A decade ago the U.S. political and media establishment was obsessed with budget deficits. This obsession did a lot of harm, helping to deprive the economy of fiscal support after the 2008 financial crisis and keeping unemployment unnecessarily high for years.
Happily, we recovered much more quickly from the Covid crisis. And you don’t have to be a Very Serious Person to worry, at least a bit, about continuing budget deficits.
But how are things going on the fiscal front? It’s complicated.
In the short run, the deficit picture has suddenly become much worse. But the causes of that deterioration may — may — be temporary.
At the same time, there has been very good news on health care costs, one of the main drivers of long-run budget concerns. As I said, it’s complicated.
First, the short run. The federal deficit for the first three-quarters of the fiscal year 2023 (which began in October 2022) was almost three times as high as a year before. Why? Very little of it was the result of new spending programs (although money is starting to flow out the door under the Biden administration’s industrial policies). Instead, it was mainly about two things: a sharp fall in tax receipts and rising interest payments.
Here’s what the tax picture looks like:
I show receipts as a percentage of G.D.P. for two kinds of taxes: personal income taxes and social insurance taxes. The latter, basically the payroll taxes that pay for Social Security and part of Medicare, have been stable. But the former surged during the pandemic, then dropped. What was that about?
Some of it was capital gains. Asset prices, especially prices of technology stocks, surged even as the economy was in partial lockdown, for reasons that would take a whole other newsletter to discuss. When people sold assets whose prices had soared, they paid part of their gains to the Treasury. Now that the stock boom is behind us, those payments have gone down.
As Justin Fox points out, inflation also played a role. The federal income tax is progressive — that is, people with higher incomes pay higher tax rates. Tax brackets are indexed to consumer prices, so higher incomes due solely to a higher overall level of prices aren’t supposed to raise overall taxes; but the brackets are based on the previous year’s Consumer Price Index, so a burst of inflation, like the one we saw in 2021-22, does raise average tax rates. Now that inflation has come way down — even if people refuse to believe it — average rates are dropping again.
So what’s happening on taxes is that the federal government in effect got a windfall from stock prices and inflation, which is now going away. We’re not looking at any fundamental deterioration.
What about spending? As a percentage of G.D.P., federal interest payments have shot up, reflecting the Federal Reserve’s policy of raising rates to curb inflation:
But will rates stay permanently higher? In the long run, interest rates tend to reflect inflation, which, as I said, is coming down fast. The question is whether the real interest rate — the interest rate minus expected inflation — will go back to the low levels that prevailed before the pandemic.
And that’s a guessing game. The Federal Reserve Bank of New York regularly estimates r-star — the real rate “expected to prevail when an economy is at full strength and inflation is stable” — and finds that it has returned to prepandemic levels, but many economists believe otherwise. A lot depends on questions like the extent to which artificial intelligence and the green-energy transition will increase investment spending, questions to which nobody knows the answer.
So is the short-term deficit surge a harbinger for the future? The answer is a definite maybe.
What about longer-run factors? The Times recently reported on a hugely important trend: After decades of rapid growth, Medicare spending per beneficiary has flattened out:
Why is this so important? Dire projections of the long-run U.S. budget trajectory are driven in part by an aging population, which means that more people will be eligible for Medicare and Social Security. But they’re driven almost equally by the assumption that health care costs will grow faster than per capita income, which was indeed the historical trend. Here’s a useful chart from the most recent Congressional Budget Office report on the long-term budget outlook:
As you can see, additional cost growth in health care is almost as important a factor as population aging, but while an aging population is more or less assured unless we suffer some kind of mass mortality event, the numbers on health care are based on the assumption that the future will look like the past — an assumption that looks increasingly dubious.
What’s slowing the growth in health spending? Providers may have become more cost-conscious, thanks in part to improved incentives under the Affordable Care Act. It’s also possible that medical innovation has either slowed or changed direction, so that we’re not seeing as many new, expensive treatments as in the past. Whatever the explanation, the long-run budget outlook is looking less alarming than it used to, even as the short-term deficit is rising.
What does all this mean for policy? The U.S. government isn’t at any imminent risk of going bankrupt, but it really shouldn’t be running budget deficits this big at full employment. Yet we don’t want to reduce deficits by cutting essential spending — above all, spending on green energy needs to be maintained, because climate change is a much bigger long-run threat than rising debt.
What should we be doing? Well, America collects a lower share of its income in taxes than other major economies, so more revenue — partly from the rich, but also from the middle class — would be a reasonable policy. It’s also effectively off the table given our partisan divisions.
Until or unless our politics improves, then, we’re going to keep running deficits bigger than even fiscal doves like myself would like. But honestly, those deficits aren’t what keep me up at night; climate disaster and the threat to democracy currently have prior claims on my capacity for brooding.