Why We Have Federal Deficits

The federal deficit is a huge public policy problem that must be understood, confronted, and solved. Federal deficits run in these last five years dwarf any precedent in U.S. post-world-war history. The Congressional Budget Office (CBO)’s latest projections warn that without legislative corrections, deficits will rise to untenable levels with severe consequences for our economic well-being. There is widespread agreement among non-partisan analysts that the deficit problem is a serious one.

About the causes of deficits, however, there is much less agreement. This is partially because partisan advocates cannot resist the temptation to blame these deficits on leading figures from across the political aisle. There is practically a cottage industry of “analyses” purporting to show why a particular individual (often President Obama for conservatives, President George W. Bush for the left) is the one to blame for the deficit problem. These studies are usually meaningless because they exclude from view any policy decisions made before their targeted political figure entered office.

If we want to understand and solve the deficit problem, we need to go about our analysis in a better way. Today the Mercatus Center is releasing a comprehensive study I completed earlier this year that does just that. Instead of focusing on policy decisions made during an arbitrarily-assigned time frame, I analyzed the sources of deficits by dissecting the budget itself, identifying deficit-driving policy decisions regardless of when they were made. The study was a mammoth undertaking; it required the digestion of practically every CBO and Office of Management and Budget (OMB) budget report published over the past forty years.

The striking finding of this analysis is that more than three-quarters of our long-term fiscal problem derives from a set of policy decisions made over a period of just seven years, 1965 to 1972. 1965 saw the establishment of Medicare and Medicaid, advocated for and signed by President Lyndon B. Johnson. Both of these programs were later expanded in 1972 during the Nixon administration, as was Social Security. Thus one Democratic and later one Republican President each worked with a unified Democratic Congress to enact a fundamental worsening of our long-term budget outlook. Nothing done by any recent President or Congress carries long-term fiscal consequences as daunting as those arising from these 1965-72 decisions. Details follow.

Defining the Question: The study examined deficits from three different vantage points. The first was to analyze the specific policy decisions that led to current projections of untenable long-term deficits. The second was to analyze the policy decisions that led to the current 2013 deficit. The third analyzed which office holders ran the largest deficits in fiscal years during which they were responsible for federal budget policy.

Each of these perspectives is useful and none is inherently superior to the others. The first two perspectives track specific policy changes, assigning responsibility to those who enacted them. The third perspective evaluates general records of fiscal stewardship. This perspective is also important, to recognize that that later federal officials bear responsibility for correcting fiscally problematic practices regardless of when they were originally adopted, and that they often possess updated information that earlier officeholders lacked. 

When undertaking such an analysis, it quickly becomes apparent that misleading, trivial and/or often bizarre results will arise unless reasonable methodological solutions are found. For example, consider that lawmakers must enact appropriations legislation anew each year (unlike mandatory spending, appropriations do not carry over automatically from one year to the next) and are thus responsible for current appropriations levels. Now, consider also that appropriations spending moves separately from revenue measures; it is spending without a specific revenue source. Going about this the wrong way, one could easily stumble into a framework in which one finds that Congress is always adding immensely to the deficit unless it ceases all appropriations and shuts down the government altogether. Such a method would nearly always find that current officeholders caused the current deficit, even if they had actually cut appropriations relative to previous levels, and even if there were more than enough incoming tax revenue to finance all such appropriations. The results of such an analysis would be uninformative and potentially very misleading.

These problems can be avoided by employing the technique of norming relative to historical practices. I pulled these historical norms from data published by CBO on revenue collections and spending category totals stretching back over the 1973-2012 period. As I demonstrate in the longer study, these forty years are a very good time span for establishing representative norms of federal budget behavior.  These historical norms illuminate the policy changes that caused our current deficit problem.

Specifically, federal tax revenues have consistently averaged 17.9 percent of GDP over the historical period. Only rarely has this level varied by even two percentage points (on the low side during the recent recession, and on the high side during the dot-com bubble and Clinton-era tax rates). Similar averages are seen over even longer spans of time. Hypothetically, if today we spent less than 17.9 percent of GDP, we could fairly say that our current deficit problem was not being driven by recent spending growth. The long-term data enable us to determine whether our deficits arise because of spending exceeding sustainable historical norms, or are due to tax collections falling short, or both. 

And we can be even more specific than that. We can use historical budget data to determine how much spending we could have afforded in each budget category, if we kept a balanced budget and if our spending priorities remained as they were in recent decades. This enables us to determine which subsequent policy changes have caused deficits to emerge, whether they involve a specific diminution in tax revenues or an increase in a specific spending category. 

The Long-Term Deficit Problem: Our long-term deficit problem turns out to be pretty simple. It consists entirely of spending growth in Medicare, Medicaid, Social Security, and the new health insurance exchanges established in the 2010 Affordable Care Act. If it were not for spending growth in these four areas, we would not have a long-term budget problem. Tax revenues under current law will well exceed historical averages, and spending in all other areas will be far less, as a percentage of GDP.  Politicians spend a lot of time debating tax policy and appropriations levels, but neither has much to do with fixing the long-term fiscal outlook.

