Why is America’s budget deficit so large?

AMERICA'S enormous budget deficit is now exceeded as a share of national income only by Greece and Egypt among all of the world's major countries. To be sure, the current deficit of 9.1% of gross domestic product (GDP) is due in part to the automatic effects of the recession.

But, according to the official projections of the United States Congressional Budget Office (CBO), even after the economy returns to full employment, the deficit will remain so large that America's national debt-to-GDP ratio will continue to rise for the rest of this decade and beyond.

Understanding how to achieve US fiscal consolidation requires understanding why the budget deficit is projected to remain so high. Before looking at the projected future deficits, consider what happened in the first two years of President Barack Obama's administration that caused the deficit to rise from 3.2% of GDP in 2008 to 8.9% of GDP in 2010 (which in turn pushed up the national debt-to-GDP ratio from 40% to 62%).

The 5.7%-of-GDP rise in the budget deficit reflected a 2.6%-of-GDP fall in tax revenues (from 17.5% to 14.9% of GDP) and 3.1%-of-GDP rise in outlays (from 20.7% to 23.8% of GDP). According to the CBO, less than half of the 5.7%-of-GDP increase in the budget deficit was the result of the economic downturn, as the automatic stabilisers added 2.5% of GDP to the rise in the deficit between 2008 and 2010.

The CBO analysis calls the changes in the budget deficit induced by cyclical conditions “automatic stabilisers,” on the theory that the revenue decline and expenditure increase (mainly for unemployment benefits and other transfer payments) caused by an economic downturn contribute to aggregate demand and thus help to stabilise the economy.

In other words, even without the automatic stabilisers that is, if the economy had been at full employment in 2008-2010 the US budget deficit still would have increased by 3.2% of GDP. Lower revenue and increased outlays each account for about half of this “full-employment” rise in the deficit.

Looking ahead, the CBO projects that enacting the budget proposed by the Obama administration in February would add US$3.8 trillion to the national debt between 2010 and 2020, causing the debt-to-GDP ratio to soar from 62% to 90%. That US$3.8 trillion net debt increase reflects a roughly US$5 trillion increase in the deficit, owing to higher spending and weaker revenues from middle and lower-income taxpayers, offset in part by US$1.3 trillion in tax increases, primarily on high-income earners.

Even this enormous increase in the projected deficits and debt underestimates the fiscal damage that the Obama administration's budget, if enacted, would inflict. The proposed budget assumes that non-defense “discretionary” spending (which requires congressional approval, unlike so-called “mandatory” spending like Social Security pension benefits, which continues to grow unless Congress changes the benefits) will rise by a total of only 5% in the decade 2010-2020, implying a decline in real terms and no scope for new programmes.

The annual level of defense spending is projected to decline by about US$50bil in each year after 2012 a very optimistic view of US military needs in the decade ahead.

Shrinking America's budget deficit to prevent a further rise in the debt-to-GDP ratio from its current level will require reduced spending and increased revenue. That increase in revenue can be achieved without raising marginal tax rates, namely by limiting the amount of tax reduction that individuals and businesses can achieve from the various “tax expenditures” that form an important part of the US tax code. But that is a subject for another column.

On the expenditure side, however, the prospect that the national debt could double during the next decade is just the start of the fiscal problem that the US now faces. The budget outlook in subsequent decades is dominated by the increasing costs of Social Security and Medicare benefits, which are projected to take the debt-to-GDP ratio from 90% in 2020 to 190% in 2035. Fundamental reform of these programmes is the primary challenge for America's public finances and thus for the long-term health of the US economy. - Project Syndicate