Annual Report | September 17, 2010 at 4:44 pm

The United States Federal Budget

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The U.S. federal government is by far the largest single entity in the world. As of fiscal year 2009, its expenditures of $3.6 trillion exceeded those of the second and third biggest governments combined. This largely reflects the size of the American economy, itself the largest on the planet. Federal spending has grown by about 5 percent over the past decade, significantly faster than the rate of inflation. The fiscal year 2010 deficit of $1.6 trillion was also, by far, the greatest in the world. In the years ahead, the federal budget will be strained by static revenue and exploding costs, largely, though not exclusively, as a result of ballooning spending on Medicare and Social Security. Major reforms are needed to put the budget on a sustainable path.

Revenues

Since the passage of the Sixteenth Amendment in 1913, the federal income tax has provided the greatest single source of revenue for the federal government. Over the past decade, income taxes have comprised approximately 45 percent of the government’s intake. Payroll taxes, the second largest revenue source, have raised about 36 percent. While income tax revenue is not earmarked for any specific purpose, payroll taxes finance entitlement programs, mainly Social Security and part of Medicare. The corporate tax, the estate tax, tariffs, and other revenues comprise the other 19 percent.

Revenues have declined from an all-time high of 20.6 percent of GDP in 2000 to a 50-year low of 14.8 percent in 2009. But these numbers are slightly misleading: 2000 saw the height of the Internet bubble, 2009 the bottom of the housing bust. In most years, federal revenue ranges between 17 and 19 percent of GDP, depending on the state of the economy.  The income tax and the corporate tax are more prone to economic fluctuation than payroll taxes. To wit, income tax revenues brought in $1.16 trillion in 2007, and just $915 billion in the midst of the recession two years later. Payroll tax receipts, by contrast, expanded from $869 to $890 billion, unchanged as a percentage of GDP.

Demographic changes in coming decades are expected to cause major revenue challenges. The retirement of the baby boom generation will require a dramatic increase in expenditures on programs like Social Security and Medicare, but there will be proportionally fewer taxpayers to finance these programs. The Congressional Budget Office estimates that revenue will peak in 2019 before declining irrevocably. If Congress chooses to extend the Bush tax cuts, or if there is a recession between now and 2019, revenue will remain considerably lower.

Expenditures

Most analysis divides expenditure into two broad categories: discretionary and entitlement spending. Discretionary spending is set by an annual congressional budget resolution, while entitlements, which consist primarily of Social Security and Medicare, are established by a long-term legislative program and do not require renewal.

Both entitlement and discretionary spending have grown substantially over the past decade. Expenditures have risen from 18.2 percent of GDP in 2000 to an estimated 25.2 percent in 2010. Discretionary spending has grown at an annual rate of 4.5 percent from 2000 to 2009. Despite the common conception that military spending, which represents about half of discretionary spending, consumes the budget, defense expenditures represented just 18.7 percent of total spending in 2009; the military budget has increased at a pace similar to that of the rest of discretionary spending over the past decade.

While the expansion of discretionary spending is a problem, entitlement growth, which has been about 5.4 percent per year over the past decade, poses an even greater challenge.  The majority of entitlement expansion has been driven by increased expenses in Medicare and other income-security programs; while Social Security outlays have increased in absolute terms, the program has decreased from 22.7 to 19.3 percent of the budget over the past decade.

If demographic projections are any indication, the bulk of entitlement growth is yet to come. The CBO estimates that in ten years entitlement spending will reach 22 percent of GDP, about as much as the federal government spends on the entire budget today. Social Security spending is expected to increase by half of one percent of GDP, and health spending up to double that. And there is no end in sight. Without changes to the current laws, mandatory spending will reach 44 percent of GDP by 2080, greater than government’s share of the economy during World War II. Such analysis assumes discretionary spending will remain relatively flat. But if I continues to grow at its current pace, government spending will reach unprecedented heights.

Deficits and Debt

The federal deficit is simply the gap between the government’s expenditures and its revenues in a given year.  The government has run a deficit every year since 1969, save for a brief period between fiscal years 1997 and 2000. In 2009, the deficit stood at $1.4 trillion, the largest nominal figure in history. This represents 9.9 percent of GDP, the largest since the end of World War II in 1945.  The CBO estimates that the fiscal year 2010 deficit of $1.56 trillion, 10.6 percent of GDP, will be greater still.

As of 2009, the CBO reports that total federal debt stood at $11.9 trillion, 83.4 percent of GDP. Much of this debt is held by the federal government itself, most of it in the Social Security Trust Fund. The public holds debt worth 53 percent of GDP. Foreign nations own about half of that; China ranks highest among U.S. creditors with $868 billion in American securities, followed by Japan’s $787 billion, the United Kingdom’s $350 billion, and oil exporters’ collective $235 billion.

As dismal as these figures are, one should hasten to add that the deficit varies with the state of the economy, and the tremendous deficits of 2009 and 2010 stem largely from the current recession. For most of the past decade, for example, the economy was in much better shape than it is today; deficits peaked at 3.5 percent of GDP in fiscal year 2004, before declining to just 1.4 percent in 2007.

The years ahead will likely prove more daunting. The CBO estimates that deficits will decline from their 2010 high, but remain over 3.9 percent of GDP through 2014 and 2015.  The cause, simply put, is that the government is not raising enough tax revenue to pay for its spending promises. Mushrooming entitlement spending will cause deficits to rise virtually unabated, reaching catastrophic levels if health care costs are not controlled.

The unchecked growth of federal debt could have dangerous consequences. As Greece’s recent fate has demonstrated, the consequence of high debt means unwillingness of creditors to lend, and the potential onset of a crisis in which the government literally cannot fund its most basic operations. The borrowing required by such high deficits induces higher interest rates, which crowd out private sector investment, lowering growth rates and living standards.

It remains relatively unlikely that the United States could fall to Grecian levels, if for no other reason than that many of its creditor nations face the same demographic squeeze that  now threatens the American budget. On the other hand America is not Greece; it is far bigger and far more central to the global economy. Even a downgrade in America’s credit rating would send shockwaves around the world, devastate those who purchase government bonds, (essentially all American investors, as well as those who receive Social Security benefits) and could trigger a global financial crisis. Recognizing this, President Obama has convened a debt commission, tasked with reigning in the nation’s debt. The solutions will almost certainly be politically unpalatable, but may still prove the best hope of averting America’s dire fiscal future.

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