US ECONOMY 101: DEFICIT, DEBT & DOUBT

As we approach the 2012 election season, all voices will converge on a single issue and this time that issue will undoubtedly be the economy.  All candidates (regardless of party affiliation) will tout their ability/plan to fix what is broken and make it stronger than ever before.   But what are we really talking about here?  It might be a good time to understand (albeit at an elementary level) the magnitude of numbers and the implication they may have.

Let’s start off with some basic definitions:

Receipts: Our government earns its revenue by collecting various taxes.  These include individual taxes that you and I file, corporate taxes from companies, payroll taxes from employers, excise taxes which are paid on goods sold or made for sale and other miscellaneous taxes.  Collectively, this income for the government is referred to as Receipts.

Outlays: Once they collect the receipts, the government is obliged to put it to good use on behalf of its people, in other words, spend the money.  In our case, this is spent in four large categories: Mandatory Spending viz. Social Security, Medicare/Medicaid, Federal disability programs, etc.; Defense Expenditures; Non-Defense Spending which is discretionary; and Interest Payments on borrowings.  This spending is referred to as Outlays.  (Discretionary spending is expenses that are determined by Congress each year.  Mandatory spending is authorized by permanent laws and the amount depends on participation rather than Congress.)

National Debt: In case you were wondering how our government would spend more than it earns, the answer is quite simple.  Like the rest of us, our government goes to a bank of sorts and borrows money with a promise to pay interest annually and the principal back at some point of time.  This loan or borrowing is our national debt.

It is important to note the link between deficits and debt.  Not unlike any average household, when you have a deficit you are forced to borrow and create a debt.  Now, as each year goes by, any further deficit you might have will lead to a further borrowing or, in other words, will increase the debt.  In our case, this has been a cycle of enormous proportions and the current debt is about $15 trillion ($15,000,000,000,000).  How much is this really?  Look at it this way.  Every single person in the US owes about $5 million each!!

The Office of Management and Budget (OMB) at the White House maintains historical records of a lot of statistics.  I have used some of their data to create some historical charts which help us understand the changes that have taken place over the past few decades.  The data is from the 2012 proposed budget and provides the current government's estimates for the next 5 years.

Looking at Receipts over the last 50-plus years, the following picture emerges: (click to enlarge)

There was a time when the bulk of the government's income came from corporation and excise taxes. This means that during that period, American companies were doing quite well and paid taxes on their earnings.  Also, the excise tax indicates that a lot of the production was domestic.  As we look down the time-line, production gets outsourced and excise taxes shrink as a percentage of total.  As companies set up off-shore tax shelters, the corporate income taxes shrink as well.  Currently, the largest portion of the government's income is from the taxes that you and I file, along with the payroll taxes our employers file on our behalf.  It is interesting to note the dramatic decrease in corporate taxes.  Over the years, corporations have lobbied with politicians to claim and retain tax breaks and the impact is evident in the chart above.

A similar snapshot of outlays shows the following: (click to enlarge)

So, where does this money that is collected go?  The general impression that an average layperson carries is that the government spends most of the money collected on defense to protect our interests.  This was true about 50 years ago when most of the spending was indeed on defense.  However, in the recent past, this spending pattern has shifted.  The largest draw on the receipts is no longer defense but mandatory spending such as Social Security, Medicare/Medicaid.  As the economy sputters, this spending increases further as more and more people seek government aid.  The other portion that is projected to increase in the coming years is Net interest.  Remember the Debt that we talked about?  Well, we have to pay it back, at least the interest on it.  As the deficit grows, we borrow more.  As we borrow more, we have to pay more in annual interest payments.

Speaking of deficits, let's look at the annual deficit over the past couple decades.  The bars show the annual change in deficit i.e. the year-on-year change in deficit. (A positive change means the deficit was less than the previous year, not necessarily a surplus.) (click to enlarge)

The US has always operated with a deficit, as it is seen in the chart.  However this deficit, or shortfall between receipts and outlays, has been relatively small.  In fact, during the late 90s, US enjoyed a surplus for a few years.  But in the recent past, the spending has increased drastically in relation to the receipts.  In the last 5 years, the deficit has more than doubled.  To put it in perspective, the "war on terror" had a smaller impact on the deficit compared to the housing crisis of 2008.  As of today, the deficit is around $15 trillion.  I remain doubtful about the current government's projection of the deficit being reduced to half in the next 3 years.  I am sure it is a noble intention but unfortunately not very realistic.

In a very basic sense, what you spend in excess of your income will be your debt. The chart below shows the growth of our national debt over the years. (click to enlarge)

Originally, I had tried to look at the debt over a longer period but in that chart, the debt line looked like a hockey stick!  I have added the annual income (or receipts) to put the debt in perspective.  Currently our debt is running about 7 times our annual income.  While this sounds bad enough, let's try to put this in perspective.  If this were a housing loan (mortgage) at 5%, then the $15 trillion house would need an annual payment of $1B.  Or in other words, 45% of your annual income would need to go towards your house payment.  And if you were committed and able to do so then in 30 years, you would own your house.  Unfortunately, this house seems out of reach right now.

Well, what can be done about this now?  Obviously, the two fundamental courses of action are reducing outlays or spending and increasing receipts.  Both are easier said than done given that this lifestyle has become a habit.  Reducing expenses would mean some sort of austerity measure on mandatory programs such as Social Security and Medicare.  Increasing receipts would mean an increase in taxes in some form: individual, corporate or both.  None of these choices is easy to swallow but this ailment will not be cured without strong medicine.

So, as we prepare for the onslaught of perfect solutions from candidates (incumbent and aspiring alike), it might be worth our while to keep in mind the severity of the problem and how important it is for our future to solve this issue.  After all, if the deficit is not curbed then we need to keep borrowing more and increase the debt.  At some point of time, the debt grows so large that you cannot afford to pay back the debt.  There is a term for this situation: bankruptcy.