Of Deficits and Debt

By Robert Lincoln
From the Winter 2010 Edition of Values

While the current U.S. budget deficit and level of total debt have reached record highs, the alarm sounded by some pundits is misplaced.

A deficit results when government spending exceeds tax receipts. It is useful to think of this in two ways: A structural deficit results from an annual shortfall of tax receipts relative to government spending in normal times. In contrast, a cyclical deficit is produced when an economic downturn leads to both higher government spending (e.g., unemployment insurance) and lower tax revenues caused by depressed incomes and profits.

Whenever government spending exceeds tax receipts the government must issue bonds to cover the shortfall, creating government debt. Since cyclical deficits should be offset over time by cyclical surpluses, the growth of government debt over time is the result of ongoing structural deficits.

It is important when comparing trends in deficits and debts to express them as a percent of gross domestic product (GDP). This puts them in context, accounting for economic growth and inflation, and gives an accurate representation of their relative importance to the economy at a point in time. When there is economic growth, the same dollar amount of debt becomes a smaller percent of GDP.

The Republican party historically–and the Tea Party movement more recently–has advocated for lower taxes, lower government spending, and balanced budgets. Democrats are popularly associated with higher taxes, higher government spending, and a willingness to tolerate deficits. While these are convenient constructs, they do not match the historical record.

The chart below shows U.S. government receipts and expenditure as a percentage of GDP over the past 50 years, segmented by presidential administrations. As can be seen, the deficits (the space between the lines) have been considerably larger during Republican administrations. The largest deficits occurred when the receipts line has declined, particularly during the Reagan/Bush and Bush II administrations. While trends in receipts and expenditures always have multiple causes, until the recent crisis the periods of rising deficits are clearly associated with large tax cuts (primarily for high-income taxpayers), enacted without corresponding restraint in spending.

The federal debt declined from 46 percent of GDP in 1960 to 26 percent in 1980. With the Reagan tax cuts, debt increased to 48 percent by 1992. In the Clinton administration the combination of spending restraint and increased taxes actually eliminated the deficit and produced a budget surplus. Debt as a percent of GDP declined steadily to 35 percent. The Bush tax cuts eliminated the surplus and stopped the decline in debt. By 2008 debt had risen to 40 percent of GDP. Despite the common perception, spending has varied far less than taxes as a share of GDP. In effect, the federal government has frequently chosen to borrow the necessary funds (usually from the high-income beneficiaries of the tax cuts) to maintain its level of spending rather than raise those funds through taxes.

The current deficit and accumulated debt of 9 percent and 64 percent of GDP, respectively, are extremely high. The cyclical deficit and the stimulus programs account for a large share–about six percentage points–of this shortfall. With an economic recovery we can expect a rapid reduction in the cyclical deficit. Remaining, however, will be a structural deficit of about 3 percent of GDP. Without action this shortfall is sure to expand due to the projected growth in Social Security and Medicare spending. This must be addressed.

The recent draft report of the so-called Deficit Commission headed by former Senator Alan Simpson and former White House Chief of Staff Erskine Bowles offers a good framework. The bipartisan commission had the luxury of making recommendations for the very long term, and has avoided the distractions caused by our divisive politics. Mssrs. Simpson and Bowles have made a good start at defining the nature of our spending and tax imbalances and identifying alternative means of achieving equilibrium. They have identified more than enough potential decreases in government spending to bring the 2030 budget into balance through expenditure cuts without any increases in receipts. Similarly, they have identified enough ways to increase receipts to bring the budget into balance without any reductions in expenditures. Which approach will win out? History would indicate that politicians’ unwillingness to make meaningful reductions in expenditures will make tax increases a significant part of the solution.