Partisan Finger-Pointing Misses Real Deficit Story: BGOV Insight

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Job seekers fill out paperwork at a career fair in Philadelphia, Pennsylvania. The largest driver of the increasing deficit was the economy itself, a Bloomberg Government analysis shows. Photographer: Paul Taggart/Bloomberg

The federal deficit is a politically charged and highly partisan issue. Yet too little of the debate is based on what actually caused the budget to go so deeply into the red. Democrats blame the Bush-era tax cuts and the wars in Iraq and Afghanistan, while Republicans point the finger at stimulus measures and runaway domestic spending.

Both sides miss the mark. A closer analysis of what’s changed in the U.S. fiscal landscape offers a clearer way to think about the deficit and, most importantly, a more practical way to do something about it.

There’s no denying the U.S. government’s fiscal position took a nose dive in the years following the financial crisis of 2008. At the end of fiscal 2007, accumulated federal debt held by the public equaled 36.3 percent of the U.S. economy, as measured by the gross domestic product, or GDP. By fiscal 2011, public debt had almost doubled to 67.7 percent of GDP.

The annual budget deficit, which feeds the debt, averaged 9.3 percent of GDP during the past three fiscal years. Compare this to the three years before the crisis, 2005 through 2007, when deficits averaged 1.9 percent of GDP. The deterioration is stunning: The average annual deficit ballooned by 7.4 percentage points in the years after the crisis.

The largest driver of the increasing deficit was the economy itself, a Bloomberg Government analysis shows. The drop in economic output during the recession made all areas of the budget look larger compared with GDP. Falling tax revenue and spending increases tied to the economic downturn constituted 4.5 percentage points, or 61 percent, of the 7.4 point increase in the deficit, this analysis reveals.

Pre-Crisis Levels

So, as the economy gets back on track, much of the deficit may automatically get back to pre-crisis levels. Tax receipts will rise and spending should fall on things such as unemployment insurance, food stamps and health care for the poor.

The big questions for the next president and Congress are what to do about the other 39 percent change in deficit spending that isn’t tied to the economic downturn.

Some of that change can be traced to one-time spending decisions that followed the recession. Economic stimulus measures promoted by the George W. Bush and Barack Obama administrations account for 1.8 percentage points, or 24 percent, of the fiscal deterioration.

Another 1.1 percentage points, or 15 percent, can be attributed to non-cyclical spending increases, such as on defense, Social Security and Medicare.

Record-Low Rates

Ironically, the growing national debt has had no real impact on the annual deficit. Interest on the debt actually fell as a percent of GDP to 1.4 percent post-crisis from 1.6 percent pre-crisis, thanks to record-low interest rates on U.S. Treasuries.

These findings suggest two things: Raising taxes across the board shouldn’t be a priority at this point in the economic cycle. Nor should cutting cyclical “safety net” programs and non-defense discretionary spending. Raising the tax burden now could lower household spending and business investment, and may have a negative multiplier effect through the economy. Badly enacted and wrongly timed austerity measures can also worsen the economic environment, actually leading to larger deficits.

What may be confusing -- and confounding -- the debate over the deficit is the threat of “sequestration,” which is scheduled to cut $1.15 trillion from the federal budget starting in January, most of it divided between defense and domestic discretionary accounts.

Entitlements Exempt

To be sure, defense is one of the areas of the budget that most needs controlling, along with Medicare and Social Security. Yet sequestration puts undue emphasis on defense, with little or no attempt to tackle the so-called entitlement programs, which are mostly exempt from those cuts.

Several deficit-reduction plans, such as Representative Paul Ryan’s House Republican budget and Obama’s Simpson-Bowles commission, have focused on the long-term funding issues surrounding entitlement programs, and they have proposed policies that would reduce those growth levels many years down the road.

Yet the real causes of the deficit suggest these areas need attention sooner rather than later. Together, defense, Medicaid, Medicare and Social Security account for 2.6 percentage points of the deterioration in the deficit; of that, 1.0 percentage point has nothing to do with the economic downturn or the stimulus. These areas of spending have already become a significant source of the deteriorating budget situation.

Sequestration reduces the deficit without tackling Social Security and Medicare. It puts the weight of adjustment too heavily on other areas of the budget, like discretionary spending, that aren’t the real culprits of the deficit problem.

(Christopher Payne is an economic analyst at Bloomberg Government. The views expressed are his own.)

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