Demystifying the deficit

After a series of posts examining the fiscal woes of the United States (see here, here and here for example), I have refrained from posting on the issue for the past couple of months, mainly because I have little to add that I have not already said. In short, yes, the US has a longer-term fiscal problem. Yes, this needs to be addressed. No, now is not the right time to be making big budget cuts. No, the US does not need to default. No, hyperinflation is not imminent. And no, the US is not Greece.

However, this is not the subject of today’s post.

Solutions to the debt problem are controversial. But today, I would like to simply examine what the cause of the US deficit is. After all, if we can’t even agree on the cause, how can we possibly come to agreement on any kind of solution?

Now, this shouldn’t be such a complicated subject — after all there is plenty of official data that will answer all of our questions. But having observed the comment thread of several blog posts (on MacroBusiness and elsewhere) in recent weeks, it occurred to me that the causes of the deficit are still a poorly understood subject. Given the misinformation, hysteria and political rhetoric that pass for serious debate in our media these days, perhaps we shouldn’t be surprised. So let’s examine some basic questions.

Why is the US deficit so large?

To many, this seems like an obvious question. Turn on Fox News, and you will be led to believe that it is the inevitable result of trillions of dollars of out of control spending from President Barack “Karl Marx” Obama. However, while the stimulus was a large reason for the deficit blowout in the immediate aftermath of the GFC, the reality, of course, is much more complicated.

The chart below (from the Center for Budget Policy Priorities) illustrates that, overwhelmingly, the biggest cause of the blowout in public debt over the past decade was the massive income tax cuts (mostly to high-income Americans) enacted by President Bush. If you add the enormous cost of the wars in Iraq and Afghanistan (and include the associated interest payments), you can explain almost half of the public debt forecast out to 2019. A large portion of the remainder is explained by the severity of the economic downturn itself, which led to a plunge in tax revenues, and at the same time, an increase in “automatic stabilizers” such as unemployment benefits and food stamps. After all, we are still emerging from the biggest economic downturn since the 1930s.

So I repeat, whatever you think of the Obama stimulus and the bailout of the big banks, etc, this has very little to do with the current and future fiscal issues of the United States.

The US was already a relatively low tax nation before the Bush-era income tax cuts, but as you can see below, it is now by a comfortable margin the lowest taxed country in the OECD. Now, I understand that this is many libertarians’ idea of a fantasy nation, but the persistently low level of tax revenues makes it very difficult to balance the budget, particularly when the US spends almost as much as the rest of the world combined on defense, and this portion of the budget has traditionally been quarantined from cuts.

Medicare Madness

So, the revenue side is a problem. But what about reckless spending? Isn’t this a bigger issue in the longer term?  The chart below shows that in the longer term, the primary driver of the deficit (in fact, you could go so far as to say the only thing that really matters) is the massive rise in projected healthcare spending in the government programs Medicare and Medicaid.

Keep in mind that the blue sliver above includes defense, as well as vital public services like education, policing, infrastructure, etc. There is simply not a lot of room to cut here.

So what’s going on with the massive rise in medical spending? Well, like most other developed nations, the US has an ageing society, and to a certain extent, a rise in medical spending is inevitable. But the problem in the US is a whole lot worse than anywhere else in the world. The chart below illustrates why (hat tip to John Hempton).

Essentially, the US spends about twice as much on healthcare as most other developed nations, and incredibly, despite this massive spending it gets very average healthcare outcomes (in terms of metrics like infant mortality, etc). As the economist Uwe Reinhart says, this is a result of the following factors:

1. higher prices for the same health care goods and services than are paid in other countries for the same goods and services;

2. significantly higher administrative overhead costs than are incurred in other countries with simpler health-insurance systems;

3. more widespread use of high-cost, high-tech equipment and procedures than are used in other countries;

4. higher treatment costs triggered by our uniquely American tort laws, which in the context of medicine can lead to “defensive medicine” — that is, the application of tests and procedures mainly as a defense against possible malpractice litigation, rather than as a clinical imperative.

So in summary, the fiscal woes of the US have little to do with out of control stimulus spending. The problem is very simple: insufficient revenues due to reckless tax cuts (mostly for the wealthy), and excessive spending due almost solely to runaway healthcare costs.

Anybody who professes to care about the deficit has to offer a solution to both of these issues.

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  1. Good post RA – the first time I saw the metrics on US healthcare spending, my jaw hit the floor.

    The major problem with their tax code – similar to ours, but not the same – is that the lower and middle classes have very high effective marginal tax rates.

    Taxation on speculation (i.e capital gains) is also extremely low, so the system has been gamed such that a high income earner who makes money in the stock or property markets is taxed less than a wage earner.

    • Exactly. Warren Buffet has been quoted as saying he is utterly baffled as to why he pays a lower marginal tax rate than his secretary.

      Hedge fund and private equity managers pay only 15% tax here, since their income is classed as capital gains rather than wages & salary. The code is riddled with loopholes like this.

    • You only need to live in the USA and see the levels of bureaucracy associated with healthcare to see where some of those costs arise. The added layers of administration and red tape come as a shock if you are used to the australian system (which is by no means a model of efficiency).

      Then just the actual costs of procedures there. Cortizone injection into my neck. 8 minutes (I was on my side looking at the clock) from start to finish to get it done. Cost $1934, thanks for coming, have a nice day.

