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The "Unsustainable" Path of Federal Fiscal Policy Part III: An Analysis of Federal Deficits and Debt in the Long-Run

In part three of our four part series we explore the long-run trends in federal debt and the annual budget deficits that lead to the accumulation of federal debt through the Congressional Budget Office's (CBO) current forecast horizon of 2088. We begin with a brief history of federal deficits and the debt and explore the origins of the current budget deficit and the national debt. We then turn to CBO projections of federal deficits over the next several years and the projected debt as a share of GDP. Finally we explore the potential negative fiscal and economic effects, as described by CBO, of the rising federal debt.

A Look Back at Prior Budget Gaps

Over the past 40 years, federal outlays have outgrown federal revenues by an average of 2.77 percent of GDP. Determined by the difference between spending and revenues, this spread is commonly called the budget gap, which can be viewed in Figure 1. When spending outweighs revenues, the United States has a federal budget deficit, which results in the need to borrow money to pay its bills. In contrast, throughout the history of the country there have been rare moments of a budget surplus, where revenues outweighed spending.

As seen is Figure 1, in the late 1990s, under the Clinton administration, federal revenues actually exceeded federal spending. This created the first long-term budget surplus that the United States had seen since the 1950s. In April 2001, the federal budget was at a peak surplus of 2.61 percent of GDP. However, shortly thereafter, the September 11th attacks triggered the need for spending on the wars in Iraq and Afghanistan. In Figure 2 it is seen that wartime is one of the major predictors of an increase in the deficit as well as debt. While the gap seemed to be narrowing after the initial defense outlays toward the middle of the past decade, the United States was then hit with the Great Recession in December 2007 and the gap between spending and revenues grew to historically large levels. These large budget gaps resulted in increased federal borrowing at a pace faster than GDP growth. Total federal government debt can be divided into two broad categories, intergovernmental debt and debt held by the public. When discussing long-term debt dynamics, the CBO typically only refers to debt held by the public since intergovernmental debt is owed within federal government programs. Since the recession, federal debt held by the public has been continuously rising. The Congressional Budget Office projects that the debt held by the public as a share of GDP will continue to grow and reach levels that have not been seen since World War II. Therefore, the current pace of growth of the federal debt is impossible to sustain and leaves policy makers with some difficult choices.

The Anticipated Rise in Public Debt

Today, the story is very different compared to historical trends prior to 2002. The large size of the gap between spending and revenues over the past few years is expected to increase further in future years which would lead to higher and higher debt levels. The CBO estimates that the rate of growth in public debt will outpace the growth rate in GDP, in the words of the CBO, "a path that would ultimately be unsustainable."

CBO estimates that, under existing law, the gap between federal revenues and spending over the next several years will shrink as a share of GDP to 2.1 percent in 2015 before increasing to 14.2 percent by 2088 (Figure 3). As we discussed in our prior two reports, the growth in the budget gap takes place even with federal revenues rising above the long-run average of 17.4 percent while outlay growth also increases sharply above the long-run average of 21 percent. Under CBO's projections, debt held by the public would rise relative to GDP in 2014 and then decline to 68 percent of GDP by 2018 before rising faster than GDP starting in 2020. By 2038, the CBO estimates that the debt-to-GDP ratio will reach 100 percent of GDP and could go as high as 245 percent of GDP by 2088 even without accounting for the negative economic feedback effects which would push the debt level even higher (Figure 4).

While CBO's baseline projections do not account directly for the feedback effects of higher debtto- GDP ratios and higher marginal tax rates, it publishes a long-term scenario that accounts for these effects. It finds that the rapid growth in debt relative to the size of the economy along with an increase in marginal tax rates would "reduce output and raise interest rates relative to the benchmark economic projections." In addition, the negative economic feedback effects would lead to lower federal revenues and higher interest payments. Combined, these effects would result in a debt-to-GDP ratio of 108 percent of GDP in 2038, exceeding the highest year on record (1947) following World War II at 106 percent of GDP.

Economic Implications of Projected Debt Levels

So what are the potential effects on long-term economic growth of deficits and the growing debt burden? In its analysis, the CBO points to several economic costs related to large and growing debt. In its report, the CBO emphasizes that for combined federal spending and revenues to be sustainable over time, debt held by the public must not increase faster than the pace of economic growth. This statement lies at the core of the challenges facing policymakers today. The new reality is that GDP growth has been stuck in the 2.0-2.5 percent range since the end of the recession; however the pace of growth of federal debt has increased on average 5 percent over the same period of time.5 Furthermore, after examining the anticipated future path of federal spending and the subsequent growth in federal debt, it is clear that the federal debt will continue to outstrip the pace of GDP growth through 2088. The implication is that, according to CBO, at some point investors would begin to doubt the government's willingness and/or ability to pay its debt obligations. This issue has become particularly more concerning in recent years as political divisiveness has become more prominent as evidenced by the recent debt ceiling debate and the government shutdown.

Among the other concerns cited in the CBO Long-Term Budget Outlook are the rise in federal interest payments and the required large changes in tax and spending policy. In addition, the high debt levels could reduce the federal government's flexibility to respond to unexpected challenges and increases the risk of a fiscal crisis.

So what needs to be done to put federal fiscal policy on a sustainable path? While the CBO does not make specific policy recommendations, it does provide some sense of the magnitude of the policy changes that would need to take place to avoid increasing federal debt relative to the size of the economy. The fiscal gap in 2014 is estimated to be around 0.8 percent of GDP, thus some combination of federal spending cuts and/or revenue increases would need to be enacted totaling 0.8 percent of GDP or roughly $145 billion in the next fiscal year to keep the debt-to-GDP ratio stable 25 years from now. If policy makers wait until 2020, the budget gap widens to 3.1 percent of GDP which would roughly translate into $735 billion in budget cuts and/or tax increases that would be needed to stabilize the debt-to-GDP ratio.

As CBO points out, the longer policy makers wait to restore budget balance, the more difficult the challenge becomes. In our final paper in this series, we will turn to the economic implications of long-run trade-offs in federal fiscal policy and its implication for long-run economic growth.

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Wells Fargo Securities