Text size

“But how will we pay for it?”

The question sounds reasonable, and to many it is sufficient to end any debate about cutting taxes or increasing government spending. Yet there is little reason to be concerned about the U.S. government’s long-term fiscal trajectory. A few minor tweaks should be sufficient to allow for greater spending on worthwhile priorities without much in the way of tax increases.

The Congressional Budget Office projects the federal budget deficit will grow significantly faster than the U.S. economy for the foreseeable future. By the late 2040s, the government is projected to spend 10% of gross domestic product more than it taxes. There is no American precedent for this phenomenon outside of a severe financial crisis or a world war. If this were to occur in an environment of stable inflation and moderate growth, the federal government’s debt would balloon from its current level of about 78% of GDP to more than 150%—and keep rising inexorably afterward.

It would be reasonable, but wrong, to blame the expected deterioration of the budget balance on Social Security, Medicare, Medicaid, and other forms of entitlement spending. After all, spending on these programs is forecast to rise by several percentage points of GDP over the coming decades, thanks to the combination of an aging population and relentless inflation in health-care costs relative to the rest of the economy.

Read more:Just How Bad Off Is Social Security?

Yet the CBO and other forecasters do not believe entitlements are the main contributor to the change in the budget balance because they believe tax revenues will rise almost as much. Incomes are expected to grow more than inflation, which should gradually push many Americans into higher tax brackets. There are also tax hikes scheduled for 2026. The net effect is that the CBO thinks the budget deficit, excluding interest, will hover around 3% of GDP for the next few decades, compared with about 2.5% today.

Editor's Choice

The Treasury Department’s most recent Financial Report of the U.S. Government is slightly more optimistic, probably because it was written too early to account for the tax changes passed at the end of last year. According to the Treasury, the cumulative federal budget deficit between 2017 and 2092, excluding interest payments, would have been worth just 1.2% of GDP. This is tiny, especially when compared with any reasonable estimate of U.S. economic growth.

The concern, therefore, should be the forecast for interest payments. According to the CBO, the portion of the federal budget deficit attributable to debt service is projected to rise from 1.6% of GDP this year to 6.3% of GDP by 2048. This would be unprecedented. That forecast, in turn, is based on the belief that the weighted-average interest rate on U.S. Treasury debt will rise from 2.2% today to 4.4% three decades from now. Rising interest rates, rising debt, and modest growth are supposed to snowball into a rapidly growing deficit and debt ratio.

Interest rates, however, are a function of the outlook for growth and inflation. Growth is forecast to be slower in the future than the present, while inflation is supposed to remain firmly under control. It is not obvious why interest rates should be so much higher in that environment than they have been over the past few years.

Suppose the government’s cost of borrowing held steady at 2%, for example, and everything else stayed the same. In that scenario, the government’s interest payments would stay below 2% of GDP for a very long time. Thanks to the smaller deficit, the debt-to-GDP ratio at the end of the 2040s would be 50 percentage points lower than in the CBO’s baseline forecast. There would be no need to raise taxes or cut spending.

This is not implausible. In fact, it is historically how governments have handled the aftermath of wars and financial crises. During World War II, the U.S. federal debt rose by 64 percentage points of GDP. It returned to its prewar level by the early 1960s—despite recurring budget deficits—because interest rates were held down by the Federal Reserve and by bank regulations, because there was a burst of inflation after the war ended, and because real growth was strong.

The financial crisis and the subsequent policy response has so far caused the debt ratio to rise about 40 percentage points of GDP. An aging population will cause it to rise somewhat further. Low real interest rates are reasonable to expect and would also be helpful for the management of fiscal policy.

Keeping the debt ratio stable should not be considered an end in itself, however, since there are good reasons to think the current level of government debt is too low. Higher government debt (in countries with their own currencies) discourages excess risk-taking and makes the financial system more resilient. The real yield on 30-year U.S. Treasury inflation-protected securities—currently 1.3%—remains far below even pessimistic estimates of the economy’s long-run growth rate even after the most recent uptick. Low rates that provide extra space relative to the CBO’s forecast could be used to pay for additional infrastructure, a more robust social insurance system, or lower taxes.

Whatever your policy preferences, the conversation about the budget deficit should change.

Write to Matthew C. Klein at matthew.klein@barrons.com