Federal Budget Deficit Explained

The federal budget deficit has been one of the most contentious political issues of the last few years and figures to be one of the most important issues in terms of its influence on the 2012 elections. The current national debt is somewhere around $15 trillion dollars, a figure that will grow at around $1-2 trillion dollars a year if government spending and tax revenues remain at current levels. In 2011, the rating agency Standard and Poor's downgraded U.S. government debt from its highest AAA rating to AA+, and many politicians and economists have of more dire consequences if the deficit remains and the national debt continues to grow. However, many other politicians and economists have also argued that federal debt levels are nowhere near dangerous level, and that, if anything, the government should increase spending in the short-term in order to avoid another recession. This hub will attempt to cut through the political junk in order to take an unbiased look at government spending in order to explain the causes, effects, and possible solutions to our federal budget deficit and rapidly increasing national debt levels.

There are two main forces driving the federal deficit:

Government Spending: The dollars the government spends on programs. This includes things like the salaries of soldiers in the armed forces, grants to the states to fund public schools, road building and infrastructure projects, medicare for seniors, and many others.

Government Revenue: The amount of money the government takes in. Revenue comes primarily from taxes, however, other revenue streams such as customs duties, the sale of resource rights and leases (such as oil drilling rights on government owned lands), and the sale of government property also help bring in revenue.

Therefore, to reduce the national debt, the federal government must either reduce the amount of money it spends (through cutting programs or reducing costs) or increase the amount of money it takes in (through increased taxes or other revenue streams).

So, if the two factors impacting debt are spending and revenue, it seems that easiest solution would be to either

A. Cut government spending to match government revenue

B. Raise taxes to match projected government spending

C. Some combination of the two to meet in the middle and balance the budget.

Unfortunately, these seemingly solutions are not entirely independent of one another. Tax revenues are highly dependent on the economy: if its going well, people are employed, companies are making money, and the government is receiving increased tax revenues (as we saw during the 1990s, when the government consistently ran budget surpluses). However, when the economy is going poorly, tax revenues will go down even if tax rates remain the same.

This extra layer of complication is hugely important in our current economy, with high unemployment and many Americans relying on the government for support through unemployment insurance and other assistance programs. Many economists believe that increased government spending has helped lessen the effects of the economic downturn, and that cutting government spending, while it will reduce that side of the debt equation, will also depress tax revenues further (the unemployed still spend money at supermarkets, which in turn are taxed by the government). So, while cutting government spending might reduce that side of the deficit equation, it will also decrease the amount of tax revenues the government takes in.

Okay, you might ask, so if we can't cut government spending without reducing revenue, why not raise revenue through increased tax rates? If we're currently taxing most Americans at 25% (in a hypothetical example), why not raise it to whatever % is needed to cover the deficit?

Similarly to government spending, government revenues are sensitive to tax rates: if employees and companies are going to be taxed at higher levels, they might be less willing to work hard in order to make money (since more dollars are going to the government). Again, economists disagree on the effect this has, since the magnitude of the effect changes depending on the rate being taxed (going from 25% to 26% might not change your habits much, but being taxed at 80% when you are used to being taxed at 30% would probably make you much less likely to put in overtime to earn extra income).

The solution that President Obama has adopted for most of his first term is one of slightly increased government spending (through the American Recovery and Reinvestment Act and increased spending on unemployment insurance) along with continued low tax rates, as the Bush tax cuts have remained in effect. For those economists who believe that increased taxes hurt growth, this is a good thing, as that extra money will hopefully be spent, stimulating the economy and increasing government revenues down the road. In effect, the government is increasing the deficit in the short-term with the hope of decreasing the deficit down the road through increased economic growth (which in turn will lead to increased tax revenues even if tax rates remain the same).

The jury is still out on whether or not this short-term approach will work over the next few years: if it does help economic recovery, than it should help increase government revenues in the next 3-10 years, even if tax and spending rates remain the same. However, almost all forecasters predict that, in the long-term, the federal government will have to make fundamental changes to its spending and tax dollars if it is to remain solvent, as future spending and tax revenues are going to be impacted greatly by the effects of an aging population on health care and social security. Almost all economists agree that some long-term adjustments are necessary in order to solve our budget deficit problem, and the solutions are not as simple as many politicians would like us to think.

The government currently spends around 74% of its revenue on three things: defense, social security, and Medicare, 8% is devoted to interest payments, and 18% is devoted to all other programs. That includes everything from scientific and medical research to education to environmental protection to building roads, bridges, and subways. While defense spending should be reduced with the end of the war in Iraq (and potentially the end of the war in Afghanistan in the next few years), social security and health care spending could skyrocket as many baby boomers retire, making them eligible to receive social security benefits and receive health coverage through Medicare. This means that any realistic attempt to balance the budget:

A. Dramatically cut defense spending, Medicare Spending, or reduce Social Security Benefits.

B. Increase taxes to raise revenue to pay for the increased costs of these entitlements

There is no other way to balance the budget. Anyone who tells you that it is possible to solve the budget gap through "eliminating pork projects" is speaking nonsense: earmarks account for less than 1% of the current federal deficit. A serious attempt to reduce the deficit will have to either increase taxes or dramatically reduce health care costs.

So how do we get to this point? See for yourself! The New York Times has put together a great tool that allows anyone to "fix the budget" themselves through a simple online tool. This allows you to cut programs, increase taxes, or close tax loopholes in order to see the programs that really impact the budget deficit. This shows you the real impact of various proposed tax increases and spending cuts on the projected budget deficits in 2015 and 2030. I was surprised to see that many of the programs which receive the most talk on the political news shows (such as congressional earmarks) have a negligible impact on the budget, where as small changes such as raising the age one can receive social security benefits can add up to hundreds of billions of dollars over the course of 20 years.