April 20, 2011

Where the Budget Deficit Actually Came From

By Greg Richards

I found that in thinking about the budget, I did not have a good mental picture of where, exactly, and when, exactly, things had gotten out of line.  So I decided to do a quick analysis of the "big pieces" of the federal budget just to get a feel for the magnitude of our financial problems and where in the budget they were located.  It occurred to me that others might be interested in this as well, and that thought is the provenance of this essay.

Just to begin at the beginning, this chart is a "50,000 foot view" of the battlefield.  This is a chart of GDP at the top and federal budget expenditures at the bottom.


The orange vertical line is at 2008, the end of the Bush (43) Administration.  All the numbers and all the charts in this essay are in current dollars.  That means that they are in dollars not adjusted for inflation.  The growth rate of GDP that one typically hears -- 4% or 3% or 2.5% -- is a real rate that has been adjusted for inflation.  But since the budget in any year concerns dollars for that year, there is no point in adjusting a historic study like this for inflation.  Inflation is a different issue and is not important here because everything -- receipts, GDP, expenditures -- are in dollars of the same year and thus of the same value for that year.

This issue comes up right away in the above chart..  You might ask, "Where are the recessions?" in the GDP data.  The reason you don't see them is that in current dollar terms they are very small -- they are significant in real terms, but inflation mutes them in a time series like this one.  The current recession is so deep that it does show up in the data.

All the charts in this essay are 1960 - 2011.  I chose 1960 as the beginning year because roughly speaking this is when socialism started to come to America.  This chart starts in the last year of the Eisenhower Administration. 

The chart shows that GDP and the federal budget both grow over time.  No surprise there.  If we are being charitable, it is very likely that this is the way a typical liberal Dem sees the problem -- i.e., that there really isn't a serious problem: both the GDP and federal outlays are growing and in a time series it doesn't look like anything catastrophic is happening. 

So that's the background.  Now let's zoom in for a finer view.  The next chart shows the federal budget as a percentage of GDP:



This chart is based on exactly the same data as the first chart: it is simply the lower line, or federal budget, divided by the upper line, or GDP.  I have put a vertical orange line on the figure for 2008, the last year the data were within their historical range and which is also the last year of the Bush (43) Administration. 

You can see that in the next three years, the first three years of the Obama Administration, federal outlays leap to the 23% - 25% of GDP range, a new high in share of GDP consumed by the federal government in this period.  Federal outlays almost got to 23% of GDP during the Reagan Administration but then began a downward trend.  The years of the Clinton Administration and its agreement with Gingrich to limit spending show a pronounced decline to a low in 2000.   They trended upward during the Bush (43) Administration, but were within their historical range.  The chart shows they were beginning to surge in the last year of the Bush (43) Administration.

So far we have talked about the federal budget.  Now let's look at how that budget was paid for -- what the surplus / deficit experience has been:



As with the previous chart, there is a vertical orange line at the end of the Bush (43) Administration.  The surplus / deficit experience in the early years of the chart is so small compared to the later years as to be almost invisible on this chart.  However, the sharp decline in the chart is the increase in the federal budget deficit starting with the Obama Administration.  And that brings us to one of the key points of this essay.  Although the last year of Bush (43) was nothing to write home about, the deficit was within its historical range.  It broke out of that range in the Obama Administration.  If we look at the chart, we can see that the deficit of the last year of Bush (43) was about $500 billion (actually -$459 billion) and in the third year of the Obama Administration will be about $1,600 billion (estimated -$1,645 billion).  Therefore, in round numbers, the question is where did that additional $1.1 trillion dollars go in three years? 

So, that is the question we are seeking to ask in the rest of this essay: where did that additional $1.1 trillion in deficit come from?  We'll start a tally, and fill in the components as we go:

Sources of the difference in the federal budget deficit between 2008 and 2011

 Total                        
 $1,100 billion
 100%

A deficit change can be due either to a decrease in revenues or an increase in spending, or both.  The numbers will show that it is both.  Even if we were to remove this "additional" deficit, we would still have the roughly $500 billion deficit of the last year of the Bush (43) Administration which itself is very large, but within historic experience as a percent of GDP. 

So, looking at the "additional" deficit beyond the 2008 level, let's find the big pieces.  To do this, we'll begin with Social Security.  Not only is it one of the large pieces of the budget and the deficit increase, it is the only category that is a "package" -- that includes both revenues and expenditures.  There are four major revenue sources for the federal government: Social Security (FICA), personal income tax, corporate income tax, and "other."  We'll consider Social Security first, as a package of both revenues and expenditures; then we'll look at some pure expenditure categories; and lastly we'll look at revenues "lost" to the recession -- i.e., the extent that revenues are "below normal" due to the recession and thus are contributing to the deficit as compared with 2008, which was the last pre-recession year.

