U.S. Economy

Is It the Spending or the Taxes? Mostly the Spending, But ...

The likely future cost of Medicare is going to force the U.S. to make some tough choices.

We're not getting younger.

Photographer: Scott Olson/Getty Images

The U.S. appears to face a future of large, chronic federal budget deficits. Is that because taxes are too low or because spending is too high?

In one sense, the question can only be answered with a value judgment -- possibly but not necessarily informed by economic evidence -- about the appropriate size of government. A commonly used alternative, though, is just to look at past taxing and spending and see whether current or expected levels are way out of line. The choice of time period is to some extent its own value judgment, of course, but it has become common practice in the U.S. to look at post-World War II averages to get some sense of what the "norm" is.

So let's do that! Federal spending since 1946 has averaged 19.3 percent of gross domestic product, while revenue has averaged 17.2 percent. 1 Yes, that's a recipe for chronic deficits, but in a growing economy, a deficit of 2.1 percent of GDP is quite manageable, and compatible with a federal debt that is shrinking in relation to the overall economy. Sure enough, federal debt held by the public has fallen from 106.1 percent of GDP in 1946 to 76.5 percent of GDP as of the end of the 2017 fiscal year on Sept. 31. (The drop is less dramatic if you look at gross federal debt, which includes money owed to the Social Security trust funds and has gone from 118.9 percent in 1946 to 105.4 percent in 2017.)

How do current and projected spending levels compare? In the 2017 fiscal year, spending was 20.8 percent of GDP and revenue 17.3 percent; by fiscal 2019, this year's spending deal and last year's tax cuts are expected to bring spending up to 21.2 percent of GDP and revenue down to 16.5 percent, according to projections released this week by the Congressional Budget Office. Spending has departed from the post-war norm more than revenue has. And if you look decades into the future, as the CBO last did about a year ago, spending is set to get much further out of line -- rising to a projected 29.4 percent of GDP by 2047. 2

The Long-Run Spending Picture (As of a Year Ago)

Federal government spending as a share of gross domestic product

Source: Congressional Budget Office 2017 Long-Term Budget Outlook

So when Manhattan Institute budget wonk Brian Riedl argues that "Social Security and Medicare’s shortfalls overwhelmingly cause the coming long-term debt," and Hoover Institution economist John Cochrane states that "entitlement spending" on Social Security, Medicare, Medicaid and such is "the central budget problem," they have a point!

Both were making these arguments in response to a Washington Post op-ed by five economists -- Martin Neil Baily, Jason Furman, Alan B. Krueger, Laura D'Andrea Tyson and Janet L. Yellen -- who all happen to have led the White House Council of Economic Advisers under Democratic presidents. Those five economists were in turn writing in critique of yet another Washington Post op-ed by Cochrane and four other Hoover Institution economists, all of whom (not including Cochrane) have held posts in Republican administrations.

The Republican economists' op-ed was about the threat of a "debt crisis" brought on by the "long-run entitlement explosion" described above. I found its downplaying and misrepresentation of the role played by last year's tax cuts in the growth of deficits irritating, so I too wrote a column critiquing it. 3 But my response, and that of the five Democratic economists, also turns out to have downplayed and misrepresented something important: the likely future cost of Medicare.

Add up the current intermediate projections of the Social Security and Medicare trustees, I wrote, "and you get a funding deficit that rises from 0.1 percent of gross domestic product in 2017 to 1.7 percent in 2035 and fluctuates between 1.6 percent and 1.8 percent for the rest of the century." The Democratic economists never offered a number for the Social Security deficit, but they did mention "the Medicare Trustees’ projections of a 0.3 percent of GDP shortfall in Medicare hospital insurance over the next 75 years."

That doesn't sound bad at all. But Medicare hospital insurance, also known as Part A, only accounted for 42 percent of the program's costs in 2016. The rest of the money went to Part B, which covers non-hospital medical services, and Part D, the prescription drug benefit added by Congress and President George W. Bush in 2003. And while Part A is paid for out of Medicare payroll taxes, which currently more than cover the costs but are projected to come up slightly short starting in 2021 or 2022, Parts B and D are paid for mainly out of general government revenues. So while there is something called the Supplementary Medical Insurance Trust Fund out of which Parts B and D are financed, estimates of its future adequacy are totally meaningless in fiscal-policy terms because they simply assume that transfers from general revenue will rise to meet costs.

Much more useful are the CBO's estimates of future Medicare costs, which strip out the misleading trust fund stuff. They show Medicare spending going from 3.1 percent of GDP in 2017 to 6.1 percent in 2047. That's a big increase!

It is also highly dependent on assumptions about the future growth of health-care costs, which is why health-care reform is probably a better framework for thinking about how to rein in those costs than "entitlement reform" is. With Social Security spending, which the CBO expects to grow from 5 percent of GDP in 2017 to 6.3 percent in 2047, modest cuts in promised future benefits do seem appropriate, although I tend to agree with the Democratic economists in the op-ed cited above that some additional revenue would be a good idea too "because Social Security has become even more vital as fewer and fewer people have defined-benefit pensions."

Finally, let's move on to a line item in the chart above that hasn't been mentioned yet: net interest. The CBO expects spending on it to go up a lot -- 4.8 percent of GDP -- between 2017 and 2047. That's not much less than the 5.2-percent-of-GDP expected rise in Social Security and health-care spending, and well more than the projected 3.9-percent-of-GDP rise in overall non-interest federal spending (government spending on everything but Social Security and health care is expected to decline as a share of GDP). Part of that increase in net interest expenditures is because the CBO expects interest rates paid on Treasury securities to normalize after dropping to extremely low levels in the aftermath of the financial crisis; part can be attributed to the growing debt load that will result if revenues fail to keep up with outlays.

It's important to remember, though, that the level of revenue is a political choice, not some immutable law of economics. Other wealthy countries get by with much higher tax burdens than the U.S., without major differences in per-capita GDP growth. And while bringing revenue to within 2.1 GDP percentage points (the average deficit since World War II, which is clearly sustainable) of the 29.4 percent of GDP in spending projected for 2027 would require a hard-to-fathom 59 percent increase in the tax burden from the 17.2-percent-of-GDP postwar average, increasing taxes would also reduce interest costs. Cut out that 4.8-percent-of-GDP projected increase in interest spending, and the tax burden would have to go up 31 percent -- still a lot, but much more manageable.

I would hope we could keep the tax hikes much smaller than that. But I don't think it's realistic to expect the country to get through the retirement of the baby boomers and the population aging that is likely to continue even after the boomers are gone at the current level of tax revenue. Spending is too high and taxes are too low.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
  1. Because recessions generally bring less tax revenue and more spending, I also went through and eliminated all the fiscal years during which recessions occurred plus the year immediately after each recession. We're currently nine years into a recovery, so I figured that would make for a more appropriate comparison. To my surprise, though, it made almost no difference, with the averages going to 17.4 percent for spending and 19.2 percent for revenue. All this data, by the way, is from the White House Office of Management and Budget's Historical Tables page.

  2. I thought about, but decided against, trying to incorporate the CBO's new 10-year forecast into this chart. That will have to wait till the CBO makes its own update later this year.

  3. Cochrane's blog post mentioned my column too (thanks, John!) but didn't really criticize it.

To contact the author of this story:
Justin Fox at justinfox@bloomberg.net

To contact the editor responsible for this story:
Brooke Sample at bsample1@bloomberg.net

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