17.3 Federal Deficits and the National Debt - Principles of Macroeconomics 3e

Learning Objectives

By the end of this section, you will be able to:

Explain the U.S. federal budget in terms of annual debt and accumulated debt
Understand how economic growth or decline can influence a budget surplus or budget deficit

Having discussed the revenue (taxes) and expense (spending) side of the budget, we now turn to the annual budget deficit or surplus, which is the difference between the tax revenue collected and spending over a fiscal year, which starts October 1 and ends September 30 of the next year.

Figure 17.7 shows the pattern of annual federal budget deficits and surpluses, back to 1930, as a share of GDP. When the line is above the horizontal axis, the budget is in surplus. When the line is below the horizontal axis, a budget deficit occurred. Clearly, the biggest deficits as a share of GDP during this time were incurred to finance World War II. Deficits were also large during the 1930s, the 1980s, the early 1990s, 2007–2009 (the Great Recession), and 2020 (the pandemic-induced recession).

This graph illustrates the federal deficit as a percentage of GDP and how it changes over time. The y-axis measures the federal deficit as a percentage of GDP, from –35 percent to 10 percent, in increments of 5 percent. A negative percentage means the government is running a budget deficit. The x-axis measures years, from 1930 to 2020. In 1930 there was a small budget surplus of around 0.5 percent of GDP. Then in the 1930s there is a budget deficit of –5 percent of GDP, which grows to 27 percent of GDP by the mid-1940s. By the late 1940s there is a budget surplus of 4 percent of GDP, and this steadily decreases into a deficit of 5 percent of GDP by the mid-1980s. The deficit slowly decreases and becomes a surplus of around 1 percent of GDP in 2000, then quickly becomes a budget deficit of around 2 percent in 2001, increasing to a budget deficit of 10 percent of GDP in 2009, decreasing to a budget deficit of 2 percent of GDP in 2015, then increasing again to a budget deficit of nearly 15 percent of GDP in 2020.

Figure 17.7 Pattern of Federal Budget Deficits and Surpluses, 1929–2020 The federal government has run budget deficits for decades. The budget was briefly in surplus in the late 1990s, before heading into deficit again in the first decade of the 2000s—and especially deep deficits in the 2007-2009 and 2020 recessions. (Source: Federal Reserve Bank of St. Louis (FRED). http://research.stlouisfed.org/fred2/series/FYFSGDA188S)

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Federal Surplus or Deficit as a Percentage of Gross Domestic Product

Debt/GDP Ratio

Another useful way to view the budget deficit is through the prism of accumulated debt rather than annual deficits. The national debt refers to the total amount that the government has borrowed over time. In contrast, the budget deficit refers to how much the government has borrowed in one particular year. Figure 17.8 shows the ratio of debt/GDP since 1966. Until the 1970s, the debt/GDP ratio revealed a fairly clear pattern of federal borrowing. The government ran up large deficits and raised the debt/GDP ratio in World War II, but from the 1950s to the 1970s the government ran either surpluses or relatively small deficits, and so the debt/GDP ratio drifted down. Large deficits in the 1980s and early 1990s caused the ratio to rise sharply. When budget surpluses arrived from 1998 to 2001, the debt/GDP ratio declined substantially. The budget deficits starting in 2002 then tugged the debt/GDP ratio higher—with a big jump when the recession took hold in 2008–2009. There was another leap in the ratio in 2020.

This graph illustrates the federal debt as a percentage of GDP over time. The y-axis measures the federal debt as a percentage of GDP, from 0 to 140 percent, in increments of 10 percent. The x-axis shows years, from 1970 to 2020. The line begins in 1970 at around 38 percent of GDP, decreases slightly to around 30 percent of GDP in 1980, the increases to 60 percent of GDP in the early 1990s, decreases to around 50 percent of GDP in 2000, then increases to 100 percent of GDP around 2012, is roughly flat for a few years, then increases to over 120 percent of GDP in 2020.

Figure 17.8 Federal Debt as a Percentage of GDP, 1942–2014 Federal debt is the sum of annual budget deficits and surpluses. Annual deficits do not always mean that the debt/GDP ratio is rising. During the 1960s and 1970s, the government often ran small deficits, but since the debt was growing more slowly than the economy, the debt/GDP ratio was declining over this time. In the 2008–2009 recession, the debt/GDP ratio rose sharply, before leveling off through the later 2010s. In 2020, it rose sharply again. (Source: https://fred.stlouisfed.org/series/GFDEGDQ188S)

The next Clear it Up feature discusses how the government handles the national debt.

Clear It Up

What is the national debt?

One year’s federal budget deficit causes the federal government to sell Treasury bonds to make up the difference between spending programs and tax revenues. The dollar value of all the outstanding Treasury bonds on which the federal government owes money is equal to the national debt.

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Gross Federal Debt as a Percentage of Gross Domestic Product

The Path from Deficits to Surpluses to Deficits

Why did the budget deficits suddenly turn to surpluses from 1998 to 2001 and why did the surpluses return to deficits in 2002? Why did the deficit become so large in 2020? Figure 17.9 suggests some answers. The graph combines the earlier information on total federal spending and taxes in a single graph, but focuses on the federal budget since 1990.

