In the Nation's Interest

Diving into the Deficit

by Courtney Baird November 06, 2014

Significant Deficit Decline for FY 2014

On October 15th, the Treasury and the OMB revealed better-than-expected budget results for Fiscal Year 2014.  The FY 2014 deficit clocked in at $483 billion, which is 6.5 percent less than was forecast in February by the Congressional Budget Office (CBO).  This year’s deficit also is a $197 billion, or 29 percent, decrease from the FY 2013 deficit.  These positive results extend a trend of falling deficits and take us back toward pre-recession deficit levels.  In dollar terms, the FY 2014 deficit is the lowest since FY 2008, and as a percentage of GDP, the deficit is the lowest since FY 2007.  Clearly, our budget is heading in the right direction. 

Reasons for FY 2014 Deficit Decline

So what is the source of these positive results?  If we take a look in dollar terms, the answer is pretty clear: the deficit decline stems from an increase in receipts, not a decrease in outlays.  Government receipts increased by $247 billion, or 9 percent, from FY 2013.  On the other hand, government spending increased by $50 billion, or 1.4 percent.

The increase in government revenue from FY 2013 resulted from both a stronger economy and the expiration of certain tax provisions.  Specifically, the Treasury Department attributes higher receipts to:

• Growth in wages and salaries, which increased collections of individual and payroll taxes
• The expiration of the temporary cut in payroll taxes and the increase in tax rates on income above certain thresholds, which went into effect in January 2013
• Growth in taxable corporate profits, which increased collections of corporate income tax
• An increase in Federal Reserve deposit earnings, due to higher yields on a larger portfolio

Although outlays increased overall, spending did decline in several agencies and programs, including: the Department of Defense, the Unemployment Insurance Program, the Federal Deposit Insurance Corporation, Flood Insurance and Disaster Relief, Crop Insurance, the Supplemental Nutrition Assistance Program, and housing programs.  Although these are improvements, significant increases in spending for Social Security, Medicare, Medicaid, and Federal Student Aid more than offset spending decreases in the aforementioned programs.  Therefore, the deficit decline does not indicate any major improvement in the programs that are the largest sources of cost growth in the budget.

Of course, asking for a decline in federal spending in dollar terms from one year to the next is setting a fairly high bar.  The 1.4 percent overall increase in spending barely covers the impact of inflation, not to mention the growth of the population.  Even in the 1990s, when the budget marched from the then-largest deficit in history to the still-largest surplus, spending in nominal dollars still increased in every single year.  More meaningfully, however, spending as a percentage of the size of the economy (the GDP) fell from 20.8 percent to 20.3 percent, an indication of some measure of restraint.

Because there was a budget deficit, cumulative federal borrowing from the public – the debt held by the public – also increased substantially during FY 2014.  However, the ratio of the debt to the GDP – the debt scaled against the size of the economy – was just about constant, albeit at a still-too-high level in excess of 70 percent.

What It Portends: Revenues

Although this budget news beats the alternative, it likely is not time to crack out the champagne just yet.

The increase in government revenue is based largely on the recovery in the economy – higher individual incomes and corporate profits result in higher tax collections for the government.  However, the recovery cannot regain the same territory twice.  Once the unemployment rate falls back to what we would call “full employment” (or the “natural rate of unemployment,” beyond which inflation accelerates), growth must slow, and the improvement in the budget from this source will dry up.  Likewise, the 2014 revenue increase resulted in significant part because of the expiration of past tax cuts.  Those tax cuts can expire only once, and so there will be no resulting bump-up in revenues in future years.  So we can hope for a strong economy in the long term to provide some help on the deficit, but the unusually strong progress in FY 2014 is largely a one-time event.

Major Healthcare Programs & Social Security

To curb the national debt and create a budget that is sustainable in the long term, we must reform the largest sources of cost growth for the federal budget: the major health care programs and Social Security.  But this year’s budget results, as widely heralded as they were, still were not positive for the major health care programs, which include Medicare, Medicaid, the Children’s Health Insurance Program (CHIP), and subsidies offered through health insurance exchanges.  Net spending by the Centers for Medicare and Medicaid Services increased by $74 billion, or 7 percent.  Spending on major health care programs has increased exponentially over the past several decades.  In 1973, federal spending on health care programs was 17.4 billion dollars and just 7 percent of the budget.  By 2013, federal health care spending had increased to 856 billion dollars and 25 percent of the budget.  In real terms, that represents a 1,000 percent increase in federal health care spending in only 40 years.

