Significant Spending Reductions Should Be Included in the Fiscal Package Before Congress

Congress is currently debating whether the 2017 Trump Administration tax cuts should be allowed to expire, thereby raising federal government revenue, or, if continued or even expanded, whether significant spending cuts should also be included in the legislative package, and if so, what should be cut.  This debate is occurring because deficits—at nearly seven percent of GDP in 2024, despite a relatively strong economy—and the ratio of federal debt to GDP—at nearly 100 percent, are at unprecedented levels. Projections, both official and outside government, indicate that trends are worsening. These fiscal conditions would likely lower living standards, raise interest rates, and increase the risks of high inflation and financial crisis in the future, especially if a recession or war were to occur. One way to inform the debate is to analyze the history of revenues and spending to see whether either have gotten more out of line of historical norms. Another way is to look at budget projections to learn the sources of the impending deterioration. I do both in this short note. 

For the historical analysis, I start at 1996 for several reasons. It had a deficit of about two percent, which many experts regard as sustainable in the long run if economic growth increases and interest rates decline—a possible favorable scenario for the future. That year also represented a roughly similar point in the business cycle as the most recent year, 2024—low unemployment, a good stock market, and decent economic conditions. In both years, a Democratic administration was in charge and there was no hot war for the US. In Table 1, I calculate the average ratios of federal government revenues and spending to GDP over four periods: 1996 to 2002, after the Clinton tax increases, welfare reform and the large stock market run-up and drop and recession, 2003 to 2012, after the Bush tax cuts, the Medicare drug benefit, and a deep recession, 2013 to 2017, after the Obama tax compromise and the ACA, and 2018 to 2024, after the Trump tax cuts, the pandemic and various Biden program expansions. Also, in the last 15 years, the baby boom generation is retiring, and birth rates have dropped. Overall, with some ups and downs, it is clear that there has been a small decline in revenues—to about 17 percent of GDP—and a large increase in spending to over 24 percent of GDP. 

Another method, resulting in the same conclusion, is seen in Table 2. It compares 1996 to the most recent year’s components of revenues, spending, and deficits. The deficit increased by 4.4 percentage points from 1996 to 2024 due to a 3.2 percentage point increase in spending and a 1.2 percentage point decline in revenues. The spending increase occurred mainly on health care, as government programs in that area expanded and costs increased, but Social Security and other mandatory spending like veterans’ benefits and food stamps also grew, while defense declined. Personal income taxes were strong in 2024 owing to a good stock market and despite the prior tax cuts, but payroll taxes were lower owing to an aging workforce and slower wage growth. Overall, this represents a 3:1 split on spending/revenue causation for the deficit. Analysis of historical norms indicates that the majority of future effort to reduce the deficit and growth in debt should come on the spending side. 

The same conclusion arises from considering budget projections. Here, I use the Warshawsky, Mantus, Pang (WMP) long-run budget macroeconomic model. Among the unique features of the model are its use of current policy, as opposed to current law, and its focus on the inefficient production—and therefore rising costs—of health care, now nearly a fifth of GDP. As shown in Figure 1, the deficit is projected to increase by over 10 percentage points over the next thirty years, and this is more than accounted for by increases in spending in four areas: Social Security, Medicare, Medicaid, and interest payments, as interest rates rise and debt grows. 

Figure 1: Projected Deficit Increases and Their Causes, Ratios to GDP, 2024 to 2054

In the model, revenues are fairly steady (ignoring possible increases in non-compliance resulting from IRS downsizing or possible legislated cuts in taxes on Social Security benefits), and non-defense, non-benefits spending actually declines over time, in ratio to GDP. Although demographics is a part of the story here, causality comes mostly from the fiscal policy of increased spending and rising health care costs. Therefore, the appropriate policy reaction should be in those directions—enforcing current law eligibility for Medicaid (including for long-term care benefits), modernizing the vocational factors in eligibility for disability benefits, making changes to Social Security and Medicare, and implementing reforms to reduce the demand for, and increase the efficient production of, health care.  The resulting benefits—higher living standards, lower interest rates and reduced risks—would be large.

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