It’s Time to Get Serious About the Federal Deficit

Last year brought widespread predictions of a recession occurring by year-end. But U.S. economic growth remained solid in 2023. The predictions of a late-year recession were reasonable, given the rapid increase in the federal funds rate; from March 2022 to July 2023, the Federal Reserve increased its target interest rate by 525 basis points. Since last July, however, as inflation has moderated, the Fed has paused its rate increases. It may not raise its target interest rate again in the near term, and it is likely to start reducing rates by the end of this year. The Fed may indeed have pulled off a “soft landing” — controlling inflation without causing the economy to collapse.

But while the odds of a recession have fallen significantly in the near term, the U.S. economy faces several major hurdles — among them, the growing federal deficit. We need to tackle the country’s huge debt by adopting responsible, sustainable fiscal policy. In today’s polarized political environment, a new nonpartisan fiscal commission could be key to achieving this

The Ballooning Federal Deficit

One of the most apparent economic hurdles facing the U.S. is its federal deficit — the gap between what the federal government spends and what it collects in tax revenue. The country’s sustained and growing deficits are a primary concern.

The deficit in fiscal year 2023 was $1.7 trillion — up $320 billion from the deficit in fiscal year 2022 according to official estimates. But in both years, unusual accounting for President Joe Biden’s student loan forgiveness plan significantly affected the deficit calculations. In particular, $376 billion of spending — the estimated present value cost of the student loan forgiveness plan — was included in fiscal year 2022. After the Supreme Court blocked the student loan forgiveness plan, fiscal year 2023 spending declined by $333 billion.

This accounting gimmick increased the deficit in 2022 and decreased it in 2023. Adjusting the deficit calculations to remove the expenditure shift across years suggests that the adjusted deficits would be roughly $1 trillion in 2022 and $2 trillion in 2023. This would mean that the federal deficit unofficially increased by roughly $1 trillion from 2022 to 2023.

In the first two months of 2024, federal government spending was $381 billion more than revenues. The Congressional Budget Office (CBO) projects that deficits will continue to grow over the next three decades.[1]

The CBO’s projections indicate that as a share of gross domestic product (GDP), the deficit will equal 6.4% in 2033, 8.1% in 2043, and 10% in 2053. By 2053, the total debt held by the public will be 180.6% of GDP — up from the current 98.2% — assuming that current law does not change. But current law surely will change, and most of the changes will lead to larger deficits.

Likely Policy Changes Will Increase the Deficit

For example, many of the provisions in the Tax Cuts and Jobs Act (TCJA) of 2017 are set to expire at the end of 2025. This includes income tax rate reductions and the expanded alternative minimum tax (AMT) exemption, larger standard deduction, cap on state and local tax deductions, and deduction for pass-through businesses. It is unlikely that policymakers will allow these provisions to expire. Further, there is considerable support for expanding the child tax credit, such as a similar, but scaled down, version of the expansion in the American Rescue Plan Act of 2021. Legislators are considering an expansion of the child tax credit in exchange for additional business tax incentives.

In June 2022, the CBO estimated that a 10-year extension of the TCJA would increase deficits by roughly $3 trillion.[2] In addition, it has projected that tax revenues will increase as a share of GDP from 18.1% in 2023 to 19.1% in 2053. The increase in revenues as a share of GDP will occur as taxpayers move into higher tax brackets over time and as the temporary provisions in the TCJA expire at the end of 2025.[3]

The CBO projects that under current law, spending will increase from 24.2% of GDP to 29.1% of GDP by 2053.[4] The assumption of current law also includes a shift in the composition of spending. For example, in the CBO’s projections, Social Security expenditures increase from 5.1% to 6.2% and government health care expenditures increase from 5.8% to 8.6%, thanks to the nation’s aging population and health care costs that grow faster than GDP. Other mandatory expenditures would shrink by 50% under current law, declining from 4.2% to 2.1% of GDP. Discretionary spending falls from 6.5% of GDP in 2023 to 5.4% in 2053. The CBO shows that an increase in debt and higher interest rates cause expenditures on net interest to rise from 2.5% of GDP in 2023 to 6.7% of GDP in 2053.

