The Basics

Understanding the Federal deficit is not rocket science. It is basically a matter of balancing revenues and expenditures. Federal revenues are largely composed of various federal taxes including income, payroll, and corporate taxes. Federal expenditures include a wide range of programs from defense to Social Security.

It is often said about American politics that “The country is philosophically conservative but liberal in its implementation”. Meaning that Americans like to preach a balanced budget, i.e. Americans theoretically want to see a balance between expenditures and revenues. However they have a very big appetite for spending programs and not such a big appetite for comparable taxes. As a result we’ve experienced growing Federal Deficits (with exceptions) over the last 30 years.

To fully understand the issue it is important to differentiate between the structural and cyclical portions of the (Federal) deficit. A structural deficit exists when during a healthy national economy, expenditures exceed taxes. Thus even in the best of economic times you will run a deficit. This is unsustainable as the deficit will grow each year and grow even more so during times of an economic recession. A cyclical deficit is one that occurs only in times of a weak economy; i.e. recessions or depressions. This is largely due to a decrease in tax revenue, which are down because business is slow and both corporations and individuals are earning less thus they pay less tax. In addition during recessions federal spending on programs such as unemployment insurance and stimulus spending to strengthen the economy goes up. The combined decreased revenues and increased spending results in temporary or cyclical deficits but eventually disappears as the economy recovers. Occasional emergencies can also add to the deficit but they are normally short term and of little consequence to the deficit. The exception being costly long term wars.

When people talk about balancing the budget there are only two ways to make that happen. Either raise revenue (i.e. taxes) or cut expenditures (i.e. federal programs). Unfortunately in most cases politicians are hesitant to discuss cutting the defense budget or Social Security and Medicare (commonly known as entitlement programs). All three are often called the third rails of US politics, largely because they are very popular with large segments of the population; any politician who talks about cuts is “electrocuted” by the opposition. Combined, these three programs exceed 70% of the US budget, see below figure. As a result of this hesitancy, most of the political discussion focuses on cutting the smaller remaining programs which include highway (2.2%), education (2.6%), energy (0.8%) and dozens of other small discretionary programs, totaling 19%, thus making significant spending cuts largely impractical.

On the revenue side there are three main forms of federal tax: income, payroll and corporate. The USA income tax structure is seen by many as a progressive tax structure, meaning that high income earners pay a greater portion in taxes because they benefit more from federal programs and they can also afford to pay more. Payroll taxes are much less progressive, than income tax, as they were originally designed to be dedicated to two specific programs 1) the American pension system, known as Social Security, and 2)the American health insurance system for seniors, known as Medicare. Corporate tax is taxes on incorporated companies, often on large companies. Small businesses usually avoid corporate tax but individuals within those small businesses pay income tax on their net profits. In recent decades payroll taxes have grown significantly as a portion of federal revenue, while corporate taxes have shrunk and income tax have remained roughly level, see below chart.