      • LOL agree. Its one thing I couldn’t get used to while living there. Wife was on a J1 Visa. Her employee paid $700 per month for HC. (in 2005)ie $8400 , I got subsidized but had to pay $190. ie $2280. So for the year with NO children we effectively were paying over $10K per year. But every time u go get care U pay via deductibles and co-payments. Meaning if your sick (heaven forbid) you continue to pay. Ours had a co-pay of $2000 per year. Then U have deductibles, where U pay some more. Its just 1 big feeding frenzy there, when it come to health insurance.

        1 thing I did learn, Troy was they will bill the insurance companies (I.C) anything they want. Your example $1934. U pay your co-pay/ded and they send balance to I.C. The I.C pays the schedule amount of say $300. Then the doctor rights off the balance as the service to them costed more than the IC paid. Instant tax deduction.

        • Yes, the system is unbelievably inefficient. As you say the doctors will bill the insurance companies whatever they want. And the insurance companies employ armies of administrators whose sole job is to deny claims to people based on fine print.

  2. Slightly off topic but i am struck by the fact that Aus is second lowest on tax as % of GDP. My personal tax rate is much higher here than it was in the UK …

    and I still hear so much noise about how australia is the most taxed country on the planet ….

      • Plus National Insurance. In Oz however, if you earn over 70K I think you need to have private health cover, or get taxed more. Add up all the medical items Medicare costs and it makes a difference.

        I’m not saying the UK system is better as look at the deficit, and the national debt and the NHS is a big part of that ongoing cost.

        • True.

          And in the UK i was PAYG and thats that. Here I am PAYG and then get yourself down to the accountant to see how much you can grab back again …

          … oh and 6b in negative gearing …

    • Zen – we have a much higher welfare churn factor than most other countries.

      As my wife complains when she gets her pay cheque each week (and me annually when I see my accountant), the lower and middle income earners receive most of their tax payable back in the form of welfare/transfer payments.

      IF you look at the distribution – I have the stats and chart somewhere – the top 25% or so of taxpayers here provide most of the tax revenue, whilst the bottom 40-50% pay almost no (net) tax after transfer payments and benefits (free healthcare etc)

      The hidden tax is inflation: Australia’s inflation is one of the highest in developed countries, but is not measured correctly by CPI. House prices, consumer prices (except TV’s…) rates, fuel, etc ad nauseam

      Any quick comparison with other “higher taxed” developed countries on these measures, and suddenly your higher take home pay packet looks a lot smaller.

    • In the UK you pay national insurance as a separate line item — from memory in the 90s when I was there it was about 8%. My line item tax was lower in the UK but when combined with national insurance it was much the same as here.

      If you examine take home pay — gross salary less tax and taxes re-worded as something else but taxes nonetheless — there isn’t much difference between Aus, USA, Can, UK up to about 100K (forget the actual number) but after that USA zooms ahead (in terms of less overall tax).

      USA is a bit tricky to model because of state income taxes varying from state to state.

      • Lots of good points here and above. Comparisons between countries are difficult to make because the rates shown in the chart above are only averages and the actual rate paid can vary a lot depending on where you are in the income distribution.

        Regarding the US states, spot on. Where I am in Manhattan, you get slogged an extra 7-8% by New York state and 3-4% by New York City. I wouldn’t have to pay either of those if I lived somewhere like Nevada or Texas. Then again, who wants to live in Nevada?

  3. RA In regards to the ageing population, do you think that the ‘younger’ generation will put off having a family earlier? in order to afford the associated costs of living nowadays young people really need two sources of income. This will stretch out the generation gaps affecting economic cycles? peak spending cycles etc?

    • Do you mean in the US? I don’t have numbers at hand, but this is already happening. Here in New York it is almost impossible to have a family without two sources of income (unless you are a hedge fund manager). My impression though is that the cost of living pressures are worse in Australia. At least housing is getting cheaper over here…

  4. I know there are demands for a reduction in the level of US public debt, and from the graphs presented its easy to understand why…. but what would be the flow on effect to various other sectors of the economy if one or more of the areas responsible for the debt were heavily cut?
    In areas like defence for example, it really is government spending that drives the whole industry is it not? Heavy and light manufacturing industries, IT hardware and software, munitions, logistics, etc.
    Also many foreign countries buy US weaponry and expertise, not to mention the geopolitical benefits the US enjoys from its military deployments, so is the current level of US spending on defence providing a negative or positive balance in terms of the economy?
    The health care industry I suspect would be more problematic, in terms of working out benefits and negatives of any reduction in the budget…but I can think of quite a few positives….private R&D for health related technology and drugs being among them.
    Such beneficiaries from the level of govt debt are ‘vested interests’ and include powerful groups capable of sustained media campaigns.
    Probably the one area where there would not be substantive ‘vested interests’ with the budgets to lobby against cuts to funding is in education….unfortunately, so I expect we will see cuts to that budget.
    If defence and health are unable to be cut without massive effects throughout the economy…how much would we all pay for oil if the US military retreated to its own borders? Then increased taxation is the only mechanism left…..and the rich and powerful media moguls will not support that any time soon.

  5. Russell– You have hit the nail on the head. The areas that need to be cut the most (defense and medical spending) are the two sectors that have some of the biggest vested interests. So what we are seeing is the path of least resistance – cuts in areas like education, public transport, etc, which do not have well funded lobbyists in Washington. Needless to say this is very shortsighted.

    And yes, there will always be flow on effects when gov spending is cut, which is why I think the problem needs to be solved over the medium to longer term. Make big cuts now and you will just plunge the economy into another depression.

  6. There are no deficits. There are only tax payers and tax recipients. I don’t voluntarily pay taxes so that a public servant can be paid AUD$1+Million.

    Rule of law?

    Armed forces are public servants in khaki.

    There are no deficits only public servants.