Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

Why deficit reduction is so hard

In the shadow of impending financial disaster, President Biden and Speaker McCarthy reached a bipartisan agreement to suspend the debt ceiling until 2025 in exchange for a commitment to limit discretionary spending over the next 2 budget years. The achievement is notable, as both parties brought a significant share of their members to support the agreement and avert a disastrous default.

The Fiscal Responsibility Act represents the largest reduction in the rate of spending growth since 2012, reducing the annual budget deficit over the next 10 years by somewhere between $500 billion and $2.1 trillion, depending on several very fluid assumptions. But to grasp the true magnitude of the debt problem, one must put this reduction in perspective by examining the composition of federal spending and recognize how little is truly controllable in the absence of major entitlement reform. Viewed in this light, the FRA is a drop in the bucket.

It helps to understand how government spending is doled out. Many people may not appreciate that Congress’s dramatic annual ritual only impacts 28% of total expenditures, referred to as the “discretionary” portion of the budget, divided about equally between defense spending and other government programs. Discretionary spending is the morsel over which the debt ceiling negotiators were wrangling and from which the reductions were garnered.

The lion’s share of federal outlays is essentially on autopilot, determined by broad legislation that does not require annual approval. So-called “mandatory” spending comprises the major health and retirement security initiatives like Social Security, Medicare, Medicaid, unemployment, and federal employees’ retirement. These programs, often referred to as entitlements, are authorized by statute and do not require annual authorization and therefore are not included in the appropriations process. In 2023, mandatory spending represents 62% of all government outlays and is growing faster than inflation.

The other automatic (and the fastest-growing) slug of federal spending is interest on the national debt, currently around 10% of total outlays. Obviously, interest expense is not directly controllable but is the product of total accumulated debt and the cost of borrowing (interest rates). This piece of the pie has expanded as rates increased over the past 2 years and is projected to swell to 20% by 2053 according to the Congressional Budget Office.

Congress rarely follows its own rules by passing the 12 required annual appropriations bills to fund the government, typically defaulting to a last-minute emergency catch-all or “omnibus” spending bill as it did in December for FY 2023. According to the CBO, discretionary outlays authorized by Congress for 2023 will reach $1.7 trillion, with mandatory spending of $4 trillion and interest on the debt totaling $663 billion, for a grand total of $6.4 trillion in US Government outlays. Fiddling at the margins of the discretionary portion cannot fix or even significantly alter the trajectory of the long-term deficit and debt problem.

$6.4 trillion is a lot of dough, but it’s a big country. However, tax revenue for 2023 will only come in around $4.8 trillion, leaving a $1.6 trillion hole that must be filled with borrowing. That hole is called the annual deficit, and it will add to the current accumulated public national debt of over $24 trillion. The US has run a deficit every year since 2001, but deficits have exploded in the aftermath of the global financial crisis and the Covid pandemic.

With this background, let’s return to the debt ceiling deal or Fiscal Responsibility Act. The legislation caps defense spending at a level 3% higher than 2023 and cuts non-defense discretionary outlays by around 9% in 2024, with additional constraints in 2025. CBO estimates that the caps will reduce cumulative deficits by around $1.5 trillion over the 10-year period from 2024 through 2033 versus its baseline projections, not an inconsequential reduction. It is only when viewed in context that the magnitude of the task is fully appreciated.

Before passage of the FRA, the non-partisan CBO had projected that annual deficits between 2024 and 2033 would total $20.3 trillion, swelling the national debt by nearly half to 46.7 trillion or 118% of GDP. For reference, that is a higher percentage of debt to economic output than even during WWII, and a level that many economists believe would permanently damage the US economy and substantially reduce Americans’ standard of living.

Under CBO’s core estimate for the FRA, 10-year cumulative deficits would be trimmed by around 7%, and result in a reduction in the 2033 national debt of just 3% compared with the current trajectory.

From this perspective, it would require the complete elimination of all discretionary spending, including defense, to balance the budget.

The FRA includes an enforcement mechanism for FY 2024 and 2025, but the 4 years thereafter are essentially just guidelines that are unenforceable. Furthermore, to secure enough votes, several offline accommodations were agreed to but not included in the legislative text that if honored would reduce the impact of the spending reductions. A reasonable estimate of realized deficit reduction is probably $1 trillion over 10 years, or a slowing of the growth in the national debt by about 2%.

Both Speaker McCarthy and President Biden are to be applauded for carving out a deal to avert a financial catastrophe, but the net impact is small ball relative to the growth in total spending. Next week: a closer look at the big picture.

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