This graph illustrates two lines: total government spending as a percentage of GDP over time and government tax receipts as a percentage of GDP over time. The y-axis measures total government spending and taxes over time as a percentage of GDP, from 10 to 32 percent, in increments of 2 percent. The x-axis measures years, from 1990 to 2020. The total spending line is almost always above the tax receipts line, except in the late 1990s to around 2001. In 1990 total government spending as a percentage of GDP is around 21 percent, and it decreases to around 18 percent in 2001. It increases to around 20 percent in 2008, then spikes to 24 percent in 2009. It then decreases to 20 percent in 2014, is roughly flat until 2019, then spikes in 2020 to 32 percent of GDP. Tax receipts as a percentage of GDP begins at around 18 percent in 1990, increases to 20 percent in 2000, then declines to 16 percent in 2004, and moves up and down between 16 and 18 percent to 2020.

Figure 17.9 Total Government Spending and Taxes as a Share of GDP, 1990–2014 When government spending exceeds taxes, the gap is the budget deficit. When taxes exceed spending, the gap is a budget surplus. The recessionary period starting in late 2007 saw higher spending and lower taxes, combining to create a large deficit in 2009. The same thing happened in a more extreme way in 2020. (Source: Economic Report of the President, Tables B-46, https://www.govinfo.gov/app/collection/erp/2021)

Government spending as a share of GDP declined steadily through the 1990s. The biggest single reason was that defense spending declined from 5.2% of GDP in 1990 to 3.0% in 2000, but interest payments by the federal government also fell by about 1.0% of GDP. However, federal tax collections increased substantially in the later 1990s, jumping from 18.1% of GDP in 1994 to 20.8% in 2000. Powerful economic growth in the late 1990s fueled the boom in taxes. Personal income taxes rise as income goes up; payroll taxes rise as jobs and payrolls go up; corporate income taxes rise as profits go up. At the same time, government spending on transfer payments such as unemployment benefits, foods stamps, and welfare declined with more people working.

This sharp increase in tax revenues and decrease in expenditures on transfer payments was largely unexpected even by experienced budget analysts, and so budget surpluses came as a surprise. However, in the early 2000s, many of these factors started running in reverse. Tax revenues sagged, due largely to the recession that started in March 2001, which reduced revenues. Congress enacted a series of tax cuts and President George W. Bush signed them into law, starting in 2001. In addition, government spending swelled due to increases in defense, healthcare, education, Social Security, and support programs for those who were hurt by the recession and the slow growth that followed. Deficits returned. When the severe recession hit in late 2007, spending climbed and tax collections fell to historically unusual levels, resulting in enormous deficits.

Longer-term U.S. budget forecasts, a decade or more into the future, predict enormous deficits. The higher deficits during the 2007–2009 Great Recession and the 2020 pandemic-induced recession have repercussions, and the demographics will be challenging. The primary reason is the “baby boom”—the exceptionally high birthrates that began in 1946, right after World War II, and lasted for about two decades. Starting in 2010, the front edge of the baby boom generation reached age 65, and in the next two decades, the proportion of Americans over the age of 65 will increase substantially. During the 2020 recession, we saw another wave of early retirements, and we are now in the middle of this major demographic shift. The current level of the payroll taxes that support Social Security and Medicare will fall well short of the projected expenses of these programs, as the following Clear It Up feature shows; thus, the forecast is for increasingly large budget deficits. A decision to collect more revenue to support these programs or to decrease benefit levels would alter this long-term forecast.

Clear It Up

What is the long-term budget outlook for Social Security and Medicare?

In 1946, just one American in 13 was over age 65. By 2000, it was one in eight. By 2030, one American in five will be over age 65. Two enormous U.S. federal programs focus on the elderly—Social Security and Medicare. The growing numbers of elderly Americans will increase spending on these programs, as well as on Medicaid. The current payroll tax levied on workers, which supports all of Social Security and the hospitalization insurance part of Medicare, will not be enough to cover the expected costs, so what are the options?

Long-term projections from the Congressional Budget Office in 2021 are that Medicare and Social Security spending combined will rise from 8.7% of GDP in 2021 to about 10.8% by 2027–2031. If this rise in spending occurs, without any corresponding rise in tax collections, then some mix of changes must occur: (1) taxes will need to increase dramatically; (2) other spending will need to be cut dramatically; (3) the retirement age and/or age receiving Medicare benefits will need to increase, or (4) the federal government will need to run extremely large budget deficits.

Some proposals suggest removing the cap on wages subject to the payroll tax, so that those with very high incomes would have to pay the tax on the entire amount of their wages. Other proposals suggest moving Social Security and Medicare from systems in which workers pay for retirees toward programs that set up accounts where workers save funds over their lifetimes and then draw out after retirement to pay for healthcare.

The United States is not alone in this problem. Providing the promised level of retirement and health benefits to a growing proportion of elderly with a falling proportion of workers is an even more severe problem in many European nations and in Japan. How to pay promised levels of benefits to the elderly will be a difficult public policy decision.

In the next module we shift to the use of fiscal policy to counteract business cycle fluctuations. In addition, we will explore proposals requiring a balanced budget—that is, for government spending and taxes to be equal each year. The Impacts of Government Borrowing will also cover how fiscal policy and government borrowing will affect national saving—and thus affect economic growth and trade imbalances.