Social Security

Social Security is an interesting piece (a) because it is large and (b) because it has its own financing mechanism, the FICA tax.  Social Security has been in surplus since its founding through to the present time.  This can be seen for the 1960 - 2011 period in the following chart:



What this chart shows is the level of overpayments that have been made each year into the Social Security "trust fund."  As most readers of AT will know, the trust fund is a fiction because, while it does contain IOU's from the federal government, they are only supported by the current ability of the taxpayers to pay taxes -- there is no "savings account" apart from those IOU's in the trust fund -- which is the same as new current appropriations when those IOU's are called on.  It is the same thing as if you "saved" by issuing yourself paper.  When you come to call on that paper you are the one who must come up with the funds, so "saving" in this way is a fiction.  All politicians of both parties have lied to the country about this fact for the last two generations.  That is why the "fixing of Social Security" by the Greenspan Commission in the 1980's was entirely from start to finish a fiction.  Apparently, in the upper reaches of government bureaucracy, you have to "make your bones" at some point like a Mafia soldier by carrying out some significant piece of flummery on the public -- Greenspan did it on Social Security and Colin Powell did it on the Iraq War.

If the overpayments into the Social Security "trust fund" were not in fact saved to be paid out in the future to beneficiaries, where did the money go?  Congress spent it.  Simple as that.  Or, as they say in the banking business, "we spent some of it on women, food and gambling and the rest we just pis*ed away."

More specifically, it was always understood that about now, with the beginning of the retirement of the baby boomers, excess payments into Social Security would first moderate, and then turn negative -- that Social Security would start to take in less than it paid out, after doing the opposite for the last 75 years.

As the chart above shows, 2008, the last year of the Bush (43) Administration, was also the last good year of overpayments into the Social Security system.  In the subsequent three years, net overpayments have dropped dramatically.  This can be seen in the chart below:


This shift in Social Security is not temporary, but permanent, reflecting the underlying demographics.  It may fluctuate from year to year, but the trend toward no overpayments -- the 0 line -- and then to net underpayments is baked in (although projections for 2012 do show a significant bounce, presumably due to employment recovery from the recession).  Thus, for instance during the decade of the 2000's, federal finances were getting a fillip of $250 - $300 billion per year from Social Security overpayments.  That does not make or break the federal budget, but it was a nice freebie to have.

In terms of our search for the difference in federal finances between 2008 and 2011, what the chart above shows is that in 2008, the federal government received overpayments of roughly $285 billion ($283 billion) and in 2011 overpayments of $60 billion ($58 billion).  This is a difference of $225 billion.  So this is our first discovery of where the additional $1,100 billion in deficit has come from between 2008 and 2011 - $225 billion, about 20%, came from Social Security.  Let's write this down:

Sources of the difference in the federal budget deficit between 2008 and 2011

 Social Security
 $225 billion
 20%
 Total                    
 $1,100 billion 
 100%

So that is Social Security, a package of both revenues and expenditures.  Now we'll move on to some major categories of the budget that are expenditure only.

Medicare

Total expenditures for Medicare are shown in the following chart.  Medicare was passed by Congress in 1965, so the numbers start in 1966:



As can be seen in the chart, annual Medicare expenditures grew by about $100 billion from 2008 to 2011, or from about $400 billion ($391 billion) to about $500 billion ($494 billion). This is about 9% of the total we are looking for.  Let's write this down:

Sources of the difference in the federal budget deficit between 2008 and 2011

 Social Security
 $225 billion
 20%
 Medicare $100 billion
 9%
 Total                  
 $1,100 billion
 100%

Medicaid

Medicaid is a joint federal / state program to finance people who get sick and cannot pay their medical bills.  It is part of the safety net.  Total expenditures by the federal government for Medicaid are shown in the following chart:



Note that they leapt up in 2009, presumably due to the effect of the recession, although investigating that is beyond the scope of this essay.  For our purposes, the point of this chart is that between 2008 and 2011, Medicaid expenditures grew from approximately $280 billion ($281 billion) to approximately $380 billion ($388 billion), or an increase of approximately $100 billion.  Let's write this down...

Sources of the difference in the federal budget deficit between 2008 and 2011

 Social Security
 $225 billion
 20%
 Medicare $100 billion
 9%
 Medicaid $100 billion
 9%
 Total                          
 $100 billion          
 100%  

I have left a space under Social Security to separate it from the other categories because the Social Security number is a net package of both revenues and expenditures while the next categories are expenditures only.

Federal unemployment insurance

Federal unemployment insurance, called "Income Security" on the books is, like Medicaid, a joint federal / state program.  Here is what these expenditures look like:


Income security expenditures by the federal government grew from approximately $430 billion ($431 billion) in 2008 to approximately $625 billion ($623 billion) in 2011.  This is a gain of $195 billion.  Since we are dealing with round numbers and 2011 numbers are estimates, let's call this $200 billion and write this down: 

Sources of the difference in the federal budget deficit between 2008 and 2011

 Social Security
 $225 billion
 20%
 Medicare $100 billion 9%
 Medicaid $100 billion 9%
 Unemployment Insurance
 $200 billion 18%
 Total                                    
 $1,100 billion 100%

Defense

The following chart shows defense expenditures:



Defense expenditures -- and remember these are current dollar, non-inflation adjusted numbers -- were flat to down in the 1990's following the fall of the Berlin Wall and the breakup of the Soviet Union.  Since we were attacked in 2001 they have more than doubled!  In 2008, they were approximately $615 billion ($616 billion) and in 2011 they will be approximately $765 billion ($768 billion), a gain of $150 billion.  Let's put that in the table:


Sources of the difference in the federal budget deficit between 2008 and 2011

 Social Security
 $225 billion 20%
 Medicare $100 billion 9%
 Medicaid $100 billion 9%
 Unemployment Insurance
 $200 billion 18%
 Defense $150 billion 14%
 Total                                      
 $1,100 billion
 100%

Since defense spending is so controversial and has grown so much since 2000, it is useful to look at it as a percentage of GDP.  The following chart shows the historical percentage of defense spending in relation to GDP:



Back in the bad old days of the Kennedy Administration, the period of the High Cold War, defense ran at 9% of GDP.  The chart shows that its level of 3% of GDP in 2000 was a historic low for the modern era.  It is now back to about 5% of GDP, historically a comfortable level for the country to bear, but, of course, that was before the growth of social programs.  Still, 5% of GDP does not seem like an outrageous level for defense, particularly given the world situation currently.

So far, we have accounted for about half the growth in the federal deficit between 2008 and 2011.  Where will the rest come from?

Other Federal Expenditures

This is everything else -- essentially everything one thinks of when one thinks of the federal government except for the military -- all those departments in Washington and the impressive buildings.  Other federal expenditures look like this:



An interesting chart.  I don't know what the reason is for the volatility in this series in the last two years.  But in terms of the quest of this essay, the search for the sources of the increase in the deficit between 2008 and 2011, other federal expenditures in 2008 were $365 billion ($365.2 billion) and in 2011 were $535 billion ($535.8 billion), an increase of $170 billion.  We'll add this to the table:

Sources of the difference in the federal budget deficit between 2008 and 2011

 Social Security
 $225 billion
 20%
 Medicare $100 billion
 9%
 Medicaid $100 billion 9%
 Unemployment Insurance
 $200 billion 18%
 Defense $150 billion 14%
 Other $170 billion 15%
 Total                                      
 $1,100 billion
 100%

Tax revenues lost to the recession

Although the economy is once again growing, we are still recovering from the last recession.  This has left the federal government with less revenue than it would have in a normal economic environment.  These lost revenues have contributed to the growth in the federal deficit.  We cannot be precise about lost revenues, but we can make an educated guess.  First, let's see what non-Social Security tax revenues have looked like historically:



Somewhat surprisingly, these categories of federal revenues have shown a declining trend as a proportion of GDP over the last several decades.  This is, quite frankly, a surprise to me.  Looking more specifically at the question we are addressing in this essay -- the components of the increase in the federal deficit from 2008 to 2011 -- non-Social Security revenues were 11.3% of GDP in 2008 and are estimated to be 9.1% of revenues in 2011.  This is a difference of 2.2%.  For simplicity, let's assume the amount of revenues the government will get back as the economy recovers is 2%.  In order to estimate how much revenue might be generated here, let's look at GDP itself.  Recall that this is shown in the first chart in this essay.  In terms of current dollars, the GDP is back to record levels, but other statistics on the economy, such as unemployment, industrial production and capital spending, are still well below the peaks of the last cycle. 

Estimated GDP for 2011 is $15,100 billion.  2% of this is approximately $300 billion.  Let's put this in our table:

Sources of the difference in the federal budget deficit between 2008 and 2011

 Social Security
 $225 billion
 20%
 Medicare $100 billion
 9%
 Medicaid $100 billion 9%
 Unemployment Insurance
 $200 billion 18%
 Defense $150 billion 14%
 Other $170 billion 15%
 Lost Recession Revenue
 $300 billion 27%
 Total                                      
$1,245 billion  
113%
 Total $1,100 billion
 100%

So, we have accounted for more than 100% of the $1,100 billion we were looking for.  Given the uncertainty of the numbers and that all the numbers for 2011 are estimates, I am inclined to stop here, with an imperfect, but still useful, result. 

This exercise does not tell us what to do about the ruinous state of federal finances.  And we should remember that the baseline for this analysis was the still very large 2008 deficit of approximately $500 billion.  But we can say a few things:

  • While it will be nice to get back the revenues lost to the recession, they are not by themselves big enough to right the ship
  • Defense expenditures are not out of line with historical levels, even given their recent growth
  • The government has lost the approximately $300 billion "freebie" it has been used to getting from Social Security overpayments.  While we are not yet at breakeven for Social Security, we are close to it, and then it will go into deficit, presumably forever
  • The costs of Medicare and Medicaid, already significant, will very likely increase in the near future.
  • The federal government has taken on more responsibilities than it can afford.  This will bring financial ruin to the country unless changed.
  • There are no obviously big savings in the budget.  It is going to have to be pared piece by piece, not only in eliminating some departments, but in looking at the expenses of how the government is delivering services. 
  • In entitlements, very likely, the served market will have to be reduced, with more responsibility left to individuals.
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