Posts Tagged budget deficit

How High a Budget Deficit Can We Sustain?

The US can sustain a budget deficit of 5%, not 3% as commonly assumed, because 2.5% inflation and 2.5% real growth combine to keep the total debt/gdp ratio stable.

With both the financial crisis and European debt crisis having a root in excess borrowing, the American political debate has turned toward deficit reduction as well. If current budget deficits (averaging 10% of GDP since the financial crisis) are recognized as unsustainable over the long term, then what level of budget deficit is sustainable? At one extreme, politicians call for a balanced budget, and at the other extreme the budget deficit is considered a distant issue. Meanwhile, many economists set the sustainable deficit threshold at 3% of GDP, and EU rules formally set the budget deficit threshold at 3% as well. What is the basis for the idea of a “sustainable” budget deficit, and is the 3% figure too high or too low?

What is a sustainable budget?

Unlike individuals or families, a nation has an indefinite lifespan, and can therefore continually roll over its debt as long as markets deem it a worthy creditor. As long as a nation’s economy is growing, its capacity for borrowing grows as well. But if the debt grows at a rate faster than the economy, then it will eventually exceed the nation’s ability to repay it. The idea of a sustainable budget deficit is summarized by the chief economist of the Concord Seo Company Coalition, “President Obama’s fiscal commission set a goal of getting deficits down to about 3 percent of GDP within five years – 3 percent being the average annual growth rate of the US economy since World War II.”

The Real Sustainable Deficit Target

There’s just one problem with the 3% target for a sustainable budget deficit – it’s too low! While GDP growth is measured in real terms, inflation also eats away at the value of the US debt over time. For instance, assume that the US has no future economic growth, but continues to have 2% inflation. Assume that we also manage to (magically?) balance the US budget. With no economic growth, does this mean that debt/gdp stays constant? Actually, inflation would cause the numerical value of GDP to continue rising, while the debt stays constant. This would cause the debt/gdp ratio to fall by around 2% per year.

In practical terms, this means that we have to look at the rate of nominal GDP growth to determine a sustainable budget deficit level [1]. To be conservative, let’s assume 2.5% real GDP growth (less than the 3% post-war average) and 2.5% inflation (within Americans’ comfort zone, and less than the 90’s and 2000’s average). Taken together, this means that if nominal GDP grows at 5% per year, a budget deficit of 5% can be sustained long term. The difference between 3% and 5% of GDP is big, over $300 Billion in 2012. As the federal budget and spending again enter serious debate after the November elections, it’s important that politicians understand the government’s true borrowing capacity – and neither the populist “balanced budget” nor the typical economist’s 3% magic number stand up to examination.

[1] Here’s the actual nominal GDP data from the Fed: http://research.stlouisfed.org/fred2/howtobcome/data/GDP.txt

Using this data, we see that nominal GDP has grown at a compound annual rate of 6.6% over the post-war period (since 1947, when the data series begins). Over the past 30 years, nominal GDP has grown at a compound annual rate of 5.4% – and this period excludes most of the late 70’s and early 80’s inflation spike. Even over the past 20 years, which are skewed downward due to the financial crisis, the nominal GDP growth rate is 4.7%.

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Budget Puzzle on NYTimes

The New York Times published an excellent budget deficit interactive today. Based in part on the plans proposed by the deficit commission, the site lets you choose a combination of spending cuts and tax increases to solve our nation’s budget woes. Here are my selections:

http://www.nytimes.com/interactive/2010/11/13/weekinreview/deficits-graphic.html?choices=hvymrb18

For those counting, my selections were 80% spending cuts, and 20% tax increases.

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How to Balance the Federal Budget

Can the US federal budget be balanced? It is obviously physically possible to balance the budget by either lowering spending, raising taxes, or a bit of both. But can the budget be balanced in a manner that is fiscally prudent while maintaining adequate funding for government’s most important operations?

I have attempted to balance the 2008 budget below while obeying the following constraints:

  1. No tax increases
  2. No spending shifts between departments, only spending cuts
  3. All spending, including entitlements spending, is fair game

The actual federal deficit for 2008 was $459 Billion, which forms the goal for the cost cutting exercise outlined in the table below [1].

