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VOL. 9, NO. 3 • MARCH 2014­­

DALLASFED

Economic
Letter
U.S. Budget Deficits Shrink,
but Long-Run Issues Remain
by Jason Saving

Compared with a
$63.2 billion increase
in discretionary
domestic spending,
the overall budget bill
is estimated to reduce
the deficit by $22.6
billion over the next
10 years—though this
does not mean deficits
would fall in each year
of the deal.

A

threatened January federal government shutdown was averted
when congressional negotiators late last year reached
agreement on a two-year budget. The
bipartisan accord partially undid forced
cuts under “sequestration,”1 replacing
them with an array of smaller spending reductions while adding “revenue
enhancements.” The deal is designed to
save slightly more money, in a targeted
manner, than would have occurred with
sequestration over the next 10 years.
The budget is only the second one
to have been passed in the last five years
and represents to some the resumption of
“normal order”—and a possible end to a
polarized environment that produced fiscal gridlock and runaway deficits.
These events come on the heels of a
less-well-reported but perhaps more significant announcement that the federal
deficit fell in 2013 to its lowest level in five
years, with still-smaller shortfalls expected
in 2014 and 2015. Could it be that the
nation’s fiscal house has been put substantially in order, with the country placed on a
permanently better fiscal trajectory? Or are
recent improvements simply a prelude to
future budgetary storms?

The Budget Deal
To understand the short-run context,
one must begin with a brief overview of the

recent budget deal passed by Congress and
signed by the president. The budget deal
will raise discretionary domestic spending in 2014 and 2015 by a cumulative $47
billion. It will also boost spending over the
ensuing eight years by a total of $15 billion. These increases will be split evenly
between defense and nondefense spending and not—for the most part—dedicated
to any specific program.
The front-loaded $63.2 billion in higher
discretionary spending is offset by $85 billion of cuts, new fees, increased fees and
other measures. The main deficit-closing
measures involve an extension of sequestration, left in place into fiscal 2022 and
2023, and the introduction of new customs
user fees during those years. Together,
these measures would reduce expected
budget deficits by $34.8 billion. The deal
would also raise $12.6 billion through higher aviation security fees, $12.2 billion in net
payment reductions to military and civilian
government retirees, $7.9 billion through
Pension Benefit Guaranty Corp. premium
increases (partly on a per-institution basis
and partly based on risk), $3.2 billion in
reduced replenishment of the Strategic
Petroleum Reserve and $1.9 billion in the
“prevention of waste, fraud and abuse” in
the nation’s welfare system.2
Compared with a $63.2 billion increase
in discretionary domestic spending, the
overall budget bill is estimated to reduce

Economic Letter

A reasonable case
could be made that
the slow recovery was
more closely akin to

Short-Term Outlook

a recession than an
expansion—abovezero gross domestic
product (GDP) growth
notwithstanding.

$1.1 trillion in fiscal 2012 (Chart 2). Even
expressed as a share of the economy, the
total federal debt accumulated during that
four-year period was the greatest since
World War II.
To be sure, economic research generally finds that countries should run deficits
when in recession—or when emerging
from them. Along with the collapse of
financial-lending channels during the
Great Recession and inexplicable labormarket sluggishness, a reasonable case
could be made that the slow recovery was
more closely akin to a recession than an
expansion—above-zero gross domestic
product (GDP) growth notwithstanding.
Nevertheless, the corollary that large deficits should not be incurred during expansions for fear of their eventual economic
consequences began taking hold. It was in
this context that the 2013 deficit came in at
$680 billion, about half the average of the
previous four years.
What caused the 2013 deficit to narrow? One answer is normal cyclical
improvement in economic activity. As the
economy slowly recovered, more individuals found jobs and firms experienced
stronger demand for the goods and services they produce, driving up federal tax revenue. For similar reasons, demands on the
federal safety net—jobless benefits, food
stamps—diminished, driving down federal
spending. Policy adjustments also contributed to the change, including the partial

the deficit by $22.6 billion over the next 10
years—though this does not mean deficits
would fall in each year of the deal. On
a year-by-year basis, the spending plan
increases the deficit by $23.3 billion in fiscal 2014, by $18.2 billion in fiscal 2015 and
by $4.2 billion in fiscal 2016 (Chart 1). The
remaining seven years contain average
annual deficit reductions of $8.2 billion,
provided a future Congress does not undo
the agreement.

