3.4: Federal Budgets and National Debt
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Figure \(\PageIndex{1}\) shows the pattern of annual federal budget deficits and surpluses, back to 1930, as a share of GDP. When the line is above the horizontal axis, the budget is in surplus. When the line is below the horizontal axis, a budget deficit occurred. Clearly, the biggest deficits as a share of GDP during this time were incurred to finance World War II. Deficits were also large during the 1930s, the 1980s, the early 1990s, and most recently during the 2008-2009 recession.
Debt/GDP Ratio
Another useful way to view the budget deficit is through the prism of accumulated debt rather than annual deficits. The national debt refers to the total amount that the government has borrowed over time. In contrast, the budget deficit refers to how much the government has borrowed in one particular year. Figure \(\PageIndex{2}\) shows the ratio of debt/GDP since 1940. Until the 1970s, the debt/GDP ratio revealed a fairly clear pattern of federal borrowing. The government ran up large deficits and raised the debt/GDP ratio in World War II, but from the 1950s to the 1970s the government ran either surpluses or relatively small deficits, and so the debt/GDP ratio drifted down. Large deficits in the 1980s and early 1990s caused the ratio to rise sharply. When budget surpluses arrived from 1998 to 2001, the debt/GDP ratio declined substantially. The budget deficits starting in 2002 then tugged the debt/GDP ratio higher—with a big jump when the recession took hold in 2008–2009.
Debt VS. Defecit?
The deficit is not the debt . The difference between the deficit and the debt lies in the time frame. The federal deficit (or surplus) refers to what happens with the federal government budget each year. The public (or Federal government) debt is accumulated over time; it is the sum of all past deficits and surpluses. If you borrow $10,000 per year for each of the four years of college, you might say that your annual deficit was $10,000, but your accumulated debt over the four years is $40,000.
One year’s federal budget deficit causes the federal government to sell Treasury bonds to make up the difference between spending programs and tax revenues. The dollar value of all the outstanding Treasury bonds on which the federal government owes money is equal to the national debt.
The Path from Deficits to Surpluses to Deficits
Why did the budget deficits suddenly turn to surpluses from 1998 to 2001 and why did the surpluses return to deficits in 2002? Why did the deficit become so large after 2007? Figure \(\PageIndex{3}\) suggests some answers. The graph combines the earlier information on total federal spending and taxes in a single graph, but focuses on the federal budget since 1990.
Government spending as a share of GDP declined steadily through the 1990s. The biggest single reason was that defense spending declined from 5.2% of GDP in 1990 to 3.0% in 2000, but interest payments by the federal government also fell by about 1.0% of GDP. However, federal tax collections increased substantially in the later 1990s, jumping from 18.1% of GDP in 1994 to 20.8% in 2000. Powerful economic growth in the late 1990s fueled the boom in taxes. Personal income taxes rise as income goes up; payroll taxes rise as jobs and payrolls go up; corporate income taxes rise as profits go up. At the same time, government spending on transfer payments such as unemployment benefits, foods stamps, and welfare declined with more people working.
This sharp increase in tax revenues and decrease in expenditures on transfer payments was largely unexpected even by experienced budget analysts, and so budget surpluses came as a surprise. However, in the early 2000s, many of these factors started running in reverse. Tax revenues sagged, due largely to the recession that started in March 2001, which reduced revenues. Congress enacted a series of tax cuts and President George W. Bush signed them into law, starting in 2001. In addition, government spending swelled due to increases in defense, healthcare, education, Social Security, and support programs for those who were hurt by the recession and the slow growth that followed. Deficits returned. When the severe recession hit in late 2007, spending climbed and tax collections fell to historically unusual levels, resulting in enormous deficits.
Longer-term U.S. budget forecasts, a decade or more into the future, predict enormous deficits. The higher deficits during the 2008-2009 recession have repercussions, and the demographics will be challenging. The primary reason is the “baby boom”—the exceptionally high birthrates that began in 1946, right after World War II, and lasted for about two decades. Starting in 2010, the front edge of the baby boom generation began to reach age 65, and in the next two decades, the proportion of Americans over the age of 65 will increase substantially. The current level of the payroll taxes that support Social Security and Medicare will fall well short of the projected expenses of these programs, as the following Clear It Up feature shows; thus, the forecast is for large budget deficits. A decision to collect more revenue to support these programs or to decrease benefit levels would alter this long-term forecast.
What is the Long-Term Budget Outlook for Social Security and Medicare?