Category 2008 Spending ($Billions) Proposed Cuts Proposed Spending
Defense 612 Cut by $150 Billion, maintaining US defense spending at a level that exceeds the entire World excluding NATO. [2] 462
Social Security 612 Phase out social security benefits for upper income seniors, cutting roughly $110 Billion annually. [3] 500
Medicare + Medicaid 587 Introduce 20% coinsurance for medical spending above $40,000 per year for Medicare and Medicaid recipients, saving $110 Billion. End Medicare Advantage subsidies, saving $17 Billion. [4] 460
Non-defense Discretionary 508 Make an across-the-board 9% cut in non-defense discretionary spending, saving $46 Billion. [5] 462
Other Mandatory Programs [5] 411 End agricultural commodity subsidies and crop insurance subsidies, saving $15 Billion. Modify student loan programs to cut out private middlemen, saving $9 Billion. [6] 387
Interest Payments 253 This cannot be cut without a US government default. 253
Totals 2,983 459 2523

As the table shows, the US federal budget cannot be balanced without deep cuts in Medicare/Medicaid, Social Security, and the Department of Defense. Roughly 60% of the budget is allocated to these major programs, making a balanced budget impossible without reductions here.

A rationale for each major budget cut is provided in the footnotes below. I invite readers to share their balanced budgets as well, or to suggest changes in the cuts that I’ve suggested. Just make sure that the numbers add up, as cutting $459 Billion from the federal budget is harder than it looks!

[1] The core budget data for the table comes from Table S-3 of the US Budget Summary Tables. The 2010 budget document is used, as actual spending for 2008 is not available in earlier versions. The 2009 fiscal year data is incomplete, and also has significant one-time items like TARP and Stimulus package spending, so I chose to focus on the finalized 2008 numbers instead.

[2] The US defense budget represents almost 50% of the entire world’s defense spending, leaving ample room for cuts without jeopardizing US security. Over time the US defense apparatus has become particularly bloated, and cuts may actually improve the DoD’s efficiency over time. It’s worth noting that the US won the Cold War with much lower defense budgets than today.

[3] Social Security was enacted to ensure that American seniors did not starve in their last years, but later grew into a mandatory retirement program. Cutting Social Security payments to upper income seniors would bring the program closer to its original goal. There are 5 million senior households with income greater than $50,000, and they represent the top 20% of all seniors in income terms. These seniors likely draw maximum social security benefits, around 30k annually if there is slightly more than one senior per household on average.  Phasing out these benefits for the wealthiest 20% of seniors would save around $110 Billion. Gross benefits reductions would be around $150 Billion (5 million * 30,000), with an offsetting loss of tax revenue from the reduction in benefits.

[4] Along with defense spending, Medicare and Medicaid are the fastest growing parts of the federal budget.  Since government resources are limited, government benefits must also be limited. Medicare and Medicaid spending can be contained by requiring individuals to pay 20% of their own health care bills beyond $40,000 per year. This change would affect only 5% of Medicare recipients, but would yield huge savings as many patients would decline expensive treatments once cost became a consideration. 32% of all Medicare spending occurs above the $40,000 line; if requiring coinsurance cut this in half, roughly $110 Billion would be saved. This analysis assumes that the breakdown in Medicaid spending is similar to that of Medicare.  An additional $17 Billion annually could be saved by ending subsidies to Medicare Advantage, which is part of current health care reform proposals under debate.

[5] Non-defense discretionary spending includes almost all other federal departments. A 10% across-the-board cut would force all departments to shrink and increase efficiency. Alternately, targeted cuts could be used to shrink certain programs, but these cuts would still have to total $51 Billion annually. Health care cost growth could be reined in through heavy cuts at the NIH, which heavily subsidizes health care and pharmaceutical research. Cutting NIH’s $30 Billion budget in half would enable other departments to get by with a 6% cut instead. One more alternative would involve eliminating Congressional earmarks, which would reduce spending by $20 Billion.

[6] Other Mandatory Programs includes federal funding for food stamps, unemployment insurance, farm subsidies, student loans, veterans’ benefits, and other miscellaneous programs written into law with automatic spending formulas. Farm subsidies in particular deserve heavy cuts, as they distort the economy while worsening Americans’ health. Eliminating commodity crop payment programs and crop insurance subsidies would save $15 Billion annually (see page 4). An additional $9 Billion in savings is possible through the removal of middlemen in federally-backed student loans. Since the federal government assumes all risk on these loans, there’s no reason to compensate private banks to issue the loans.

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