The Debate Over Spending and Taxes Kicks into High Gear
American Century Investments
March 3, 2011
President Obama submitted his 2012 federal budget to the Congress on February 14, which called for a reduction in the current record federal budget deficit ($1.6 trillion for 2011) while leaving spending at historically high levels. In order to obtain some historical perspective on the new budget proposal, in this Weekly Market Update we’ve combined the numbers for this budget and its forecast (from 2012 to 2021) with historical numbers from the Congressional Budget Office (CBO) going back to 1971.
Over the 10-year time frame from 2012 to 2021, outlays (i.e., spending) as a percentage of GDP is forecast to decline from 25.3% this year to 23.6% next year and down to an average of approximately 23% for the remainder of the 10-year period. Revenue (also as a percent of GDP) is forecast to rise from approximately 14% this year to 20% by 2021 due to a combination of tax increases (mainly on businesses and upper income households), a winding down of spending for the wars in Iraq and Afghanistan and miscellaneous increases in fees. A freeze on spending for most discretionary programs would also be implemented. As a result, the budget deficit would decline from nearly 11% of GDP this year to 3% by 2017.
Not surprisingly, the budget was greeted with substantial criticism within the Republican-controlled House of Representatives, which has the legislative responsibility for taxation. In terms of raw numbers, House Republicans were disappointed that the budget proposal did not do more to rein in the alarming growth of federal debt that began last decade. In addition, they criticized many of the tax increases, such as raising the highest marginal tax rate on upper income households to 39.6%. They also pointed out the budget failed to address any elements of mandatory expenditures, primarily entitlement programs such as the Social Security, Medicare and Medicaid programs.
The Budget in a Historical Perspective
The chart below (and the other charts in this Weekly Market Update) provide readers with a 51-year perspective, including 40 years of history (1971 to 2010), the current year (2011) and 10 years of forecasts based on the White House budget proposal (2012 to 2021). Blue shaded bars or dashed lines in these charts are intended to highlight the current and forecast years of 2011 to 2021 versus historical years (green shaded bars and solid lines).
The line labeled Revenues accounts for all sources of federal government inflows including individual and corporate income taxes, social security receipts (Social Security, Medicare and Medicaid premiums paid by employers and employees), estate and excise taxes, duties and other fee-based sources of income. The line labeled Outlays includes all expenditures by the federal government. These are often roughly classified into discretionary spending which Congress has the ability to review each year (such as defense spending and domestic programs like education) and mandatory expenditures which we noted above include the major entitlement programs like Social Security or Medicaid.
Under the current budget proposal, government revenues would accelerate beginning next year to shrink the budget deficit by paralleling the growth in overall outlays. As these two lines begin to move in parallel, the budget deficit (plotted at the bottom of the chart) will shrink to approximately $650 billion or 3% of GDP. These deficits are considered structural as opposed to cyclical because the budget assumes no economic downturns over the 10-year forecast period and annual GDP growth rates of approximately 3.5%, which in itself is an optimistic assumption.
But even at this reduced level of deficits, the national debt (plotted as the bars in the chart below) will continue to increase from about $10.9 trillion this year to $19 trillion in 2021.
The Impact of Mandatory Expenditures
Both political parties recognize that the key to truly addressing the ongoing budget deficit issue (which is the cause of our exploding federal debt) is addressing mandatory expenditures for entitlement programs. But in the calculus of Washington politics, neither side wants to be the first to propose any entitlement cuts for fear of being attacked by the other side. One encouraging sign with the release of the White House budget was a comment by Jacob Lew, President Obama’s budget director, who noted that this topic needed to be addressed and it would be most productive to do so using closed door meetings between the White House and Congress. There, a compromise or agreement acceptable and supported by both sides could be hammered out before presenting it to the public.
The chart below presents the magnitude of the challenge at hand. We’ve plotted the relative percentage of overall federal budget outlays used for mandatory expenditures (mainly entitlement programs), discretionary expenditures (primarily domestic and defense spending) and net interest on government debt for 10-year increments beginning in 1971. As the chart illustrates, the percent of total spending allocated to mandatory expenditures has grown from approximately 35% in 1971 to 55% this year and is forecast to slightly exceed 60% by 2021. The ovals above each bar illustrate the total federal budget outlays that year in trillions of dollars, which have grown from $0.2 trillion in 1971 to $3.8 trillion this year and are forecast to increase to $5.7 trillion in 2021. Hence, mandatory expenditures are a growing percentage of a growing overall budget and are largely responsible for the growth.
Net interest on national debt, which has recently been held in check by historically low interest rates over the past two years, is forecast to increase based on both a modest increase in long-term Treasury rates and (more importantly) a substantial increase in national debt. The Obama administration budget forecasts net interest expense will increase from 5% to 15% of total outlays between 2011 and 2021. Given these increases in share of total outlays for mandatory programs and net interest expense, the share of budget available for domestic programs, including national defense, will decline from 37% to 24% over the next decade. Over the longer-term history, share of spending for domestic programs will have declined from nearly 60% of the total budget in 1971 to 24% in 2021. While this still represents an increase in absolute (nominal) dollars given the growth in the size of the federal budget, its rate of growth is much slower than for mandatory programs. In fact, between 2011 and 2021, the rate of growth for domestic programs is forecast to be effectively zero despite overall outlays increasing from $3.8 to $5.7 trillion.
Normalized Spending on Outlays
When talking about spending that totals in the trillions of dollars, it helps to place these in some type of perspective relative to other factors that people can comprehend. Two factors often used to “normalize” spending are its size in relation to our country’s population and size of the economy (GDP), both of which are also growing over time. In the chart below, we plot both the history and forecasted values of national debt per capita (i.e., based on population size) and national debt per dollar of GDP generated in the same year (i.e., based on size of the economy).
As the chart illustrates, an odd contrast emerges as national debt per capita continues to rise substantially during the forecasted years of the budget (increasing from about $35,000 to $55,000) while the dollars of national debt per dollar of GDP quickly reaches a plateau. One reason for this is our population growth is now slightly less than 1% per year while the forecasted rate of economic growth the budget forecast assumes is close to 3.5% over most of the coming 10 years (with no assumption of a slowdown or recession during this period).
Some have criticized this assumption as unrealistic. But unrealistic or not, the forecast does point to one indisputable fact: Strong economic growth can be a powerful counterweight against our debt growing out of control (at least as measured relative to the size of the economy). This is one of the few points that all parties in the current budget and national debt debate can agree upon. The problem is in developing consensus about what policies (fiscal and monetary) can best ensure a future period of robust economic growth.
The Debate’s Just Begun
For those already weary of listening to politicians and news commentators discuss and debate the current budget, the bad news is we’ve really only just begun. Somehow—whether through a grand compromise between political parties or fierce legislative battles—the issue of mandatory expenditure growth will have to be tackled. While the current House of Representatives leadership debates whether to cut, for example, $50, $60 or even $100 billion out of discretionary spending for this year (2011), keep in mind that even $100 billion is only about 2.5% of next year’s overall budget outlay forecast of $3.8 trillion and less than 10% of next year’s forecast budget deficit.
And the fact that the 2012 presidential campaign season is (in reality) only about six to eight months away from beginning (for the Republicans it has informally begun already) means that negotiations and proposals will be complicated by each party’s attempts to maximize their gains from whatever compromises they propose. In other words, the national budget and debt debate is likely to be with us for at least until the end of next year.
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