Reality Check – Strategies for Reducing Our Debt-to-GDP ratio

Monday’s Reality Check – a weekly presentation of facts and figures to help us all discuss important issues with some degree of understanding. Because, despite living in this post-modern, post-truth world, the fact remains that facts still remain.

Continuing our discussion of the federal debt and deficit, today we are going to look at some general strategies as to how we might reduce the annual deficit as well as the outstanding national debt.

As we noted earlier, the consensus of economists is that the level of debt compared to annual GDP should not exceed 60 or 70 percent under normal economic conditions. Currently, as of 2015, the US debt-to-GDP ratio was about 100%, although it should be noted that the economic conditions of the last 7 years have hardly been normal. And it should also be noted that this is not the first time the US debt-to-GDP ratio has been at levels like this – it was similar to current levels at the height of the Great Depression in the 1930s and reached well over 120% by the end of World War II. So it is not like we haven’t been here before in the wake of an enormous economic shock.

Most of us, when faced with a large debt that we are looking to reduce, would first address the issue by making sure that we stop adding to that debt, by eliminating our annual deficit.  And, for most of us who are actually spending more than we are making, the only option is to cut spending.  And that is clearly one of the options for eliminating the annual deficit, with the hope that we could get to an annual surplus that we could use to start paying down the debt. An earlier post broke down current spending, noting that 65% of spending goes to non-discretionary items such as Social Security and Medicare/Medicaid. And, of the remaining 35% that is discretionary, the military budget accounts for nearly 55%. And, as we saw in the graph in the previous post, despite all the political posturing over the past 40 years, the level of spending has never fallen below 17.39% (in 2000) and hovered in the mid-18% range for the pre-recession years in the early 2000s.

So let’s look at the other side of the equation  – federal revenues and their composition.  Unlike most of us who can hardly go in to the boss and demand a raise, the federal government can, in fact, increase revenue. The obvious method for doing this is to simply raise taxes and, in theory, that will raise more revenue. First, let’s understand what the composition of federal tax receipts look like.  At present, almost 80% of federal tax revenue comes from the payroll and income tax. But it wasn’t always this way:

Corporate income tax has shrunk substantially as a percentage of federal revenues over the last 60 years while payroll taxes have increasingly made up that difference. Somewhat surprisingly, income tax revenue of that period has remained pretty constant. But the composition of that income tax revenue has also changed enormously since the 1980s. The graph below shows the effective tax rates (this includes all revenue paid to the federal government by individuals) over the last 50 years:

As you can see, the rates for the top 1% have dropped dramatically, the rates for the bottom 40% have also come down as well, and the for mass of us in the middle, rates have pretty much remained the same.

Besides cutting spending or increasing tax rates, a third method for bringing down the debt-to-GDP ratio is to simply grow the economy. A fast-growing economy will normally result in increased revenue without any increase in tax rates. Additionally, if you could get GDP to grow at 4% and your annual deficit still amounted to 3% of GDP (near its current level), your debt-to-GDP ratio would start to decrease. And this is what happened in the late 1990s when a combination of a booming economy and tax increases lowered out debt-to-GDP ratio by about 9%.  The reverse is also true, which highlights why a prolonged downturn like that one we have just experienced for the last 8 years is so damaging to our debt situation.

And lastly, the one other method to reduce the debt that dare not mention its name – inflation. Just like the French after World War I, our economic generals seem determined to fight the last war – the one against runaway inflation in the 1970s. Inflation will tend to increase tax revenue while also reducing the real value of the prior debt. This is in fact what happened in the late 1970s – the annual deficit was running about 3% to 4% of GDP but the actual debt-to-GDP ratio decreased in that period because inflation was running far above that.  Now, no one is recommending that kind of runaway inflation, but certainly a return to the long-term average of between 3% and 4% could help improve our debt-to-GDP ratio.

So those are the general choices for cutting the debt going forward.  A combination of all of the above would certainly be effective, but getting the economy to grow at a robust rate as soon as we can is clearly the most painless solution for all. That’s just a fact.