Friday, July 12, 2013

The Federal Budget - A Double-Edged Problem

A recent study of the Federal Budget for the years 2014 and beyond prepared by Mindy R. Levit for Congress examines both the spending and revenue projections for the future.  Here is a summary starting with spending and closing with revenue.

Over the past 40 years, on average, federal spending has averaged 21 percent of GDP while revenues have averaged only 18 percent of GDP, resulting in a string of deficits since the early years of the new millennium.  Here is a graph showing how, since 1970, outlays (in green) have outstripped revenues (in blue) for most of the past 40 years:

By fiscal 2012, outlays were 22.9 percent of GDP, down from their peak of 25.2 percent of GDP in fiscal 2009.  Projections suggest that outlays will be 22.9 percent of GDP in fiscal 2023, still well above the annual average of 21 percent over the past four decades.

Let's start by looking at the spending side of the ledger.  Here is a breakdown of where Washington spends by type:

In fiscal 2012, mandatory spending (in dark blue) comprised 57.4 percent, discretionary spending comprised 36.3 percent and net interest payments comprised 6.3 percent of all spending.  Social Security, Medicare and Medicaid constituted a whopping 44.4 percent of all federal spending in fiscal 2012, a fact that should not go unnoticed as we enter the perfect demographic storm.

In fiscal 2012, discretionary spending (spending that is controlled by annual congressional appropriations acts for example defense) shown in olive green totalled 8.3 percent of GDP.  Since fiscal 2000, discretionary spending as a percentage of GDP has risen by 6.3 percent annually in nominal terms, well above the rate of inflation. What's to blame?  Increased spending on homeland security and funding of the American Recovery and Reinvestment Act of 2009.  On average, over the same time period, defense discretionary outlays rose by 7.1 percent in nominal terms.  You'll notice on the bar graph that discretionary spending is expected to drop to 5.5 percent of GDP by 2023.  This will be its lowest level ever, a scenario that while necessary, is quite unlikely to occur for many reasons including:

1.) The odds of another recession requiring a bailout (notice how discretionary spending rose in 2008 to 2010).

2.) The aging infrastructure across America that will require hundreds of billions (and perhaps trillions) of dollars worth of upgrading and replacement.

In fiscal 2012, mandatory spending (spending on income security programs etcetera) shown in dark blue totalled 13.1 percent of GDP, up from 9.7 percent in fiscal 2000.  These expenditures are expected to grow over the next decade and will reach 14.1 percent of GDP in fiscal 2023, its second highest level since fiscal 2000.  It's the growing use of entitlement programs like Medicare, Medicaid and Social Security that are creating the problem.

Now, let's look at the revenue side of the ledger.  In fiscal 2012, federal revenues totalled 15.8 percent of GDP, nearly the lowest level since fiscal 1950 and down substantially from 20.6 percent in fiscal 2000!  Revenue collection has been depressed (and depressing for the IRS) as a result of the economic downturn and various tax relief measures.

Here is a breakdown of where Washington gets its revenue:

As we all know, Washington's largest source of revenue is individual income taxes (as shown in dark blue) which hit 7.3 percent of GDP in fiscal 2012.  Notice the relatively tiny olive green wedge showing corporate tax revenue?  Despite the fact that Corporate America constantly whines about the high level of corporate taxes in America, their share of the revenue pie has actually dropped substantially since the mid-2000s and while it is expected to grow slightly over the short-term, between 2016 and 2023, it is expected to decline again (even without the projection of a recession).  In fiscal 2012, corporate taxes in total equalled only 1.6 percent of GDP, less than one-quarter of the revenue taken in from individuals.

Now, let's put the two sides of the ledger together and see where that leaves us.  There is no doubt that spending is going to be a problem in the future, particularly on entitlements.  The combination of rising health care costs and an aging population will act in concert to keep federal health expenditures rising faster than GDP.  It is projected that federal health spending will rise from 5.4 percent of GDP in fiscal 2012 to 10 percent of GDP in 2035 and 18 percent of GDP in 2085.  Keeping in mind that total federal revenues are generally less than 20 percent of GDP, one can quickly see that a problem is looming unless changes are made soon.

On top of that, there is the issue of interest on the public debt.  In fiscal 2012, Washington spent $233 billion or 1.4 percent of GDP on net interest payments.  The only thing saving Washington from even worse numbers is the long period of artificially low interest rates that have allowed Congress and the President to accumulate massive amounts of debt without "paying the piper".  The Congressional Budget Office has looked at the future and it is not a particularly happy scenario.  By fiscal 2023, interest payments on the debt are expected to reach $857 billion or 3.3 percent of GDP.  In combination with the expenditures on entitlements, these two line items will consume all tax revenue.

While a series of crises have kept the prying eyes of the media distracted from Washington's budget problems, this report shows us that nothing has changed and that the next phase of the federal budget crisis is just around the corner. 

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