It is unlikely that U.S. lawmakers would allow such a change in the composition of spending. For example, other mandatory spending includes programs that provide income security, poverty relief, payments related to refundable tax provisions, and benefits to retired federal employees and disabled veterans. It will be difficult for legislators to cut these benefits by 50%. But at some point, the U.S. must reduce the gap between spending and revenues.

Note that without congressional action, exhausting the trust funds for major entitlements would lead to a reduction in expenditures. However, the CBO assumes such expenditure reductions will not occur under current law. Adopting sustainable and responsible fiscal policy has been a significant hurdle facing Congress, and in the past two decades it has not been successful at addressing this issue.

Looking to the Last Major Fiscal Commission

Policymakers should examine the last major fiscal commission, the 2010 National Commission on Fiscal Responsibility and Reform (NCFRR). The NCFRR report advocated for significant expenditure reductions, aiming to reduce the ratio of spending to GDP to roughly 23%. In addition, it proposed a cap on the revenue-to-GDP ratio of 21% — roughly a three-percentage-point increase in the revenue-to-GDP ratio compared to the average over the past 40 years. The NCFRR report proposed reducing individual marginal tax rates (for most taxpayers) below those that would prevail even if the temporary TCJA provisions became permanent. It included proposals in which the top individual income tax rate was between 23% and 29% and recommended that the top rate not exceed 29%. Generally, it focused on policies to reduce budget deficits and increase economic growth — a critical factor in solving the nation’s fiscal crisis.

Economic Growth Relies on a Broad-Based, Low-Rate Tax System

A book chapter I co-authored with Alan D. Viard in 2008 analyzed the macroeconomic effects of a permanent reduction in tax rates on different types of income, including wage, interest, dividend, and corporate income, as well as the effects of a permanent increase in tax credits and deductions.[5] The reductions were debt-financed for 10 years and then paid for by either a reduction in transfer payments or an across-the-board tax increase.

We found that the wage, dividend, and corporate rate reductions led to an increase in GDP in the long run when offset by reductions in transfer payments. The increase in GDP was the largest for the dividend and corporate tax rate reduction. An increase in personal tax credits decreased GDP in this case. If an across-the-board tax increase offset the cuts, the effect on GDP was negative for all the tax cuts except for the dividend tax cut, which did not affect GDP.

The most significant decrease in GDP (0.8%) occurred with increased tax credits (that is, spending through the tax system). The implication is clear: A broad-based, low-rate tax system will increase economic growth, while a narrow-based, high-rate tax system will reduce economic growth. Reducing economic growth will make solving the budget crisis more difficult, as increased economic growth results in higher revenue and lower expenditures in general.

Extending the temporary provisions of the TCJA would lower marginal tax rates but narrow the tax base by increasing the net amount of credits and deductions. While lower tax rates increase incentives to work and save, using deficits to finance the tax rate reductions will offset, to some extent, the long-run positive effects.

Policymakers Must Act

Eventually, the tendency of politicians to drown future generations in debt must be checked. Policymakers should reduce expenditures, reform entitlements, and maintain a broad-based (that is, with minimal tax expenditures), low-rate tax system, or otherwise implement a more fundamental reform like moving to a consumption-based tax.

Given that in today’s polarized political climate it is near impossible to reach a consensus on these issues, it is time to assemble another fiscal commission — one that starts by reexamining and using the framework laid out by the NCFRR and whose proposals receive an up or down vote in both houses of Congress. Regardless of the exact path, policymakers must step up and take seriously the country’s rising levels of debt relative to GDP.

Notes

[1] Congressional Budget Office (CBO), The 2023 Long-Term Budget Outlook (Washington, DC: Congressional Budget Office, 2023), www.cbo.gov/publication/59331.

[2] CBO, The 2022 Long-Term Budget Outlook (Washington, DC: Congressional Budget Office, 2022), www.cbo.gov/publication/57971.

[3] CBO, The 2023 Long-Term Budget Outlook.

[4] CBO, The 2023 Long-Term Budget Outlook.

[5] John W. Diamond and Alan D. Viard, “Welfare and Macroeconomic Effects of Deficit–Financed Tax Cuts: Lessons from CGE Models,” in Tax Policy Lessons from the 2000s, edited by Viard (Washington, DC: AEI Press, 2008), 145–93.

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