The federal budget deficit has experienced significant fluctuations in recent years, resembling a rollercoaster ride. In fiscal year (FY) 2019, the deficit was at 4.6% of GDP. However, in FY 2020, the deficit surged to a staggering 15% due to the economic turmoil caused by the pandemic, and the subsequent massive fiscal aid measures implemented in response. The deficit gradually returned to pre-pandemic levels in FY 2022, thanks to a robust economic recovery and the expiration of various pandemic-related fiscal programs.
Unfortunately, the trend of deficit reduction has come to a halt this year. Currently, the federal budget deficit stands at a noteworthy 8.6% of GDP, or 7.1% of GDP when accounting for the Supreme Court’s decision to invalidate President Biden’s student loan forgiveness plan. What factors are responsible for this recent deficit expansion?
Revenue has declined from its recent peak of approximately 19.5% of GDP in FY 2022, which was reminiscent of the revenue levels during the prosperous 1990s tech boom. It has regressed to its long-term average of 17.4% of GDP. While tax revenues from worker incomes and corporate profits have remained stable, decreased receipts from capital gains income, a surge in business tax refunds, and diminishing Federal Reserve remittances have been primary drivers behind the 10% drop in revenue this year.
On the spending side, there isn’t a single dominant factor responsible for the increase in non-interest expenditures compared to the pre-pandemic period. Expenditures on entitlement programs like Social Security and major healthcare initiatives, as well as those related to national defense, veterans’ benefits, and various other spending categories, have been steadily rising.
Interest expenses have witnessed a substantial increase due to higher interest rates. In FY 2019, the federal government allocated about 1.8% of GDP to interest payments. As of the 12 months ending in June, net interest costs had climbed to 2.3% of GDP. Although this remains below the levels observed in the 1980s and 1990s, despite a significantly higher debt-to-GDP ratio today, interest costs are expected to continue rising as maturing debt is refinanced at current elevated interest rates.
On the whole, it appears likely that federal budget deficits in the range of 6-7% of GDP will persist for at least the next few years. If this materializes, it would mean that the annual budget deficit as a percentage of GDP would be approximately two percentage points wider than it was before the pandemic and nearly double the average deficit seen over the past 50 years.
Substantial budget deficits may exert upward pressure on Treasury yields. Research suggests that for each percentage point increase in the structural budget deficit, longer-term yields on Treasury securities may rise by roughly 15-30 basis points, assuming all other factors remain constant. Elevated Treasury yields would, in turn, amplify borrowing costs throughout the economy.
It’s worth noting that Congress has the potential to address the projected budget shortfall by either increasing tax revenues, reducing spending or a combination of both. However, such actions are unlikely to occur before the 2024 election, making 2025 the earliest plausible timeframe for substantial fiscal consolidation efforts.
Fortunately, the United States possesses the capacity to finance these deficits due to its status as the world’s largest economy, generating $27 trillion in GDP annually and boasting over $150 trillion in household net worth. The U.S. dollar remains the world’s primary reserve currency, with no apparent alternatives on the horizon, and the U.S. Treasury market maintains its position as the world’s deepest and most liquid bond market. These factors are unlikely to change in the near future. Nonetheless, the substantial medium- to long-term fiscal imbalance could pose a potential structural challenge for the U.S. economy.