The Burden of Debt

By Charles Webb

Regardless of political affiliation, everyone should be extremely concerned by the level of debt that is being accumulated by our government. The projected deficit numbers are unprecedented by any historic measure.

Just two years ago, the total debt of the federal government was 69% of our gross domestic product. Last year it was 83%; this year it has risen to 94%. By 2013 or 2014, if we continue current economic policies, it will exceed 100%. And those numbers don't even include the tens of trillions of dollars in future Social Security and Medicare promises that are already with us (future unfunded liabilities).

How bad is it? Last year, the International Monetary Fund released its annual review of U.S. economic policy. Its summary contained these bland words about U.S. fiscal policy: "Directors welcomed the authorities' commitment to fiscal stabilization but noted that a larger-than-budgeted adjustment would be required to stabilize debt-to-[gross domestic product]."

Delve deeper, and you will find that the IMF effectively pronounced the U.S. bankrupt.

Section 6 of its July 2010 selected-issues paper says: "The U.S. fiscal gap associated with today's federal fiscal policy is huge for plausible discount rates." It adds that "closing the fiscal gap requires a permanent annual fiscal adjustment equal to about 14% of U.S. GDP."

The fiscal gap is the present value of the difference between projected spending (including servicing official debt) and projected revenue in all future years.

To put 14% of gross domestic product in perspective, current federal revenue totals 14.9% of GDP. So the IMF is saying that closing the U.S. fiscal gap from the revenue side requires, roughly speaking, an immediate and permanent doubling of our personal income, corporate and federal taxes, as well as the payroll tax. That also assumes those higher rates would have no negative impact on the economy, which of course they would.

So what is the solution? This debate is now raging on in Washington and clearly falling along party lines. On one side of the debate, the Democrats want to raise taxes on wealthier tax payers as a way to slow the deficit. I emphasize slow because the administration has not offered a plan that projects a balanced budget. Instead, there are only hopeful projections that show the deficit becoming more manageable.

The Republicans, on the other hand, believe that by cutting taxes the economy will grow its way out of this pile of debt. In truth, they're both wrong. I would summarize the two positions as tax and spend vs. borrow and spend.

Our problem is clearly in spending. The following table shows a breakdown of the federal budget over the last eleven years.

One interesting line item shown is Net Interest. Interest rates in 2000 were roughly 3 times higher than they are now. Yet the government's interest expense is now 27% higher. This shows you how much the country's debt expense has grown. It also gives you some idea of how bad an increase in interest rates would be on the budget problem. That number alone could easily double in a matter of a few years. The potential increase in taxes on the wealthy (however you want to define that) may simply go towards paying the higher interest cost and make no contribution towards closing the budget gap.

The relationship between economic growth and interest rates poses an interesting problem to a government in debt. The best way to tackle the debt problem is to grow your way out of it. Higher economic activity will lead to higher tax revenues. However, higher economic activity also leads to higher inflation and interest rates. Thus, the government's interest expense rises and consumes much of that additional revenue.

Attacking This from the Top Line

In 2000, federal tax revenues totaled just over 2 trillion dollars. Peak revenues topped out in 2007 around 2.57 trillion dollars. Even after the real estate bust and ensuing financial collapse, tax revenues only declined to 2.1 trillion - higher than any year before 2004.

On the other hand, congress' Office of Management and Budget is estimating expenditures to be 3.8 trillion this year and reaching 4.47 trillion in 2016. There is no way that deficits of these levels can possibly be addressed through higher taxes. By comparison, the total net worth of every billionaire in this country is estimated at 1.3 trillion. You could confiscate every penny of every one of those households and not even cover the deficit of one year.

The following table displays the current sources of tax revenues.

To put these numbers in the proper context, to close the budget gap, individual taxes would have to double, corporate taxes would have to quadruple, payroll taxes would have to more than double, or some combination of the three. Anyone who thinks this is possible or reasonable is simply out of touch with reality.

Tax policy has real economic consequences. It's unreasonable to expect that tax revenues will increase by simply raising tax rates. To be clear - tax rates are not the same thing as tax revenues. The more tax rates go up, the more those subject to taxes shift their resources from productive activities to areas designed to shelter their income. The reverse is true when high tax rates decline.

There is plenty of historical evidence of this reality. The best example of this was when top tax rates were slashed in the nineteen-eighties. Billions of dollars were freed up and directed towards productive activities when the top marginal rates were slashed. So much so that this country was pulled out of one of the worst economic situations ever faced.

When the wealthy shelter their income, they don't invest in things that create jobs. They also don't repatriate overseas earnings. Our comparatively high corporate tax rates are currently keeping billions of dollars in other countries. Simply raising tax rates is counterproductive.

What to Do

In our opinion there is only one way to tackle the deficit. The government simply needs to spend less. The deficits have become so large that these spending cuts are going to have to focus on the largest programs and agencies. This means pushing back the retirement age for social security, wrapping up military operations and getting healthcare costs under control.

We've written extensively about our thoughts on Social Security over the years so we won't rehash that now other than to say that the government needs to get out of the pension business. The wars will eventually draw to an end.

Healthcare is a trickier issue. What we don't think is that pushing millions of people on to Medicaid is going to do anything but bankrupt the states and lead to yet more bailouts. We've also written about healthcare reform so we won't get into that again.

The bottom line is that the biggest programs will have to be radically changed which will take political will. Beyond that, general spending needs to come down and only grow at the same rate as the rest of the country (CPI). It's inexcusable to see the percentage growth numbers in every category from 2000 to now. Keep in mind this was during some of the lowest inflation years in our country's history.

It appears that the market will ultimately force change. Yesterday S&P downgraded the rating on U.S debt. This was an unimaginable occurrence in our lifetime.