BROOKINGS RESEARCH – “Why did the budget deficit grow so much in FY 2023? And what does this imply about the future debt trajectory?”
The Hutchins Center Explains
The CBO recently released data on the federal budget deficit for Fiscal Year 2023 (the government’s fiscal year ends September 30th). A fiscal year (FY) represents a one-year period in which the government reports how it is (or is not) balancing its budget– comparing the amount it collects (revenues) to what it spends. If spending is higher than revenues, the government runs a budget deficit, which adds to the national debt. The national debt is financed by the government issuing Treasury bonds on which it must pay interest to the buyers of the bonds.
The release of this data for FY 2023 prompted researchers at the Brookings Institute to publish an analysis that compares FY 2023 with FY 2022. After adjusting for a distortion related to Biden’s student loan proposal, the numbers showed that the deficit grew by a lot, not by a little. In FY 2022, the deficit was 3.9% of Gross Domestic Product (GDP, a measure of the size of the U.S. economy). It increased in 2023 to a staggering 7.5% of GDP. This was mostly attributable to revenues falling in FY 2023, dropping from 19.4% of GDP in 2022 to 16.5% of GDP in FY 2023. On the face of it, these two data points are concerning, suggesting a threat with uncertain consequences for the future of our government.
Economists generally warn that a government deficit for any Fiscal Year (FY) over 3% of GDP enters a danger zone, jeopardizing the government’s capacity to keep up with the increasing debt.
The jump from 3.9% to 7.5% looks alarming, but the authors proceed to identify various one-time factors that, if omitted from the analysis, unveil a less serious short-term picture but perhaps a longer-term warning.
The researchers at Brookings found that the primary culprit for the significant escalation of the FY 2023 deficit was a decline in revenue driven by several one-time factors. These included the IRS extending filing deadlines for California residents due to natural disasters, businesses receiving significant refunds linked to pandemic-era tax credits (like the Employee Retention Tax Credit), reduced Fed remittances, and lower profits from loan collections typically remitted to the Treasury. But, in the longer term, underneath these temporary effects, there are the more fundamental deficit drivers like the impact of soaring interest rates leading to higher interest payments and mandatory “entitlement” spending on programs such as Social Security, Medicare, and Medicaid.
The authors argue that a real concern for the future debt trajectory is high interest rates. Interest rates have been low for decades, keeping interest expenses for the US government low. But now, the recent run-up in interest rates could lead to squeezing out of other important government spending (like investments in infrastructure) unless tax revenues increase significantly.
The dire forecasts of rising deficits are largely due to these high-interest payments. As the deficit escalates, so does the debt, which forces the government to pay more interest on Treasury bonds, and so the vicious cycle continues. And if interest rates rise, as they have recently in our economy, we are in trouble.
However, the authors point to one phenomenon that has helped us in the past and could save us again in the future: improving productivity. “Productivity” measures how much each hour of labor produces in goods and services, a number that gets larger usually through innovation and technology. If the economy can grow faster than the deficit through an emerging field like artificial intelligence, the government could generate more tax revenue, keeping up with our growing debt. The graph to the right illustrates the potential impact of this concept, showing how different interest rates lead to an increase in debt as a percent of GDP. However, productivity gains [or] can offset that. [or] counterbalance this effect. This is because when the economy does well, the government collects more taxes from higher individual wages, capital gains, and corporate profits. Put another way, higher productivity boosts GDP, so deficits decrease as a percentage of GDP.