The rate of growth in healthcare costs has been slower than predicted of late.  Some believe that they have seen the light at the end of the tunnel.  But even at the slower recent rates of growth, healthcare costs still explode the budget – although admittedly at a somewhat later date then heretofore projected.  That should prompt not a declaration of victory, but rather a determination to use this extra time to address and solve the problem. 

Net spending for Social Security also increased in FY 2014, rising by 5 percent from $867 billion to $906 billion.  Spending on Social Security has also increased steadily over the past half century.  In 1973, federal spending on Social Security was $49 billion and just 20 percent of the budget.  By 2013, Social Security spending had increased to $814 billion and 24 percent of the budget.  In real terms, that represents a 280 percent increase in Social Security spending in only 40 years.  Social Security is a popular and successful program.  It should be safeguarded so that it can continue to serve future generations of elderly retirees.

Unfortunately, these trends of rising costs are expected to continue.  According to the CBO, federal spending on major healthcare programs and Social Security will be the largest contributor to growth in the national debt over the next 25 years.  Over just the next 10 years, the CBO estimates that annual net federal spending for the major health care programs will increase by more than 85 percent in dollar terms, growing from 4.9 percent of GDP to 5.9 percent of GDP.  Annual net spending for Social Security is projected to grow by almost 80 percent, from 4.9 percent of GDP in 2014 to 5.6 percent of GDP in 2024.  CBO’s Long-Term Budget Outlook forecasts that federal healthcare spending will almost double as a share of GDP in the next 25 years, growing to 8.0 percent of GDP by 2039.  Social Security will also increase in the next 25 years, rising to 6.3 percent of GDP in 2039.  It will be extremely difficult – if not impossible – to accommodate such growth in the budget through either greater revenues alone or reductions in other spending alone.

Causes of Projected Growth in Spending on Healthcare & Social Security

Overall, there are three main causes for the projected increase in federal spending for the major health care programs and Social Security: aging of the population, excess cost growth, and provisions from the Affordable Care Act. 

According to the CBO, the number of people who are age 65 and older will increase by 82 percent between now and 2039, due to both aging of the oversized baby-boom generation and the longer life spans of the baby boomers and of their predecessors and successors.  In contrast, the number of people between ages 20 and 64 will increase by only 11 percent over the next 25 years.  Today, the older group is 24 percent of the size of the younger group, but by 2039 this share will increase to 39 percent.  This means that a larger share of the population will be drawing benefits from Medicare and Social Security, and benefit outlays will grow faster than the economy.  As a result, costs for Medicare and Social Security will grow faster than revenues received for the programs, and there will be continued shortfalls in finances for both programs.

Excess cost growth will also contribute greatly to growth in federal spending on major healthcare programs. The CBO explains excess cost growth as the extent to which costs per beneficiary, adjusted for demographic changes, grow faster than potential GDP per capita.  According to CBO’s projections, excess cost growth for Medicare will average 0.6 percent per year from 2015-2039.  Excess cost growth for Medicaid will be higher, averaging about 1.5 percent per year from 2015-2039.  For the exchange subsidies, CBO’s baseline projections imply an average annual rate of excess cost growth of about 1.6 percent per year for private health insurance premiums from 2015-2039. Excess healthcare cost growth can be attributed to many issues, such as increasing rates of chronic diseases and increasing costs of healthcare services. 

Two provisions from the Affordable Care Act will also contribute to spending increases for major healthcare programs.  First of all, the ACA allows states to expand eligibility for Medicaid to adults whose income is below 138 percent of the federal poverty level, which increases federal spending for Medicaid.  The CBO estimates that 80 percent of the potential newly eligible population will live in states with expanded Medicaid programs by 2018, and so an extra 13 million people will have coverage through Medicaid and CHIP each year from 2018-2024.  Secondly, the ACA expanded federal support for health insurance to people with incomes above the federal poverty line.  Households with incomes up to 400 percent of the federal poverty level are eligible for federal subsidies for health insurance purchased through exchanges.  The CBO estimates that each year between 2019 and 2024, 19 million people will receive subsidized health insurance coverage through the exchanges.

In conclusion, if we do not reform these programs, there will be a substantial imbalance in the federal budget over the long term.  Larger deficits will boost debt held by the public to 78 percent of the GDP in 10 years – even if healthcare cost growth continues to slow.   By 2039, federal debt held by the public will exceed 100 percent of the GDP.  This level of debt has only been seen once before in U.S. history – at the end of World War II – and would be a major cause for concern in today’s much more vulnerable economic environment.  CED has detailed policy recommendations that we believe would help to solve these lingering policy problems.  We hope to work closely with our Trustees to remove these roadblocks to long-term economic growth and prosperity for all Americans.