In 1946, just one in every thirteen Americans was over age 65. By 2000, it was one in eight. By 2030, one American in five will be over age 65. Two enormous U.S. federal programs focus on the elderly—Social Security and Medicare. The growing numbers of elderly Americans will increase spending on these programs, as well as on Medicaid. The current payroll tax levied on workers, which supports all of Social Security and the hospitalization insurance part of Medicare, will not be enough to cover the expected costs, so what are the options?
Long-term projections from the Congressional Budget Office in 2009 are that Medicare and Social Security spending combined will rise from 8.3% of GDP in 2009 to about 13% by 2035 and about 20% in 2080. If this rise in spending occurs, without any corresponding rise in tax collections, then some mix of changes must occur: (1) taxes will need to increase dramatically; (2) other spending will need to be cut dramatically; (3) the retirement age and/or age receiving Medicare benefits will need to increase, or (4) the federal government will need to run extremely large budget deficits.
Some proposals suggest removing the cap on wages subject to the payroll tax, so that those with very high incomes would have to pay the tax on the entire amount of their wages. Other proposals suggest moving Social Security and Medicare from systems in which workers pay for retirees toward programs that set up accounts where workers save funds over their lifetimes and then draw out after retirement to pay for healthcare.
The United States is not alone in this problem. Providing the promised level of retirement and health benefits to a growing proportion of elderly with a falling proportion of workers is an even more severe problem in many European nations and in Japan. How to pay promised levels of benefits to the elderly will be a difficult public policy decision.
Exercises
- A friend lends you $200 for a week, which you agree to repay with 5% one-time interest. How much will you have to repay?
- Suppose you obtain a $3,000 T-note with a 3% annual rate, paid quarterly, with maturity in 5 years. How much interest will you earn?
- A T-bill is a type of bond that is sold at a discount over the face value. For example, suppose you buy a 13-week T-bill with a face value of $10,000 for $9,800. This means that in 13 weeks, the government will give you the face value, earning you $200. What annual interest rate have you earned?
- Suppose you are looking to buy a $5000 face value 26-week T-bill. If you want to earn at least 1% annual interest, what is the most you should pay for the T-bill?
- You deposit $300 in an account earning 5% interest compounded annually. How much will you have in the account in 10 years?
- How much will $1000 deposited in an account earning 7% interest compounded annually be worth in 20 years?
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You deposit $2000 in an account earning 3% interest compounded monthly
- How much will you have in the account in 20 years?
- How much interest will you earn?
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You deposit $10,000 in an account earning 4% interest compounded monthly.
- How much will you have in the account in 25 years?
- How much interest will you earn?
- How much would you need to deposit in an account now in order to have $6,000 in the account in 8 years? Assume the account earns 6% interest compounded monthly.
- How much would you need to deposit in an account now in order to have $20,000 in the account in 4 years? Assume the account earns 5% interest.
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You deposit $200 each month into an account earning 3% interest compounded monthly.
- How much will you have in the account in 30 years?
- How much total money will you put into the account?
- How much total interest will you earn?
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You deposit $1000 each year into an account earning 8% compounded annually.
- How much will you have in the account in 10 years?
- How much total money will you put into the account?
- How much total interest will you earn?
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Jose has determined he needs to have $800,000 for retirement in 30 years. His account earns 6% interest.
- How much would he need to deposit in the account each month?
- How much total money will he put into the account?
- How much total interest will he earn?
- You wish to have $3000 in 2 years to buy a fancy new stereo system. How much should you deposit each quarter into an account paying 8% compounded quarterly?
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You want to be able to withdraw $30,000 each year for 25 years. Your account earns 8% interest.
- How much do you need in your account at the beginning?
- How much total money will you pull out of the account?
- How much of that money is interest?
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How much money will I need to have at retirement so I can withdraw $60,000 a year for 20 years from an account earning 8% compounded annually?
- How much do you need in your account at the beginning?
- How much total money will you pull out of the account?
- How much of that money is interest?
- You have $500,000 saved for retirement. Your account earns 6% interest. How much will you be able to pull out each month if you want to be able to take withdrawals for 20 years?
- Loren already knows that she will have $500,000 when she retires. If she sets up a payout annuity for 30 years in an account paying 10% interest, how much could the annuity provide each month?
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You can afford a $700 per month mortgage payment. You’ve found a 30 year loan at 5% interest.
- How big of a loan can you afford?
- How much total money will you pay the loan company?
- How much of that money is interest?
