Monday, October 25, 2010

Politics and the Federal Budget

This is the nastiest political season that I can ever remember. The bitter partisanship that has taken over the political world since at least 1994 is giving us a rash of television ads that are viciously personal and contain little in the way of objective truth. One of the topics that has been bandied about is the federal budget. Ads say things like “I’ll get spending under control” and “I’ll cut taxes” and “I’ll cut the deficit”. The truth is, they might be able to do one or two, but doing all three is a fiscal impossibility. We, the voting public, need to have politicians who will speak the truth and work toward solutions. To do that, we need to be armed with the truth ourselves.

Here’s how the current 2010 federal budget breaks out. The estimated receipts (taxes, customs duties, and so forth) amount to $2.38T (trillion) dollars. Estimated expenditures amount to $3.55T. This means the estimated deficit is $1.17T. For comparison, this amount is equal to the total federal budget of 1989, or to the entire national gross domestic product (GDP) of 1972.

There are two components of expenditures. One is mandatory spending. These expenditures are required by law. The other component is discretionary. These expenditures are proposed by the President and modified and approved by Congress.

In the current budget, mandatory spending amounts to $2.18T. This includes Social Security ($678B), Medicare and Medicaid ($743B), the interest on national debt ($164B), and a myriad of other mandatory programs ($582B).

Discretionary spending amounts to $1.37T. The biggest portion, by far, goes to the Department of Defense ($664B). Next is Health and Human Services ($79B). All the other federal departments (Transportation, Veterans Affairs, State, Homeland Security, and so forth) receive lesser amounts.

Note that, if we subtract mandatory spending ($2.18T) from revenues ($2.38T), that leaves only $200B before we start running a deficit. But as soon as we include defense spending, we’re running a deficit of nearly a half trillion dollars before we spend a dime on anything else.

Now for a little history. The 2001 federal budget (submitted by President Clinton) amounted to $1.8T, which was 21.2% of GDP. The government had a budget surplus that year of $153B.

The 2009 budget (submitted by President Bush) amounted to $3.1T, which was 24.7% of GDP. The deficit for that year was $1.4T. Note that this deficit was almost as much as the entire federal budget of only eight years previous. When proposed by President Bush, the 2009 deficit was stated to be about $400B; however, this did not include the cost of the wars in Iraq and Afghanistan. Combined with the onset of the recession (which decreased revenues from taxes by over $600B), this resulted in an actual deficit over three times the original projection.

As noted earlier, the 2010 budget (submitted by President Obama) is $3.8T, which is 25.1% of GDP, with a deficit of $1.17T. This percentage is higher than at any time in our history, with the exception of World War II.

This massive deficit is in stark contrast to recent history. In 2001, the Congressional Budget Office (CBO) (a non-partisan staff element of Congress) estimated that the federal budget would have annual surpluses of about $850B in 2009 and 2010. Instead, we have large deficits, which are forecasted to reach unsustainable levels by the end of this decade. Peter Orszag, former Director of the Office of Management and Budget (OMB), attributed the majority of the causes to the tax cuts of 2001 and 2003, the Medicare prescription drug benefit, and fallout from the financial crisis (reductions in tax income, increase in social safety nets expenses, and comparatively minor expenditures from the stimulus and bailout)

Some believe that we can eventually cover the deficit by growing the economy. That was true once, but not now. The Government Accounting Office (GAO) estimated that the GDP would have to grow by double-digit levels for next 75 years to outgrow the debt. Double-digit growth is possible only for an undeveloped country, such as Afghanistan, and then only for a short time. During 90’s “boom” years, the American economy grew about 4-6% annually.

During an election season, there is usually a lot of talk about cutting fraud, waste, and abuse. Every politician of every political party for the past 200 years has vowed to do that. The problem, of course, is that waste and abuse mean different things to different people. Federal funds to, say, build the I-26 connector in Asheville might be hailed here as a vital element of the economy, but be viewed by Alaskans as a waste of their tax dollars. Regarding real fraud, waste, and abuse, the OMB estimates that the federal government may have made $98B in “improper payments” in 2009. This means that, even if we eliminated fraud, waste, and abuse entirely this year, our deficit would only drop from $1.17T to $1.07T.

We’ve already noted that Social Security, Medicare/Medicaid, other mandatory programs, and defense are the federal government’s biggest expenses. Social Security and Medicare/Medicaid are both fiscally unsustainable. Their expenses are growing rapidly, far faster than GDP, even in “good” years. Economists across the political spectrum, the Social Security Administration, the Department of Health and Human Services, the OMB, the Congressional Budget Office, and many more have warned that Social Security and Medicare/Medicaid must be overhauled to ensure their long-term sustainability. These overhauls must be done by laws passed by Congress. Unfortunately, Congress has not been willing to address them in any meaningful manner. The reason is that real overhauls can only be done by reducing benefits (such as delaying the retirement age for Social Security), raising taxes, or both. It is impossible to fix them in any other way. However, virtually no politician in the current environment is willing to push for those reforms. Every year those reforms are delayed will make the reforms more costly down the road.

Expenditures are only half of the budget equation. The other half are revenues from taxes, fees, and other sources. Contrary to popular belief, the amount of taxes collected by the US is quite low relative to other developed nations. About 25% of US GDP is collected in federal, state, and local taxes, while most developed countries are in the 30-40% range.

Despite the relatively low tax burden and high deficit in this country, there is a strong push for more tax cuts. Democrats want to extend income tax cuts for the lower and middle classes at a cost of $2.3T over ten years, while Republicans want to extend the cuts for everybody (cost: $3.1T over ten years). The claim is that tax cuts will stimulate the economy. While that is true, it is also true that tax cuts do not generate enough revenue to pay for themselves even in “good” times. Studies by the Congressional Budget Office and the Treasury during President Bush’s tenure showed that increased economic activity only generated about a 20% return on the dollar. Making the tax cuts permanent, therefore, will also make a rapidly growing deficit permanent.

Most economists agree that deficit spending by the federal government is necessary during a financial crisis, such as the one we’re in, in order to keep it from becoming a full-blown depression. The current deficit levels, however, are unsustainable over the long run. We must do a number of very difficult things in the next few years. They include:
- Raise federal revenue levels. This means increasing taxes, customs duties, and fees.
- Reform Social Security by decreasing benefits, raising taxes, or both.
- Reform Medicare and Medicaid by decreasing benefits, reining in growing health care costs, raising taxes, or some combination of all.
- Reduce discretionary government spending. Defense spending is the obvious first choice, as it is almost the same size as Social Security and Medicare/Medicaid, but all federal departments should be evaluated.

For an example target, our goal might be to return the federal share of the GDP to the historical average of about 20%. Our current GDP is about $14.6T, resulting in a federal budget of $2.92T. To get there, we need to cut expenditures by $630B and raise revenues by $540B.

If we are to dig ourselves out of this fiscal hole, our politicians must work together. The Clinton Administration and Republican-led Congress did just that during the latter 1990’s and produced budget surpluses. Although surpluses that begin to pay down the national debt may be too much to realistically hope for at this stage, a sustainable deficit is not. As we get ready to go to the polls next week, we should ask ourselves whether our candidates will work toward fiscal discipline, or will they put partisan politics above the national good. This year, that question is critical. We don’t need any more grandstanding and nasty name-calling, we need leaders who will address the serious problems that we now face. That will require a bi-partisan effort.

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