Why the US has a Deficit

Most of the popular press information I have read about the current US Deficit is at best incomplete and often is very inaccurate. First, let’s be clear about what the deficit is. The deficit is the annual excess of expenses over revenue. The US Debt is the accumulation of all previous deficits.

An important distinction regarding deficits is whether the deficit is “structural” or temporary. A structural deficit means that unless changes are made to increase revenue, reduce ongoing expenses or both, the government is expected to run a net deficit over an entire economic cycle.

A temporary deficit should disappear (or even correct itself) over a period of time. When the economy enters a recession a temporary deficit will arise when revenues decrease because of smaller personal and corporate income and expenses increase to cover (for example) additional unemployment insurance. This deficit is temporary because, when the recovery is complete, revenue is restored and the additional expenses are eliminated.

A good place to start looking for methods to “solve” the US deficit is to understand how it came about. The last time the US experienced a “surplus” was Fiscal Year 2001. Since then four significant changes have occurred: (1) Revenues decreased significantly because of the Bush tax cuts; (2) Congress passed and Bush and Obama signed legislation significantly increasing expenses; (3) Bush engaged in two wars (Afghanistan and Iraq) & Obama has not ended those engagements. Neither Congress nor the presidents chose to pay for those wars by increasing revenue or cutting other expenses; and (4) the US economy entered a major recession.

Items (1), (2) and the long-term aspects of (3) [for example, increased medical care for injured military] are structural in nature. The short-term costs of war (item 3) and the recession (item 4) are temporary. The growth in interest expense on the increased US Debt related to the short-term war and recession costs are structural.

In 2000, US Government revenue equaled about 20.6% of Gross Domestic Product (GDP). By 2009 this had declined to 14.8%. The average from 1970 through 2009 was about 18%. In years of boom, tax receipts are higher as a percentage of GDP than they are in recessions and so part of the difference is accountable solely to different economic times (the temporary aspect). However, most of the decline in revenues was introduced through the Bush tax cuts and is, therefore, permanent and structural. (If you don’t think they are structural, just ask any Republican and most laypersons if they would consider reverting to the pre-Bush tax rates as a tax increase. Of course, they do.)

At the same time Bush and Congress cut revenue, they increased spending. In 2000, Federal spending was about 18.2% of GDP. By 2008, it increased to 20.7% of GDP. This 2.5% increase in GDP was a combination of Iraq and Afghanistan war costs (item 3 above) on top of increased program costs (item 2). The Republicans trumped the previous spending increases of the Democrats under Clinton and literally and figuratively went hog wild.

In 2009 Federal spending as a percentage of GDP jumped to 24.7% in an effort to ameliorate the financial crisis. Only during World War II have Federal expenditures taken up a larger portion of GDP. However large this problem is, the recession portion should at least be a temporary problem. When people are out of work, they don’t pay taxes and they do need assistance. As a country we can argue how much assistance they need and for how long, but neither the argument nor its resolution touches the bigger issue, which is the structural deficit.

The Structural Problem in a Nutshell

If much of the recent problem is caused by the recession, won’t that portion self-correct as the economy continues to recover? Normally, yes, but this time, we’ve muddied the issue through political “hardball” positions.

As an aside, Americans shouldn’t worry about TARP and one-time bail-outs to GM or AIG. Other than increased interest costs, they are not a structural issue; they are more like unemployment compensation with the added advantage that much of it will be paid back. Besides, most nonpolitical economists agree that securing the financial system prevented a much deeper recession than the bad one we experienced.

I’m not an economist, so I am not developing my own estimates of the structural deficit. Those who do purport to have the answer frequently have political agendas that lead to over/under estimating the severity of our current situation. Many agree that in 2007 the structural deficit was around 3%. Estimates of our present structural deficit range from 6% to 10%—double or triple what it was shortly before the financial crisis.

Some spending that once might have been considered transient is now appropriately characterized as structural. Many member of Congress indicate that cuts to Defense spending are “off the table.” Those statements and recent actions in Afghanistan, Libya, etc. tend to give proof to the structuralization of what should have been temporary costs. Furthermore, applying an actuary’s understanding of the unfunded off-budget obligations we have accrued for Medicare, Medicaid, Social Security and Federal employee/Military pensions and post-retirement healthcare leads me to think we are understating our long-term structural deficit.

So whether the right number is 6% of GDP, or 8% or 10%, it is a really big problem. Even the low end estimate of 6% means to balance the budget requires changes in the order of $900 billion per year. At the high end we’re over $1.5 trillion a year. I’ll end this post with these sobering figures.

Next time we’ll look at the components of Federal revenue and expenses and start to develop a picture of what will be necessary to close this structural gap.

~ Jim