America’s finances are in trouble. Despite relatively optimistic predictions by the Congressional Budget Office (CBO), the current deficit of $1.4 trillion is only going to get worse.
In July, CBO projected that the federal government budget deficit would be 3.7 percent of GDP in 2023, down from recent record highs of 12.4 percent of GDP in 2021. While still above the pre-pandemic average (since 2000) of 3.5 percent, this would be the lowest percentage since 2017.
President Biden has claimed credit for this reduction and used it to justify the lack of funding for his proposed student loan forgiveness program. Unfortunately, the current economic outlook belies this rosy scenario and the near future deficit picture is much darker.
My rough calculation (detailed below) is that the 2023 deficit will come in at 6.4 percent of GDP, or nearly 70 percent higher than the CBO projection. This would occur before we even feel the full force of the inevitable structural deficits arising from an unreformed Social Security program and the many increasingly expensive government health care programs for the elderly and low- and moderate-income households.
There are two reasons for this massive increase in the 2023 deficit projection. First, interest rates are already much higher than originally assumed and will likely rise further. Second, asset prices are much lower, which means fewer capital gains or even losses, and therefore lower personal income tax revenue to the government. In particular, if we assume, as Harvard economist Larry Summers has foretold, that Treasury security rates will be around 5 percent, my estimate is that the net interest payments by the federal government in 2023 will be $210 billion higher than CBO projected in July.
Even more significant, instead of personal income tax revenues coming in at a projected 9.8 percent of GDP in 2023 — compared to 10.6 percent in 2022 — when capital gain tax payments were at record highs on a nose-bleed stock market at the end of 2021 — a more prudent projection would be 8 percent. This is the level experienced in 2019, before the pandemic, and in 2014, when unemployment was 6 percent (a level that Larry Summers also anticipates) and asset markets were much less frothy. The federal government’s expected revenues will be reduced by about $480 billion at this more modest rate of personal income tax revenue with no other changes in other projected tax collections. So the deficit will increase in total by $690 billion.
Added to the $1 trillion already projected by the CBO for 2023, this means a deficit of 6.4 percent of GDP, even with no other unexpected increases in spending, (on unemployment insurance for example). This increase would bring forward deficit levels projected for 2034 by the CBO.
What has caused this rapid deterioration in the deficit outlook? An immediate cause, of course, is the change in Federal Reserve monetary policy; the raising of interest rates and tanking asset markets, in an attempt to get raging inflation under control.
Yet, consider also fiscal policy since the beginning of 2021: According to the calculations of the Committee for a Responsible Federal Budget, the Biden administration has approved $4.8 trillion of new borrowing from 2021 to 2031, either through legislation, partisan and bipartisan, or executive actions. The long list includes the massive American Rescue Plan in early 2021, veterans’ benefits, the food stamp increase, health program changes and student debt cancellation. This borrowed amount is net of new taxes and revenue collections and does not include the possibility that new programs scheduled to end in the next few years will be renewed. Nor does it include the cost of COVID pandemic-related relief programs which arguably should have been terminated by now. It should also be noted that the few legislation pieces passed with revenue enhancements, such as the infrastructure law or the “Inflation Reduction” Act, were front-loaded with spending and back-loaded with revenues, making the latter’s likely realization somewhat doubtful.
So, what is the consequence of nearly $5 trillion of new borrowing? At about 20 percent of GDP, I estimate, (based on a standard model) that such an increase in outstanding federal debt leads to a 90 basis points increase in interest rates or almost 1 percentage point. This is about half of the increase from the 3 percent level that CBO projected in July to the 5 percent that Larry Summers now foresees. So while Federal Reserve monetary policy may have kept interest rates too low for too long through 2021, it’s our fiscal policy — spending by the administration and Congress — which is the real cause for the deteriorating budget situation.
It is harmful to put the entire burden of correcting the inflationary bias of our economy on the Fed. Instead, we need to first cut the deficit quickly, especially through reductions in spending because the recent poorly-targeted spending increases have been the main cause of our deteriorating fiscal situation. Then, we need to work hard and soon on structural reforms to prevent future large and growing deficit increases.
Senior fellow Mark J. Warshawsky is the Searle Fellow at the American Enterprise Institute. He previously served as assistant secretary for economic policy at the U.S. Department of the Treasury and deputy commissioner for retirement and disability policy at the Social Security Administration.