Debt, deficits, and fiscal responsibility

Let’s start with the basics: Congress authorizes the expenditure of funds for a host of initiatives that define the role of government.  It also sets tax rules that determine the amount of tax revenues the government collects. These two responsibilities, however, are carried out largely independently, allowing for a mismatch between what is collected and what is spent.  When the tax collections fall short of expenditures, we operate with a deficit; when the tax collections exceed the expenditures, we operate with a surplus.

The debt derives from running deficits, cumulatively.  In other words, deficits add to the debt, while surpluses decrease the debt.  For illustrative purposes, suppose we start off with no debt. By the end of Year 1, we’ve incurred a deficit of $100; in Year 2, a deficit of $200; and in Year 3, a deficit of $300.  Our debt at the end of each of those three years would be $100, $300 (= $100 + $200), and $600 (= $100 + $200 +$300), respectively. If we end up operating at a surplus of $50 in Year 4, the debt will decline by that much, to $550.

Keynes taught that fiscal tools – i.e., taxes and government spending -- can be used to manage the economy. When we want to stimulate economic growth, we can do so by increasing government spending or reducing taxes; and conversely, when we want to slow the economy, we can do the reverse – reduce spending or increase taxes.

It’s not the deficit, per se, that determines whether fiscal policy should be characterized as expansionary or contractionary. Rather, it’s the change in the deficit. Consider three cases where we start with a deficit in the first year.  In Case 1, the deficit stays exactly the same in the second year as it was in the first; in Case 2, the deficit rises further in the second year; and in Case 3, the deficit shrinks in the second year.

Case 1 – Unchanged deficit: Although this outcome would result if any change in government spending were perfectly matched by an equal change in tax revenue collections, let’s keep it simple by assuming both government spending and tax revenues are unchanged from year to year.  Such an outcome would be neither expansionary nor contractionary. This neutral economic policy notwithstanding, with a deficit staying at the same level every year, the level of outstanding debt will be ever-increasing. 

Case 2 – The deficit rises: This scenario would reflect an expansionary fiscal policy where both the deficit and the debt will increase.

Case 3 – The deficit falls:  In this case, we’d be experiencing a contractionary fiscal policy with the debt continuing to grow albeit at a declining pace.

Although we can look to the change in the deficit as being the marker as to whether fiscal policy is contractionary or stimulative, it’s important to recognize that this policy choice isn’t necessarily deterministic. That is, the overall private economy may very well be overriding, irrespective of the direction of fiscal policy. Put another way, the fact that the fiscal policy may foster a marginal contractionary influence doesn’t necessarily portend a slowdown of economic activity.

Keynes would have us use fiscal tools countercyclically, stimulating the economy to counteract high levels of unemployment and depressing the economy in the face of unacceptably high rates of inflation. Concerns about the level of debt, however, were largely seen as secondary to Keynes; but he published his treatise back in the 1930’s when the level of outstanding federal debt burdens was much more contained. 

These days, with debt servicing costs accounting for more than 13 percent of all federal spending, many fiscal conservatives see the level of debt as something that deserves greater consideration.  If it goes unchecked, the debt burden (i.e., interest payments required in connection with that debt) could become unsustainable.  To avoid this potential problem, those concerned would generally want to see money spent as a fiscal stimulus to be reversed over time, albeit gradually to preclude unnecessarily pushing us into a recession. 

To put this issue in perspective, the federal government hasn’t run a surplus since fiscal year 2000, which means that the federal debt has been growing every year since. The deficit spiked in 2009 following the great recession of 2008, reaching a level approaching $1.5 trillion; but after that, deficits gradually fell to about $0.5 trillion in 2015, before again moving higher.  The deficit really skyrocketed in fiscal 2020, however, reaching more than $3 trillion due largely to Covid relief spending, but the reduced tax revenues due to the passage of the Tax Cuts and Jobs act in December of 2017 certainly contributed. 

With the Covid funds largely spent without being extended, the deficit has retreated from the historical high in 2020; but it’s still elevated, historically, coming in at more than $1.8 trillion for fiscal year 2024 (ending September 2024).

The large jumps in the deficit in 2009 and 2020 seem wholly consistent with the Keynesian idea of using fiscal stimulus countercyclically; but at this point, the size of coming deficits have become more worrisome. The progression of these deficits will depend in part on whether the tax cuts enacted in the Tax Cuts and Jobs Act of 2017 will be allowed to expire in 2025, as per the dictates of the legislation, or if they will be extended, which, of course, is a promise that Trump made during his campaign.

The Trump promise notwithstanding, at this point, it’s appropriate to re-examine the question of whether the tax cuts originally enacted in the 2017 legislation should be made permanent, or allowed to expire, reverting to the pre-2017 provisions.  Personally, I don’t see any justification for extending the tax cuts. Given the fact that current tax revenues don’t cover existing government spending obligations, piling up additional debt when we don’t face any pressing need to stimulate the economy seems inappropriate, especially now with the debt burden as high as it is.  

Thankfully, we’re well positioned to be able to address our historically high interest burden that we’re currently facing. In fiscal 2024, for the first time, spending for the interest on federal debt exceeded that which was spent on national defense.  The remedy, of course, should be to prioritize working to reduce the size of the deficit.  Raising taxes and cutting government spending should be on the table; and part of that package should be allowing the tax cuts of the 2017 legislation to expire. These measures don’t have to happen in one fell swoop, but reasonable minds should be able to devise some schedule for gradually reducing the deficit.  We should start that process now, while we’re enjoying a healthy economy and the prospect of precipitating a recession appears to be remote.