. While we could certainly stop increasing our military budget, existing obligations make this very difficult, and interested parties have long mastered the art of fear-mongering to avoid having their budgets slashed.
5. Increase Taxes — all this brings us to the perhaps inevitable conclusion that at some point, taxes will have to go up if we’re going to close the deficit and begin paying off our debt. There’s simply no way around it. Postponing this decision is counterproductive for growth since it creates uncertainty for corporations looking to make long-term business investments.
Be it corporate taxes, income tax, payroll taxes or a wealth tax, someone’s got to pay. The most likely candidates are corporations, which currently enjoy unreasonably low effective tax rates, and the top 1% of wealth holders with capacity to pay more.
The inevitability of higher taxes has direct consequences on financial decisions today. Those contributing to deferred saving accounts should ask themselves whether the burden of higher tax rates in the future might be offset by the benefit of tax deferral at today’s rates.
The current deficit and resulting mounting debt are a result of reduced tax collections, not spending. And while the situation is not critical today, it places the U.S. in a weakened position as the economic cycle draws to a close. It may be politically convenient to claim we can outgrow, inflate, our weasel our way out altogether of paying our debts, but the unfortunate reality is that one of these days, taxes are going to have to go up, and it shouldn’t take us by surprise.
– AD
