U.S. Budget Deficit - Five Key Questions

What Can and Should Be Done About the Deficit

A regular reader asks the following questions about the U.S. deficit:

"I would be delighted to have a non-partisan explanation for the massive deficit announced by the President this week. I would like to know the following:

  1. What caused it?
  2. Can it be good?
  3. Can it be corrected without raising taxes?
  4. How should it be dealt with?
  5. How long should it take?"

I will give my views regarding these five questions below, though I must admit I am a little hesitant to do so, since the answers to the questions will naturally be somewhat subjective in nature.

I would love to hear your answers to the following five questions - you can leave them at this blog post.

Before we begin, some backround information on the budget deficit. Experts from a June 29, 2008 New York Times article on the budget deficit:

  1. "The White House predicted Monday that President Bush would leave a record $482 billion deficit to his successor...

    "Mr. Nussle predicted Monday that the deficit would more than double in the current 2008 fiscal year — to $389 billion, from $162 billion in 2007 — before shooting up to $482 billion in the 2009 fiscal year, which begins in about two months.

    "The deficit projected for 2009 would be the largest in absolute terms, easily surpassing the record of $413 billion in 2004. The White House and many economists prefer to measure the deficit as a share of the economy. The projected 2009 deficit would be 3.3 percent of the economy. That is the largest share since 2004, but well below the percentages recorded in the 1980s and early 1990s. In 1983, the deficit was 6 percent of the overall economy."

    What Caused the U.S. Federal Budget Deficit to Get So High?

    Perot Charts had an excellent chart showing spending and tax revenue, as a percentage of GDP, from 1980 to 2008. From the chart, it becomes clear that since 2000 there are three basic sources causing spending to be higher than tax revenue:

    1. Tax rate cuts in the beginning of the decade, in particular the tax rate cuts of 2001 and 2003.
       
    1. Accelerated levels of spending increases, particularly between 2001 and 2003.
       
    2. The slowing of economic growth in 2007 (and the associated housing crisis), which both acts to increase government spending and decrease tax collections.

    In theory, absolutely. The 2001 and 2003 tax cuts could increase long-run economic growth, which would act to increase the size of the economy in the future and government tax revenue along with it. The tax cuts could be either partly or fully self-financing thanks to their stimulative effect.

    The standard Keynesian school of thought would suggest that in the kind of troubled economic times the U.S. is currently experiencing, increasing spending and running a budget deficit to stimulate aggregate demand would be appropriate.

    A large budget deficit is more justifiable in 2008 than it would be in, say, 2005 when the real GDP growth rate was over 4 percent.

    Is it good? I do not believe it is, for the following reasons:

    1. The United States (similar to many other aging countries) is going to face a potential Medicare and Social Security crisis as the population ages. It will need all the budgetary room it can get to continue to fund these programs.
       
    2. The deficits (and resulting debt) must be financed. The interest payments crowd out the government's ability to cut taxes and to continue financing programs (such as the ones in point 1). The government debt, all else being equal, will cause interest rates to rise and may, eventually, lead to the U.S. bond rating to be downgraded. This would not be unlike the situation Canada found itself under in 1995:

      "...Moody's made a lot of Canadians mad. When the credit rater considered cutting Canada's debt, and its interest rate rose, the government suddenly faced the prospect of about $300 million in added payments on its bonds...

      "While just a fraction of Canada's overall debt, it was a significant cost for a cash-strapped government about to lay off 45,000 employees. The government, for example, spent about $300 million on the annual compensation of about 5,000 civil servants and the same amount on the yearly pensions of about 50,000 senior citizens...

      " Moody's was unmoved. That April, the credit rater pulled the trigger, downgrading Canada's domestic debt rating to "Aa1," a notch below the coveted "AAA." S&P had a different take, affirming Canada's triple-A domestic rating, but it did revise its outlook on Canada's foreign-currency debt, changing it to "negative" from "stable."...

      "Whether Moody's was right remains debatable. This much isn't: It took Canada more than seven years to get that triple-A rating back in May 2002."
       
    1. There is not a lot of evidence to suggest that the 2001 and 2003 tax cuts will be anywhere near self-financing. As well, one of the justifications often given for the tax cuts is that they would slow the growth of government spending. However, this Starve the Beast theory of government spending is largely discredited.

      The final three questions the reader asked are as follows:

      • Can it be corrected without raising taxes?
      • How should it be dealt with?
      • How long should it take?"

      Can the U.S. Budget Deficit Be Corrected Without Raising Taxes?

      An improved economy would act to reduce this deficit, but I cannot see how that alone will be enough. Either tax rates will have to be raised or spending decreased. Can either party find enough cuts in spending to make up the difference (without also raising spending in other areas?) It is possible, but I do not see it happening - particularly given the increased financial pressure exerted by Medicare and Social Security over the next several decades.


       

      How Should the U.S. Budget Deficit Be Dealt With?

      If raising taxes is the only way to eliminate the deficit, then from a strictly economic point of view, the government should try to raise the money in the least economically damaging way. An obvious choice would be a sales tax. In an ideal world the FairTax could be implemented, but in reality, there is no way to increase sales taxes high enough to eliminate all forms of income taxation. But the basic idea is sound - taxes on income are more economically damaging than taxes on consumption.

      Another obvious choice would be taxes on pollution, either directly or indirectly through the gas tax, with the reasoning being that here the distortions have a positive element - less pollution.

      Of course, more than simply achieving the highest level of GDP growth goes into tax policy. Since sales taxes are inherently regressive, we need to take that into account.

      Plus tax policy will be determined more by sound politics than sound economics. Can a party implement a national sales tax and continue to stay in power?

      How long should it take?

      Ideally, the government would want to be running a surplus during the next boom period in the economy. But will it happen?

      I doubt it - but I have been wrong many times before.