Subscribe to our podcast to hear thoughtful perspectives on the business of business.

Part One of Two

The tax reform package that Republican congressional leaders have promised will be ready for President Trump’s signature by Christmas is engulfed in considerable debate over which specific details will make the final cut, which will be left out, who will benefit most, and what the impact on our economy will be.

Those are all important questions that I will discuss in a future blog post when it is definite as to what will be in the final package. The one thing that seems clear is that whatever plan is approved will add at least another $1.5 trillion to the national debt over the next decade.

That figure comes from the bipartisan Joint Committee on Taxation, which scored the proposals and arrived at its estimate based on $5.5 trillion in tax cuts and $4 trillion in offsets. It also considers some degree of “micro dynamic scoring” to reflect probable behavioral changes in the economy.

The question that is receiving little or no debate is: Should we be adding any amount to our nation’s debt at this point?

To answer that question, I believe we need to understand what our current debt is, who we owe the debt to, how much it will grow even without tax cuts, and what impact all of that debt will have on our economy.

I understand why eyes tend to glaze over when economists or lawmakers start talking about hundreds of billions and even trillions of dollars. But I also believe that understanding what those billions and trillions of dollars mean to you, your family, and your future is critically important.

How Much Do We Owe? And To Whom?

Our total federal debt currently totals almost $20.5 trillion, and is expected to grow by 50 percent to more than $30 trillion over the next 10 years, according to the nonpartisan Congressional Budget Office, which produces independent analyses of budgetary and economic issues to support the legislative budget process.

The reason: the CBO projects that mandatory spending—especially on Social Security and Medicare—coupled with interest costs, will grow exponentially, causing trillion dollar annual deficits within 5 years.

The trend has already begun. This past year’s deficit was almost $700 billion, up from almost $600 billion last year.

So who is it that we owe all of this money to?  Approximately $5.6 trillion of our total federal debt is owed to “ourselves”, i.e. to various federal programs: $3 trillion to our entitlement trust funds and about $2.5 trillion to government retirees and other programs. That makes our true “public debt” portion about $14.5 trillion.

About a third of our debt, $6.3 trillion, is owed to foreign shareholders (with $1.2 trillion of it owed to each China and Japan, a quarter trillion each to the Cayman Islands and Switzerland, and $100 billion to Russia, just for full disclosure.) The rest of the total “public” debt, about $8 trillion, is held by U.S households, pensions, corporate America, and various other institutional investors.

How Much Debt is Too Much?

Gross Domestic Product, or GDP, is the value of the goods and services produced by the nation’s economy less the value of the goods and services used up in production. It is the primary measure of economic growth. The question, then, is whether our economy is large enough to sustain this level of accumulating debt, which comes down to whether we are able to service the debt without crowding out our other national spending needs and private capital investment.

Alternatively, although worse: Would we have to “print money” and cause hyperinflation?

Our current nominal GDP is $19.5 trillion, which is close to our debt level. That gives us a debt-to-GDP ratio of 104 percent.

So what?

This is where all these dizzying numbers begin to suggest what we may be facing. A 2008 working paper for the nonprofit National Bureau of Economic Research, authored by economists Carmen M. Reinhart and Kenneth S. Rogoff, found that countries will have serious future fiscal challenges when their debt-to-GDP ratio exceeds 90 percent.

Some even suggest that there is serious trouble ahead when the ratio exceeds 60 percent! And the World Bank concludes that the “tipping point” is around 77 percent. (However, there have been exceptions such as Japan, currently 239 percent of debt-to-GDP.  Nevertheless, many argue that Japan is not a valid benchmark since much of their debt is owed internally, not to foreigners, not to mention it has contributed to their stagnation of zero percent growth over the past 20 years.)

Even if we exclude the “public” debt portion of $5.6 trillion, (as some economists support), the current ratio for the U.S. is about 77 percent, according to the CBO.

However, why should that amount be excluded? After all, as long as America’s retirees are led to believe their retiree trust funds owe them their promised retirement and health care benefits, are those obligations not real? The point is that if the retiree funds were to be consolidated into the overall federal balance sheet on the basis that we owe that amount  to “ourselves,” of course mathematically the liability would disappear. But so, too, would the receivables those retiree funds were counting on to pay out the promised benefits.

But for the sake of argument, let’s say we do exclude the $5.6 trillion of debt “we owe ourselves.” The CBO forecasts that the debt-to-GDP ratio will exceed 90 percent in 10 years (based on the average 2 percent annual real GDP growth we have seen since the Great Recession of 2007-09) and surpass 97 percent if the current tax reform proposals pass.

Historically, our debt-to-GDP ratio did soar higher than that in 1946, peaking at just over 120 percent. But the prolonged economic expansion that followed World War II, with an average 5 percent growth in real dollar GDP per year for several decades, eventually brought our debt ratio down to just above 30 percent in the 1970s. That scenario is very different from what the CBO is forecasting about future GDP growth over the next 10 years, even with tax reform. 

Furthermore, interest costs on our federal debt, currently at 6 percent of federal spending at an average 1.5 percent interest rate on the debt, is forecast to triple over the next 10 years due to increasing interest  rates, as well as the $10 trillion forecasted increase in debt. This will inevitably put pressure on raising taxes or cutting other areas of federal spending.

What Role Do Social Security and Medicare Play in the National Debt?

One of the biggest challenges we face is our future federal obligations for Social Security, Disability, and Medicare.  According to the most recent Medicare Trustees report, on page 212, the combined obligations of those funds to cover everyone alive today as well as those who will be born over the next 75 years is a staggering $50 trillion!

And that amount is after discounting to today’s dollar value, i.e. present value, and it is also after factoring in all the payroll taxes scheduled to be paid in. The bottom line is the trustees project that the assets of the trust funds for all three programs will be depleted within about 15 years.

The problem is pretty simple. We are living longer than the actuaries who pegged the payroll tax rate had planned on when these programs began, and there are fewer contributing workers as a multiple of the number of retirees. As a result, the average household in America will take out $500,000 more in retirement benefits on a present value basis, “apples to apples,” than they paid into the Trust Funds in payroll taxes over the years. And yes, that is after factoring in a reasonable rate of return above inflation being added to the taxes we paid in!

Where Do We Go From Here?

Understanding the nature of our debt and the forecast of its escalation is only the first step.

In the second part of my analysis of the impact of current tax reform efforts on the national debt, which will appear here on ilLUminate in two weeks, I will look at the prospects of addressing this problem with alternative approaches of taxing, cutting, or growing our way out of the hole we’ve dug ourselves into as a nation. And I will also discuss how we can begin to honestly address this important issue.

Related Posts

For more information, see Bob Duquette’s previous two-part series on tax reform: Why We Need True Tax Reform and ’Massive’ Middle Class Tax Relief Is Just Around the Corner! Really?

Robert Duquette

Robert Duquette

Robert Duquette is a professor of practice in the Department of Accounting at Lehigh Business.