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The U.S. Budget Problem

8/1/2011 --

ANN ARBOR, Mich.—The current U.S. budget deficit and the projected growth rate, if they remain at the same levels, clearly are not sustainable.

According to the Congressional Budget Office, the United States is spending about $3.7 trillion while taking in about $2.2 trillion a year, a difference of $1.5 trillion, or almost 50 percent of spending. The four big budget items are healthcare ($820 billion), Social Security ($720 billion), defense and wars ($700 billion), and income security, interest, and federal pensions (totaling $840 billion). The sum of these four items already equals about $3.1 trillion—representing 141 percent of revenues. Simply speaking, everything else adds up to about $600 billion, meaning that even if we were to literally cut these "miscellaneous" expenditures to zero, we only get a 16 percent reduction in spending and the United States will still face huge and unsustainable budget deficits of $900 billion per year, or about 6.5 percent of GDP.

At current projections, the budget deficit in 2015 is estimated to be about $2.3 trillion (or 13.5 percent of the estimated $17 trillion GDP in 2015), while U.S. debt is on track to reach $23 trillion. We currently are pointing a finger at Greece and accusing them of irresponsible fiscal policy, yet this deficit level would surpass that of Greece and is, therefore, not sensible. The debt level in 2015 would equal 135 percent of the GDP. Any loss of confidence and associated increase in U.S. interest rates on $23 trillion of debt would truly present a serious risk to the U.S. budget and the economy.

Even more critical to the burgeoning deficit are the growth rates of these four big spending groups. Almost the entire incremental deficit comes from the four spending biggies. In four years, healthcare spending is projected to add an extra $320 billion per year. (This is the biggest of the four biggies.) Defense tacks on an extra $100 billion a year, Social Security adds another $110 billion, and income security, interest. and federal pensions add another $300 billion, totaling $840 billion a year—which is the entire incremental deficit. Clearly, growth in these four spending groups, especially healthcare expenditures, must be controlled if the budget deficit itself is to be controlled.

Looking further into the future is really scary. The problem just grows and grows without bounds in the next 10 or 15 years. Today, we have a chance to solve the problem before we truly go bankrupt.

The way I see it, in spite of the magnitude of the problem, our deficit problem is not that complicated. The simple math above tells us where to look to both identify the problem and propose sensible solutions. First, there is a runaway budget deficit that needs to be addressed, and addressed very soon before it is too late. We cannot continue down this path for four more years, let alone 10 or 15 years. Cutting $150 billion a year from the budget (or $1.5 trillion over 10 years as currently discussed in Washington) is simply not a serious solution. In fact, this $1.5 trillion over 10 years represents only one year of today's budget deficit, and thus implies we've solved 10 percent of the problem and are accepting the massive and growing budget deficits for nine of the next 10 years. If the political will to solve the problem cannot be found today, I doubt we will find it when the problem becomes intractable in 10 years.

How much of a cut is needed to solve the problem? An absolute maximum deficit consistent with our long-term economic growth rate of 2-3 percent, or $400 billion a year, is sensible. This means that at a minimum, in the steady state, we must cut about $1 trillion a year from the deficit (from 2011 levels). When I say cut, I mean a real spending cut from 2011 levels, and no Fed-speak about a relative drop in projected spending relative to some other dubious and uncertain projection.

The simple math indicates that one cannot chop $1 trillion or more a year from the deficit and solve the problem unless the four spending biggies—healthcare, Social Security, defense, and other federal entitlements—are on the table for significant cuts. Any realistic deficit reduction plan must involve these four spending groups. Otherwise, it is not credible. Furthermore, given the size of the cut that is necessary, even draconian federal spending cuts alone are not going to solve the problem nor would they be desirable. Thus, any sensible steady-state solution would need to involve revenue increases.

This, too, has a relatively straightforward solution: Our tax policy needs to be revised to increase the size of the tax base. We currently have a strange tax system where almost 50 percent of the working population pays zero federal income taxes. In turn, those who don't pay taxes really don't care about either the tax base or the tax rates. With one-half the population having no desire to change anything on the revenue side and the other half of the population completely focused on taxation, inevitably, we get class conflicts.

Thus, any sensible steady-state solution to the budget problem will involve sacrifice for everyone: 1) drastic cuts to the four spending biggies are needed, 2) widen the tax base to cover most working Americans, and 3) all Americans must pay more taxes.

The tough part clearly is going to be selling this comprehensive solution to the populace. Any magical solution that focuses entirely on spending cuts or entirely on tax increases should not be taken seriously. Any gimmicks that will require reasonable people to ask: "What do you mean by a cut?" are not acceptable. The job of Washington politicians is to find the tradeoffs between real spending cuts and real tax increases that will make it palatable, and to explain to the public why this is the only long-term sensible solution. This is how I see it.

Nejat Seyhun is the Jerome B. & Eilene M. York Professor of Business Administration and a professor of finance.



For more information, contact:
Bernie DeGroat, (734) 647-1847, bernied@umich.edu