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Marie can afford a $250 per month car payment. She’s found a 5 year loan at 7% interest.
- How expensive of a car can she afford?
- How much total money will she pay the loan company?
- How much of that money is interest?
- You want to buy a $25,000 car. The company is offering a 2% interest rate for 48 months (4 years). What will your monthly payments be?
- You decide finance a $12,000 car at 3% compounded monthly for 4 years. What will your monthly payments be? How much interest will you pay over the life of the loan?
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You want to buy a $200,000 home. You plan to pay 10% as a down payment and take out a 30 year loan for the rest.
- How much is the loan amount going to be?
- What will your monthly payments be if the interest rate is 5%?
- What will your monthly payments be if the interest rate is 6%?
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Lynn bought a $300,000 house, paying 10% down, and financing the rest at 6% interest for 30 years.
- Find her monthly payments
- How much interest will she pay over the life of the loan?
- Emile bought a car for $24,000 three years ago. The loan had a 5 year term at 3% interest rate, making monthly payments. How much does he still owe on the car?
- A friend bought a house 15 years ago, taking out a $120,000 mortgage at 6% for 30 years, making monthly payments. How much does she still owe on the mortgage?
- Suppose you invest $50 a month for 5 years into an account earning 8% compounded monthly. After 5 years, you leave the money, without making additional deposits, in the account for another 25 years. How much will you have in the end?
- Suppose you put off making investments for the first 5 years, and instead made deposits of $50 a month for 25 years into an account earning 8% compounded monthly. How much will you have in the end?
- Mike plans to make contributions to his retirement account for 15 years. After the last contribution, he will start withdrawing $10,000 a quarter for 10 years. Assuming Mike's account earns 8% compounded quarterly, how large must his quarterly contributions be during the first 15 years, in order to accomplish his goal?
- Kendra wants to be able to make withdrawals of $60,000 a year for 30 years after retiring in 35 years. How much will she have to save each year up until retirement if her account earns 7% interest?
- You have $2,000 to invest and want it to grow to $3,000 in two years. What interest rate would you need to find to make this possible?
- You have $5,000 to invest and want it to grow to $20,000 in ten years. What interest rate would you need to find to make this possible?
- You plan to save $600 a month for the next 30 years for retirement. What interest rate would you need to have $1,000,000 at retirement?
- You really want to buy a used car for $11,000 but can only afford $200 a month. What interest rate would you need to find to be able to afford the car, assuming the loan is for 60 months?
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Suppose you just discovered that your uncle, who died 100 years ago, had left you $2000 as a gift so you can attend college.
- If your uncle invested that money at 4% annually for 100 years, how much would you have today?
- Repeat Part (a), using 4% monthly instead.
- Repeat Part (a), using 4% continuously instead. Compare your answers.
- If $15,000 is invested in an account earning 3% interest continuously, how much is the investment worth after 20 years?
- You want to invest some money so that in 36 years, you will have $100,000. Supposing that you have an account earning interest at 5.2% continuously, how much do you have to invest today?
- You have just found a great investment opportunity, assuring you that the money will be compounded continuously at 9%. How much money do you have to set aside now so that in 10 years you will have $1,000,000?
- Briefly describe the main difference between a “deficit” and a “debt.”
- Give a simple definition for “federal deficit.”
- In FY 2017 (October 1, 2017 to September 30, 2018), the U.S. Federal Government had a total revenue of about $3.33 trillion and total expenditures of $4.11 trillion. The GDP for that year was $20.23 trillion.
- How much was the federal deficit for FY 2017?
- The national debt as of the end of FY 2016 was $672. Using (a), calculate the national debt as of the end of FY 2017.
- Find the debt/GDP ratio at the end of FY 2017.
- Find the deficit/GDP ratio for FY 2017.
- In FY 1987, the national deficit was $150 million. By what percentage did the deficit change between 1987 and 2017 (30 years)?
- So far (as of 2019) there has been just one year when the national deficit exceed $1.4 trillion. Using online resources, find out what year that was and why the deficit was so high.
- What was the last fiscal year when there was a national surplus instead of a national debt?
- The last few paragraphs of the text of this chapter suggest three potential solutions to the crisis of Medicare and Social Security. Discuss the pros and cons of each possible solution listed. What other factors need to be known to decide which is best? The three potential solutions are as follows:
- Dramatic tax increase
- Dramatic spending cut in other areas
- Mandatory age increase for retirement/Medicare eligibility
Contributors and Attributions
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Saburo Matsumoto
CC-BY-4.0