Six misconceptions about the deficit and national debt

Six misconceptions about the deficit and national debt

As we head toward the election, one topic that is sure to feature prominently is America’s annual budget deficit and national debt. Relative to the size of the economy, federal debt is at its highest level since WWII. The United States spends about as much on interest as we do on defense. Politicians rightly conclude that this is far from ideal, but are they correct when they say we are doomed? Hardly.

In our January newsletter, we pointed out that there has been no correlation to spikes in national debt and market crashes. And despite the spike in the debt post-COVID, there has not been a crash.

The amount of debt owed to the public is huge, near $30 Trillion. More important than the amount of debt is the extent to which it is a burden. The burden is a function of the size of the debt and the interest payable relative to the size of the economy.

For example, let’s say Tom and Jerry each have $100,000 of debt. Tom pays 18% interest on his debt, makes $60,000 a year and his only asset is a home worth $150,000. Jerry, on the other hand, pays 6% interest on his debt, makes $500,000 a year and has assets totaling $5 million.

Tom and Jerry have an identical amount of debt, but the burden of the debt is clearly a much bigger issue for Tom. The level of the burden is assessed by relating the debt to other factors. Tom’s situation looks so much worse because relative to his income and net worth, his debt represents a substantial burden. Jerry could take on much more debt and still not face as great a burden as Tom.

Today, we want to address some common misconceptions about the national debt.

All the statistics in this discussion are from the U.S. Treasury or the Bureau of Economic Analysis (BEA), an agency of the Department of Commerce. The BEA is tasked with “…providing the most timely, relevant, and accurate economic accounts data in an objective and cost-effective manner…that’s nonpartisan, nonpolitical, and neutral on policy.”

Misconception #1: Today’s deficit and national debt relative to Gross Domestic Product (GDP) makes it the most burdensome in history

The burden a debt causes is a function of the size of the debt, interest rates paid, and the overall health of the entity in debt. While today’s debt level is large, interest rates are low. In fact, the debt burden was 25-30% higher in the 1980s than it is today – even though today’s debt is considerably larger compared to the size of the economy. In the 1980s, federal debt was about 40% of GDP but it is nearly equal to GDP currently. If interest rates continue to fall, the debt burden should remain within bearable levels for the foreseeable future.

Misconception #2: The debt is rising at an unprecedented pace

The debt increases when there is a deficit. Deficits are caused when one spends more than is collected in income. Today’s deficit is just about the same percentage of GDP as it was in 1983. Historically, our national debt has increased by about 8.8% per year. Other than the COVID induced increase in spending, the debt has risen in line with that pace in recent years.

Today’s deficit is just about the same percentage of GDP as it was in 1983.

Misconception #3: More debt should push interest rates higher, and less debt should allow interest rates to decline

The national debt has some influence, but it does not dictate interest rates. In fact, there have been several periods in which the debt seemed to have very little influence on rates, if any. Interest rates began rising in the mid-1960s, but the debt did not grow as a percentage of GDP until the early 1980s. Conversely, in both the 2010s and the 1940s, debt levels rose yet interest rates fell and stayed near historic lows. Inflation levels and the strength of the economy play larger roles in determining interest rate levels than the federal debt.

Misconception #4: Raising tax rates on the rich will lower deficits and the national debt

The idea here is that raising tax rates on higher income individuals will raise revenue and therefore reduce the annual deficit and national debt. A flaw in that thinking is that when rates change, so does behavior. For every dollar that starts going to Uncle Sam, that is a dollar the taxpayer cannot spend, save, or donate.

For the last 75 years, the top rate on individual income has ranged from 70% to just under 30%. Despite all the rate changes, the revenue has held steady in the range of 15-20% of GDP.

In addition to income taxes, there is often a call to increase estate taxes. Such taxes account for a mere 0.6% of federal revenue. However, to raise revenue from that tax, the tax rate would need to increase or more households would need to be subject to the tax. Raising the rate would not raise much additional revenue. The option of increasing the number of households subject to the tax is problematic because to meaningfully reduce the deficit, significantly more households would need to be subject to the tax. This would mean more family farms and small businesses (America’s largest source of jobs) would face forced sales to cover the tax.

Misconception #5: Only one political party is responsible for overspending

As mentioned, revenue has come in at a steady 15% to 20% of GDP for 75 years. The driving factor for the level of the annual deficit has been spending. The track record is crystal clear on this: the government’s propensity to spend more than it takes in is persistent. Regardless of which party held the White House or controlled the respective houses of Congress, overspending has been so persistent that the U.S. has only had a budget surplus in six of 64 years since 1960.

Regardless of which party held the White House or controlled the respective houses of Congress, deficit has been so persistent that the U.S. has only had a budget surplus in six of 64 years since 1960.

Misconception #6: Governmental finances should play by the same rules as households

The last misconception we will discuss today is rooted in our Tom and Jerry example above. It is very easy to say, “If I ran my finances like the government, I’d be broke.” That sentiment is fair. Households cannot persistently spend more than they make and rack up debt indefinitely. However, governments are not households. Governments can in fact maintain debt indefinitely. Governmental debt only becomes a massive problem if the total financial and economic picture looks a lot more like Tom than Jerry.

It is also important to remember that paying interest on our national debt is not a complete waste of money. Some of that interest goes into our pockets because many bank accounts, money market accounts, CDs and a myriad of other securities are backed by U.S. government debt. In addition, some of the debt is used for the benefit of our society like important services, national defense, and infrastructure investments.

At the highest level the solution is not terribly complicated. The deficit will fall, and the growth of our debt will slow if we lower spending, raise revenue (taxes), or deploy a combination of both. Where it gets complicated is what people think should change to lower spending or raise revenue.

Political candidates have widely varying views of how to approach the issues of the deficit and debt and they will express those views with conviction. We encourage all our clients to choose what approaches they support and vote accordingly. However, this Fall as candidates on both sides of the aisle blame the other side for our country not looking like Jerry, please keep in mind that we are still very far from looking like Tom.