Getting to Zero: How Congress Could Balance the Federal Budget

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Capitol Building in WashingtonCongress is back in session in Washington, and investors know what that means -- the resumption of "rhetoric for dollars" regarding the U.S. budget and the deficit. But is it possible to summarize the deficit's core issues, sans the rhetoric and the hype? Here's a try:

The nonpartisan Congressional Budget Office (CBO), the legislature's budget tabulator, projects a $1.15 trillion budget deficit for this year, fiscal 2011, and a $766 billion deficit for fiscal 2012. But that was before the Obama administration and congressional Republicans agreed to extend the Bush tax cuts.

The good news from the agreement? Almost no one's taxes will increase in 2011 (except certain lower-income Americans). The tax cut extension also applies to 2012. The bad news? The 2011 budget deficit will likely be more than the CBO's estimate. Economists at Goldman Sachs (GS) are forecasting that this year's deficit will match 2010's $1.3 trillion.

A Deficit That's a Decade in the Making

To be sure, a trillion is an almost incomprehensibly big number. And because trillion-dollar budget deficits started only as recently as President George W. Bush's last year in office, it seems like the era of gargantuan gaps has present-day roots.

However, the $1.15 trillion deficit stemmed from policy decisions stretching back more than 10 years. Individually, each action by the president and Congress (aside from the business cycle, which no one can control) represented a significant allocation of resources -- a major policy decision. Moreover, what's astonishing during the 10-year period is that the nation was unsuccessful at either raising revenue from other sources or cutting other spending along the way to pay for the new initiatives. Among the initiatives/decisions that got to where we are now:

  • Defense spending for the Iraq/Afghanistan wars and for national security programs following the 9/11 terrorist attacks. Impact: increased deficit by $163 billion in 2011.
  • The 2001 Bush individual income/corporate income tax cut. In 2000, individual income taxes totaled $1 trillion; corporate income taxes, $207 billion. Had the 2001 tax cut not occurred and tax payments just kept pace with inflation (likely, given that the U.S. economy was expanding for much of the period), in 2011 individual income taxes would have totaled $1.275 trillion, corporate income taxes $263 billion. Impact: increased deficit by $331 billion in 2011.
  • The 2007-2009 recession. The Great Recession really hurt the nation's fiscal picture, due to increased spending for unemployment compensation, food stamps and other programs, and via reduced tax/fee revenue. Impact: increased deficit by about $250 billion in 2011, according to the Center on Budget and Policy Priorities, a liberal think tank in Washington, D.C.
  • Add about $50 billion for the bank bailout and other financial crisis support programs. All told, $794 billion of the projected $1.15 trillion deficit is due to supplemental war spending, the 2001 Bush tax cut and the recession.
Even excluding the above factors and assuming the deficit "normalizes" after the Bush tax cuts expire, war spending ends and typical GDP growth rates resume, the U.S. would still be running a roughly $356 billion deficit -- slightly less if federal interest payments are reduced. Hardly an insignificant sum.

That means Congress will still have to find additional spending cuts and/or tax increases to balance the budget.

Politically Plausible Cuts


Is it possible to find cuts and decrease spending outside of the initiatives described above? Indeed it is, and the Heritage Foundation, a conservative think tank based in Washington, has outlined $343 billion in what the group calls "available spending cuts."

Now, some of Heritage's recommendations seem more likely to yield savings (replacing the $15 billion farm subsidies program with improved crop insurance) than others (cutting Medicare payment errors in half by 2012 to save $44 billion).

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But according to my analysis, about 50% of Heritage's proposed cuts are plausible, and of these, about 40% to 50% have a chance politically of being implemented, if the cuts affect Republican and Democratic constituencies equally. That would amount to an additional $75 billion in spending cuts.

Some of those savings that could become a reality include about $10 billion from a federal travel budget reduction; $6.5 billion by reducing energy subsidies; $2 billion from merging all four agriculture and research agencies; and $500 million by eliminating business subsidies from the National Institute of Standards and Technology.

To be sure, I don't agree with Heritage's entire list, but the important point is that there are programs that can be cut and in some cases eliminated -- enough to produce another $75 billion in budget savings. That would reduce the budget deficit to $281 billion.

Heritage's list doesn't specify whether the cuts should be made in one year or over several years, only that "Congress needs to start cutting spending now." I'd phase in my $75 billion in cuts over a four-year period, fiscal 2012 through 2015, which would give affected programs and constituencies more time to adjust.

Almost a Rounding Error

Now, how to eliminate the remaining $281 billion deficit? Beginning in 2015, cut about another $100 billion from the Pentagon budget over five years -- roughly $20 billion per year. Even after these reductions, the defense budget would still be roughly $548 billion in fiscal 2016.

Then impose a modest value-added tax to total about $50 billion, which would lower the deficit to about $131 billion, excluding annual net interest savings.

Of course, a $131 billion annual deficit is not a balanced budget. But compared to today's $1.15 trillion gap, $130 billion almost looks like a rounding error.

Congress would need to assess economic conditions in 2016, as well as evaluate increased Social Security/Medicare costs associated with the baby boom generation's retirement, before implementing additional cuts and/or tax increases. Nevertheless, getting to a roughly $100 billion deficit would be a victory in itself.

And it can achieved if Americans, especially policymakers, remember the following:

  1. No single decision created today's deficit -- it took numerous decisions.
  2. It took about 10 years for the budget to get this out of whack, so it's going to take at least five years, probably longer, to return the nation to fiscal health.
  3. For deficit reduction to be fair, it must involve equal sacrifices by both Republican and Democratic constituencies.
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