Unfortunately, the budget deal does
not solve the nation’s budget problem. To
get a handle on the nation’s short-term fiscal situation, it is useful to review a bit of
budget history.
Just six years ago, the 2008 deficit
totaled $458.6 billion. While it was the
highest ever in dollar terms, as a share of
the economy it was only about 1 percentage point above the post-Vietnam average of 2.2 percent (and far below deficits
amassed in the 1980s). The best available
forecasts called for the dollar amount of
the deficit to fall with each passing year,
entering surplus by 2012 and remaining
there as far as the eye could see.
One year later, the picture changed
dramatically: The 2009 deficit rose by $1
trillion to $1.4 trillion, a record peacetime
deficit. It remained above $1 trillion for
each of the next three years: $1.3 trillion in
fiscal 2010, $1.3 trillion in fiscal 2011 and

Chart

1

Anticipated Impact of Budget Deal on Federal Deficit

Billions of dollars
30
23.3
18.2

20
10

4.2
0
–1.8

–3.2

–10

–4.8

–5.5

–5.6

–20
–30

–20.4
–26.8
2014

2015

2016

2017

2018

2019

2020

SOURCE: Congressional Budget Office.

2

Economic Letter • Federal Reserve Bank of Dallas • March 2014

2021

2022

2023

–22.6
Total

Economic
Economic Letter
Letter
expiration of the 2001/2003 “Bush tax cuts,”
expiration of a 2 percent Social Security
payroll tax reduction and, to a lesser
degree, the across-the-board spending cuts
from sequestration. One other important
factor was a yet-to-be-explained slowdown
in medical cost growth, which helped hold
Medicare and Medicaid spending in check.
Taken together, these factors should
boost federal revenue and reduce
expenditures, at least as a share of the
economy—and that is exactly what the
data show (Chart 3). From a 60-year low of
15.1 percent of GDP in fiscal 2009, federal
revenues grew to 16.7 percent in fiscal 2013
and are expected to reach 18 percent—the
nation’s long-term historical average—in
2014. Similarly, federal outlays have fallen
from a peacetime high of 25.2 percent of
GDP in 2009 to 22.7 percent in 2013 and
are expected to fall further, to 22 percent
in 2014.

The Longer-Term Picture
Over the next 10 years, annual deficits
might be expected to gradually decline
as the recession’s aftereffects increasingly
enter the rearview mirror and the “targeted, timely and temporary” short-term
stimulus measures intended to combat
the recession fade to insignificance.3 This
expectation would certainly be consistent
with both 2013’s marked reduced deficit
and expected declines in 2014 and 2015.
Further, support for this view would be
provided by the pickup in revenue from
60-year lows and measures—such as the
recent two-year budget agreement—that,
at least ostensibly, reduce annual deficits.
However, this outlook turns out not
to be the case. After bottoming out at 2
percent of GDP during 2015–18, annual
deficits are projected to rise with each succeeding year, reaching nearly 3.5 percent
of GDP by 2023. The primary reasons: the
retirement of baby boomers, which raises
entitlement outlays (Social Security and
Medicare), and an expectation that interest
rates will rise sharply over the next decade,
dramatically increasing U.S. borrowing
costs.
What about further down the road?
Under a “current law” scenario (under
which Congress makes no adjustments to
the existing policy environment), deficits
would grow inexorably over time, rising to
6.4 percent in 2038, reaching 14.2 percent

Chart

2

Budget Deficits Exceed Forecast Levels

Surplus or deficit/GDP
4

January
2008
forecast

2
0
–2
–4
–6

Actual

–8
–10
–12
1950 1955

1960

1965 1970 1975

1980 1985

1990 1995

2000 2005 2010

SOURCES: Office of Management and Budget; Congressional Budget Office.

