Budget Challenges for the Next President

 

This November the country will elect a new president, and whether it is Barack Obama or John McCain, he will face daunting problems. There is a high likelihood that the economy will be in recession, housing will still be stagnating, oil prices will remain high, and credit markets will continue to be unsettled. Unfortunately, there is very little that any new administration will be able to do about any of these except perhaps try to ride them out. There are a number of longer-run issues, however, that the new president and his administration must begin to address. We will focus on a number of these issues in this and future articles, beginning with the budget deficit. Let's start with a bit of historical perspective.

 

For four years from 1998 through 2001, the United States ran budget surpluses-the first surpluses in 29 years. These surpluses were the result of strong economic growth that boosted government receipts and divided government that restrained federal spending. Unfortunately, the economy sank into recession in 2001, and tax cuts were quickly passed to stimulate economic growth. While the policies were successful at getting the economy moving again, they led to outright declines in government revenues. With terrorist attacks on New York and Washington occurring at the same time and triggering the onset of a global war on terror, government spending accelerated. The combination made short work of the surpluses.

 

In 2002, the economy slipped back into deficit, and by 2004 the deficit increased to more than $400 billion, or 3.6% of GDP. Over the next three years, strong economic growth whittled the deficit down to about $162 billion, or 1.2% of GDP by 2007. But slowing growth is once again curtailing federal revenues, and deficits of more than $400 billion are now forecast for this year and next.

 

The future course of the deficit has thus become an issue for the candidates in the upcoming election and has intensified the debate over the expiration or renewal of the 2001 and 2003 tax cuts. With both candidates claiming that they will reduce the deficit and balance the budget, it might be enlightening to look at the underlying budget arithmetic.

 

In 2007, federal revenue was $2.6 trillion, or 18.8% of GDP. The largest component of this total was individual income taxes at $1.2 trillion (45.3%), followed by social insurance and retirement taxes at $870 billion (33.9%), corporate income taxes at $370 billion (14.4%), and excise taxes and other revenue at $165 billion (6.4%).

 

Over the last 25 years, federal revenue averaged 18.3% of GDP and fluctuated in a relatively narrow band with a high of 20.9% and a low of 16.4 %. As one would expect, total federal revenues were, and are, highly dependent on the state of the economy as well as the rate structure imbedded in the tax regime at any given time. Because of the progres-sivity and lack of indexing that has existed in the tax code under virtually all current and prior regimes, a rapidly growing economy tends to produce a higher total tax take as individuals and corporations experience bracket creep.

 

Thus, the latter part of the Clinton administration, with its higher tax rates and relatively strong economy, saw tax revenues grow at an almost 8% annual rate, and the total tax take as a percentage of GDP reached its high point of 20.9% in 2000. The lower rate structure under President Bush and relatively slow economic growth during the 2001 recession and for some time thereafter produced an actual decline in federal revenues from 2001 to 2003 and the lowest total tax take of 16.4% in 2004.

 

In 2007, federal spending was $2.7 trillion, or 20% of GDP. The three major components of total spending are mandatory spending-primarily Social Security, Medicaid, and Medicare-at $1.5 trillion (53%); discretionary spending at $1.1 trillion (38%); and net interest at $237 billion (10%). Discretionary spending has two basic components-defense spending at $549 billion and nondefense spending at $493 million. As the name suggests, mandatory spending includes expenditures that are promised or guaranteed and therefore represent spending that Congress does not need to appropriate on an annual basis (it's sort of on autopilot). Discretionary spending, on the contrary, must be allocated and appropriated by Congress each year.

 

Over the past 25 years, federal spending has averaged 20.8% of GDP and ranged from a high of 23.5% of GDP in 1983 in the wake of the severe double dip recession to a low of 18.4% of GDP in 2000 during one of the most bitterly partisan periods in recent history. Generally, periods of slow growth contribute to a higher level of government spending relative to GDP owing to the relatively higher level of welfare and transfer payment. Periods of divided government are associated with lower spending to GDP ratios because of the inability to pass appropriations.

 

So much for the history lesson. What might this mean for the future? How will the next president deal with this issue? The Office of Management and Budget currently projects that FY2008 will see government revenue at $2.5 trillion (17.6% of GDP), government spending at $2.9 trillion (20.5% of GDP) and a deficit of just more than $400 billion (2.9% of GDP). 

 

If the goal of the next president is to balance the budget over his term, he must do much more than just cut spending or increase taxes by about $400 billion. He must put spending and revenue on a balance going forward. That will not be easy to achieve because there is a great deal of positive momentum on the spending side and negative momentum on the revenue side.

 

Let's start with the components of government spending. Mandatory spending for entitlement programs, representing 53% of all government spending, has grown at a 5.5% pace over the last five years and close to 6% over the last 20 years. With the aging of the baby boomers, it is unlikely that we would experience growth below this range-even with entitlement reform. If we take the low end of this range, we can expect that mandatory spending will be more than $2 trillion by 2012. Net interest costs fluctuate with interest rates and the level of national debt. But assuming that we will have about $6 trillion of debt held by the public at about a 4.5% average interest rate, we will be experiencing net interest costs of around $270 billion.

 

Discretionary spending is much harder to predict because it depends heavily on the programs proposed by the administration and approved by Congress. Divided government has yielded much lower growth rates than periods when Congress and the administration are of the same party. For example, Clinton's last six years saw only a 2.1% average annual growth in discretionary spending, while the first six years of the Bush term saw an 8.4% annual growth. If we use these percentages as upper and lower bounds for growth in discretionary spending, we end up with somewhere between $1.2 trillion and $1.6 trillion in discretionary spending in 2012.

 

These spending assumptions are on the conservative side for mandatory and interest payments. I believe that the discretionary assumptions are also conservative. Granted they make no assumption about an end to the war in Iraq, but they also do not include any major new domestic programs to address our infrastructure, energy shortage, or education-all of which everyone knows we need.

 

Add the spending side up and you get $3.5 trillion to $3.9 trillion. Assuming the economy grows at about 6% in nominal terms (2.5% real and 3.5% inflation), our GDP will be around $18 trillion in four years. Thus, balancing the budget would require a tax "take" of 19.4% to 21.7% of GDP. The lower end of this range was only reached or exceeded during the latter years of the Clinton administration, and the upper end exceeds anything we have experienced in the last 25 years!
I believe that the only way we can achieve a balanced budget in the foreseeable future is to seriously rein in federal spending and to maintain a strong economy to generate growing federal revenues. Voters in November must decide which candidate is more likely to provide that policy mix.