Interest costs also play a deficit-driving role under current projections, but these too would remain well within historical norms were it not for the growth in Medicare, Medicaid, Social Security and ACA exchange outlays. 

The total distribution of long-term deficit drivers is as in the accompanying pie graph. There is not space here to explain the derivation of these numbers, which can be found in the full study.

Let us review these contributors one by one:

1) Medicare. Medicare is the single biggest contributor to our long-term deficit problem. What many do not appreciate is that the vast majority of our currently projected Medicare costs derive from the program’s original enactment in 1965. There was a significant Medicare expansion in 1972, and its Part D prescription drug benefit was added in 2003. But the majority of Medicare legislation in recent decades has reined in projected cost growth rather than added to it. Thus, most of this component of the long-term problem is with us courtesy of President Johnson and the Congress of 1965.

2) Medicaid and the ACA Health Insurance Exchanges. CBO groups these together in its long-term spending projections. Around 30 percent of the projected excess spending growth in this combined category is due to the ACA, which dramatically expanded Medicaid and established new health insurance exchanges.  But again, most of the other costs derive from Medicaid’s original enactment in 1965. Medicaid also underwent an expansion in 1972, and a series of smaller-scale expansions from 1985 through 1990, but this category of spending growth is also predominantly a Johnson administration creation.

3) Social Security. If the pre-1972 Social Security benefit formula were still on the books, projected Social Security spending would be well within affordable historical norms. Legislation in 1972 during the Nixon administration increased benefits by 20 percent across the board, in addition to introducing annual COLAs and indexing the growth of benefits paid to new claimants. 

The Current-year Deficit: Responsibility for the current-year deficit is more diffuse than the long-term deficit. As with the long-term deficit, growth in Medicare, Medicaid and Social Security outlays is a big part of the problem. In addition, growth in income security programs as well as lower-than-typical tax revenue collections have played a role. Again, see the accompanying pie graph, the full derivation of which can be found in the full study. 

The reason that tax revenues were lower than historical norms this year was because of legislation enacted by the last outgoing Congress and signed by President Obama; without that law, tax collections would have exceeded historical averages. Some of the recent growth in income security spending is attributable to recent expansions of the earned income tax credit (EITC) and child tax credit, and extensions of unemployment insurance, all during the Obama administration. Another significant portion traces back to an expansion of the EITC enacted in 1993 under President Clinton. Notably, even with ongoing military operations abroad, all current appropriations spending (including defense) remains within levels affordable within a balanced budget assuming current interest rates; appropriated spending is simply not the main reason we have been running large deficits.

Summarizing the Policy Decisions: One of the interesting aspects of our current political dialogue is the cognitive disconnect between widespread recognition that our budget problems are rooted in the rising costs of Medicare, Medicaid and Social Security, while at the same time enormous political energies are expended arguing over the budget effects of less significant policy choices. The study assumes that 50 percent of the responsibility for fiscal policy decisions resides with the president, 25 percent with the House majority party, 20 percent with the Senate majority party, and 5 percent with the Senate minority party. Those assumptions lead to the following allocations of responsibility for our projected long-term fiscal imbalance, and for our current-year deficit, respectively. Due to rounding errors, the totals on the table do not add. 

A brief glance at this table clarifies why so much of our contemporary budget debate is simply misplaced. Political opponents of President Bush have devoted tremendous energies to debating, for example, the fiscal effects of the “Bush tax cuts,” the Afghanistan and Iraq wars, and the Medicare Part D prescription drug benefit. But in the grand scheme of our budget problems these issues are sideshows; Bush tax policies have since been replaced by others signed by President Obama, and in any case the long-term deficit problem exists despite projections of higher-than-typical tax collections. Even with the ongoing costs of war, all appropriations including defense make up a smaller share of the federal budget than they did when deficits were much smaller. And while the Medicare prescription drug benefit undoubtedly added to that program’s costs, presently it constitutes 11 percent of total Medicare spending. If it makes sense to be concerned about 11 percent of Medicare spending, it makes far more sense to be concerned with the other 89 percent.

Fiscal Stewardship Track Records: The third method of evaluating federal deficits is simply to measure the sizes of the deficits run during different fiscal years and allocating responsibility among those in office at the time. For obvious reasons, this method finds that deficit responsibility shares have been much higher on an annual basis during the Obama administration than during any other studied. 

As with all matters pertaining to the complex federal budget, much important information resides in the methodologies and assumptions underlying these various figures, which are provided in detail in the full study. 

But while the specific numbers are affected by the specific methodologies, the general picture is clear and transcends any subjective methodological choice: specifically, the fiscal problems now bedeviling policy makers are primarily those created during the seven-year span of 1965-72, when there was much less understanding of the magnitude of the spending commitments being taken on, as well as of the practical constraints binding what the federal government could responsibly promise. We will never get our deficit problem under control until we reduce our emphasis on budgetary side issues, and focus instead on scaling back our projected spending commitments for Medicare, Medicaid, Social Security and the ACA’s new health insurance exchanges. From a budgetary perspective, everything else is mere distraction.

Charles Blahous is a senior research fellow for the Mercatus Center, a research fellow for the Hoover Institution, a public trustee for Social Security and Medicare, and a contributor to e21.