Who Will Pay for the Federal Debt?

This article is part 1 of a 2-part series

Scott Middleton, CFA, CIMA® and Brooks Urich

The federal government ran a deficit of $3.1 trillion during its fiscal year 2020, more than triple the level of the prior year. Amounting to more than 15% of GDP, the 2020 deficit was the largest as a share of the U.S. economy since 1945. The federal debt, which is the accumulation of all deficits, was over $27.5 trillion at the end of calendar year 2020. As indicated in Exhibit A, the Congressional Budget Office projects that the federal debt as a percentage of GDP will accelerate dramatically in over the next 30 years to unprecedented levels.

How will the U.S. ever get out from under its unprecedented level of debt? Who will pay for it?

Exhibit A

Federal Debt as a Percentage of GDP

Source: Congressional Budget Office, The 2020 Long-Term Budget Outlook, September 2020.

Cutting Spending

The most straightforward solution to reducing the debt load is for the government to spend less than it receives in revenue for a long period of time. Making up for the 2020 deficit in the current fiscal year would entail across-the-board cuts in government spending by about 50%. Social Security, Medicare, and Medicaid benefits total about $2.4 trillion in this year’s spending, and unemployment benefits amount to an additional $500 billion. Imagine a sudden 50% cut in your Social Security, health and unemployment benefits to offset last year’s deficit. Even a 50% cut in these benefits would not make up even one-half of last year’s deficit. All other government spending would need to be cut by one-half as well. As the U.S. recovers from the 2020 recession, there is a nonexistent appetite for even modest spending cuts.

Raising Taxes

The other side of the deficit issue is federal tax revenue. During the 2020 Presidential campaign, Joe Biden promised he would not increase taxes on households earning less than $400,000 per year. Instead, higher taxes would be assessed on corporations and higher-income individuals. The Biden plan is projected to raise $2 trillion and $3 trillion over a decade, or about a 6% increase in federal revenue.

If the Biden tax proposals are passed and the above projections are accurate, it would take between 11 and 17 years for the additional government revenue to pay off just the 2020 deficit. Such increases would barely begin to address the accumulated federal debt in excess of $27 trillion. The danger of significant tax increases is that they could choke off economic growth, leading to a recession and more even more deficit spending.

Elusive Surpluses

The federal government has a very thin record spending less than its income. Since 1969 there have been only four fiscal years when the federal government ran a surplus: the consecutive years of 1998 to 2001. Those surpluses were due to a combination of deliberate cuts in expenditures, higher tax rates, and especially strong economic growth. The total of the budget surpluses from 1998 to 2001 was $560 billion—relatively modest when compared to the current accumulated debt.

Exhibit B

Federal Spending and Revenues as a Percentage of GDP

Sources: Congressional Budget Office, The 2020 Long-Term Budget Outlook, September 2020; Office of Management and Budget, Historical Tables, Budget of the United States Government, Fiscal Year 2021, February 2020; and Peter G. Peterson Foundation.

The largest deficit increases over the past 15 years have been from falling tax revenues during two deep recessions (2008-2009 and 2020) and especially from concurrent, massive spending increases to aid those out of work and stimulate economic growth.

Democrats tend to avoid spending cuts, and Republicans tend to shun tax increases. As the adage goes, politicians may know how to solve the debt issue, but none of them knows how to get reelected after doing it.

Looking Back

Arguably the most important factor in reducing the relative size of the federal debt in the decades after World War II was strong U.S. economic growth. In the 1950s and 1960s the U.S. had strong growth in the number of workers, and even greater growth in real output per worker. The combination of those two factors has not been surpassed in any decade since the 1960s, despite developments in technology.

The U.S. government debt did not pay off its debt after WWII; total debt continued to grow. However, GDP growth outpaced the increase in total federal debt, and the Debt-to-GDP ratio decreased.

A review of the last 120 years or so indicates that Germany, Japan, Russia, Greece, and many other nations have experienced periods of out-of-control debt. Government actions have typically led to either defaulting on sovereign debt or devaluing their currencies, leading to much higher inflation at home. Higher domestic inflation usually makes debt problems worse, not better, as it typically leads to higher interest rates on future government borrowing.

Looking Forward

Every consumer has to pay off his or her loans; individuals’ careers and lifespans are finite. However, because the U.S. is projected to have a perpetual lifespan, it is much more critical that it manages the level of its ongoing debt, as opposed to paying it off completely.

The government may be able to manage its interest payments as long as interest rates on government borrowing remain low, which is a serious uncertainty in the coming years and decades.

Ideally the U.S. will be able to manage its indebtedness through an acceleration in economic growth. However, there are two significant, long-term headwinds for U.S. growth. First, research by American economists Carmen Reinhart and Kenneth Rogoff suggest that economies with higher levels of government debt tend to have slower economic growth rates. Second, the U.S. working-age population is projected to grow very slowly in the coming 20 to 30 years. Some of these headwinds could be offset somewhat through higher worker productivity growth and increased immigration.

Now What?

What potential portfolio changes should investors consider in light of the government’s long-term debt issues? That topic will be the focus of part two of this article.