Chart

3

Revenues Near 60-Year Low; Outlays Near 60-Year High

Percent of GDP
26
24
Outlays
22
Expected
level

20
18
Revenues

16
14
12
1950

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2014

SOURCE: Office of Management and Budget.

of GDP by 2088 (Chart 4). Entitlement
spending would grow at roughly the same
pace over that period, driven mainly by
the interplay of an aging population with
ever-more-expensive medical technology.
This is no coincidence, because it is precisely this growth in entitlement programs
(and to a lesser extent a sizable increase in
interest payments) that causes long-term
deficits to soar.
The accumulation of historically high
federal fiscal deficits over a prolonged
period is significant for at least three reasons. First and perhaps most obviously,
large and growing deficits directly increase

the interest payments required to service
them, requiring sacrifices (or higher taxes)
elsewhere. Second, an abundance of economic research illustrates that increased
borrowing eventually “crowds out” competing demands for capital from private
investment, relegating the economy to a
lower growth path. Future generations will
face a lower standard of living than they
would otherwise experience. Finally, carrying a higher stock of debt makes it more
difficult for government to respond appropriately when the next recession occurs.
Indeed, this was precisely the situation
faced by the U.S. after running historically

Economic Letter • Federal Reserve Bank of Dallas • March 2014

3

Economic Letter

Chart

4

Long-Term Fiscal Imbalances Remain Unaddressed

Saving is senior research economist and
advisor in the Research Department at the
Federal Reserve Bank of Dallas.

Deficit/GDP
0

–5

whose standard of living will sink lower as
a result.

Extended baseline (current law)

–10

–15

–20

–25
2013 2018 2023 2028 2033 2038 2043 2048 2053 2058 2063 2068 2073 2078 2083 2088

Notes
This is a package of across-the-board spending cuts
intended to trim spending by $1.1 trillion over the next 10
years.
2
Smaller tax and spending provisions account for the
remaining $12.4 billion.
3
See “Fiscal Stimulus Issues,” testimony before the U.S.
Congress Joint Economic Committee by Lawrence H. Summers, former U.S. Treasury Secretary, Jan. 16, 2008.
1

SOURCE: Congressional Budget Office.

unprecedented peacetime deficits during
2001–08.
Addressing this issue requires acknowledging two unpleasant fiscal realities. The
first is that, while the explosion in shortrun deficits over the last few years was
driven mainly by temporary phenomena,
including poor economic conditions and a
deliberate choice to “stimulate” the economy, the long-run situation is caused primarily by a structural imbalance between
what entitlement recipients have been
promised and the agreed-upon revenues
to pay for those promises. The second is
that such an imbalance cannot be corrected without cutting spending (including
entitlements) or raising taxes.
An often-voiced principle in resolving
this dilemma is that government should
keep its promises; this principle may be

DALLASFED

more difficult to apply than is initially
apparent. A decision to spend less means
asking entitlement recipients, many of
them elderly and on a fixed income, to
accept lower benefit checks than they
expected. This may well reduce their standard of living, perhaps to unacceptable
levels. But taxing more, on the other hand,
requires asking working-age citizens to
accept a lower after-tax income than they
had expected, which reduces the standard
of living of both themselves and their
dependents.
Deciding who should bear the burden
of this fiscal adjustment is difficult, but this
does not change the inescapable reality
that the burden exists and must be borne
by someone. And should that “someone”
not be found in the current generation, the
burden will be borne by future generations,

Economic Letter

is published by the Federal Reserve Bank of Dallas. The
views expressed are those of the authors and should not
be attributed to the Federal Reserve Bank of Dallas or the
Federal Reserve System.
Articles may be reprinted on the condition that the
source is credited and a copy is provided to the Research
Department of the Federal Reserve Bank of Dallas.
Economic Letter is available on the Dallas Fed website,
www.dallasfed.org.

Federal Reserve Bank of Dallas
2200 N. Pearl St., Dallas, TX 75201

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