The government’s fiscal year is over
Another federal fiscal year is in the books. The new fiscal year is a time for reflecting upon the past year and looking ahead to the new one. With the presidential election less than one month away, the U.S. fiscal policy outlook is sharply in focus.
Federal spending increased by $392 billion (+7%) for 2024. Outlay growth outpaced nominal GDP growth despite the latter being on track to grow by a very solid 5.5% in FY 2024. Yet, just a handful of spending categories have accounted for the entirety of the year’s outlay growth. Interest spending on the national debt jumped by $227 billion, while spending on Social Security and health insurance for the elderly (Medicare) accounted for a combined $174 billion increase in expenditures. Spending on national defense (+$52 billion) and veterans (+$40 billion) also saw meaningful growth this fiscal year.
Federal government spending is typically characterized as either mandatory or discretionary. Mandatory spending covers programs where total outlays are dictated by eligibility rules, such as age or income. Examples include Medicare (health insurance for elderly individuals) or Medicaid (health insurance for lower-income individuals). In contrast, discretionary spending is set each year by Congress. Congress sets a topline spending amount, and then that pot of money is allocated to various government programs and initiatives. As an example, most national defense activities fall into the discretionary category.
It is the discretionary section of the budget that tends to receive the most attention since these spending levels are set during the annual budget process. When headlines about a government shutdown loom large, policymakers are debating spending levels for the discretionary segment of the budget, while most mandatory spending occurs on autopilot from year-to-year. Yet, discretionary spending only accounts for about one-quarter of federal spending. Spending on Social Security, Medicare, Medicaid and civilian and military retirement benefits are not a part of this process despite accounting for the lion’s share of federal expenditures.
Despite the federal debt-to-GDP ratio jumping roughly 35 percentage points in the five years following the start of the Great Recession, the ultra-low interest rate environment of the 2010s kept interest outlays as a share of GDP near historic lows. Yet, today’s higher rate environment combined with more government debt makes the ongoing climb in debt outstanding a different kettle of fish. The potent combination of another jump in debt outstanding (from 79% in 2019 to 95% in 2024) and interest rates near 15-year highs has led to a rocketing up in interest expense as a share of GDP. Interest expense has grown to account for 13% of all federal outlays over the past year.
At a cost of $843 billion through the first eleven months of the fiscal year, interest outlays have surpassed national defense spending ($798 billion FYTD). While the start of the Fed’s easing cycle may bring some relief to debt expenses in the near term, a return to the benign rates of the 2010s is unlikely to be in store. Under CBO’s baseline projection for the next decade, interest outlays as a share of GDP continue to climb, hitting 4.1% in 2034 under the assumption that the average interest rate on the federal debt is about 3.5%. Even under a more favorable alternative scenario of lower interest rates, the ratio drops back only to around 2.5%. The credit card mentally by the American politicians has resulted in an enormous amount of wasted money, as they pay for the interest rates for the loans as a result of spending too much and borrowing too much.
Unlike interest expense, increasing deficit pressure from rising spending on mandatory spending programs is not a new phenomenon. The aging of the population and rising healthcare costs have propelled spending on Social Security and Medicare to new highs. In FY 2024, Medicare and Social Security will be about 8.8% of GDP. This compares to 8.3% in 2014 and 6.6% in 2004. CBO projects that the trend will continue and that these two spending categories will account for 11.2% of GDP in 2034, creating a structural source of bigger budget deficits in the absence of spending cuts elsewhere or higher tax revenues.
In the absence of any meaningful effort to curtail the structural rise in outlays due to mandatory spending, pressure to limit spending growth increasingly has been directed toward discretionary spending. For defense, more limited spending growth over the past decade has been facilitated by the winding down of the wars in Iraq and Afghanistan, similar to the peace dividend of the early 1990s following the fall of the Soviet Union and end of the Cold War.
Yet, this relief valve for the deficit could be harder to rely on ahead with geopolitical risks on the rise. The ongoing conflict between Russia and Ukraine, conflicts in the Middle East, and tensions with China over Taiwan and the South China Sea point to a potentially more fraught security environment. Defense-related investment already shows signs of picking up. Amid a generally gloomy environment for industrial production, defense and aerospace output has risen 3.3% over the past year versus total manufacturing production being little changed.
The U.S. government generally taxes and spends less than its largest advanced economy peers. U.S. government expenditures across all levels of government (i.e., the spending by central, state, and local levels of government) were 38.1% of GDP in 2023, among the lowest of its peer countries. On the other side of the ledger, revenues as a share of GDP in the U.S. are lower than all of its peers in the G7 and materially below those of some higher-tax economies. This is likely the result of an unusually dysfunctional U.S. tax system with many loopholes and opportunities to deductions, resulting in only 50% of the population and corporations pay any tax at all. The tax system is vastly inefficient and needs a significant revamp.
The trajectory for U.S. fiscal policy depends in part on the outcome of the November 5 election. One key change to revenue collection could come via international trade policy. Former President Trump has proposed a 10% tariff on all imports of foreign goods and a 60% tariff on Chinese goods. If implemented in full, this proposal could lead to a significant increase in tax revenue. The federal government generated roughly $77 billion in tariff revenue in 2023. If Trump’s proposed policy had been in place on the $427 billion American imports of foreign goods that came from China and the roughly $2.6 trillion of imports from all other countries, the U.S. government would have collected more than $500 billion in tariff revenue last year.
Of course, tariffs along these lines would cause imports into the United States to shrink, particularly from China, and as a result that $500 billion figure likely represents more of an upper-bound than a base case. Economic growth also would likely weaken, weighing on other sources of tax revenue. Nevertheless, the federal government would likely collect new tariff revenues worth hundreds of billions of dollars annually under Trump’s proposal, a major increase relative to recent history.
Tax revenues also could be boosted if Congress allows large parts of the Tax Cuts and Jobs Act (TCJA) to expire as scheduled at the end of 2025. Under a return of the tax code to its pre-2018 state, federal revenues as a share of GDP would rise to 18.0% over the next decade according to projections from CBO. This would put revenues slightly higher than the long-run average of roughly 17.3% of GDP.
The fiscal cost of extending the TCJA is sizable. If done without offsetting revenue raisers or spending cuts, a TCJA extension would cost roughly $4.6 trillion over the next decade and increase annual federal budget deficits to 7%-8% of GDP, a degree of borrowing unprecedented outside of wartime or recession. Even so, regardless of how fiscal policymakers deal with the looming TCJA debate, outlays are expected to continue to trend higher, ensuring historically large budget deficits in the absence of Congressional action.
There is plenty to be gloomy about when it comes to the U.S. fiscal policy outlook. The U.S. dollar remains the world’s reserve currency with no obvious alternatives in sight, and the market for U.S. Treasuries is the world’s deepest, most liquid bond market. The United States’ ability to finance its budget deficits is supported by the world’s largest economy, which generates $29 trillion of GDP annually and possesses a substantial amount of wealth.
The U.S. government’s debt-to-GDP ratio is historically high, but it is not without precedent. During and immediately after World War II, the federal government’s debt was roughly the same size as the U.S. economy, just as it is today. It is truly pathetic that the U.S. debt-to-GDP ratio is the same as during the WWII. Putting the U.S. on a sustainable fiscal trajectory once again will require some difficult decisions, including a reformed tax system and significantly lower government spending. Politicians are wasting money and the whole U.S. government is incredibly inefficient.