Smith Faculty Opinion Article
The 30 Seconds Outlook
June 1, 2010
“I do not think it is overstating things to describe our current budget
situation as a crisis.”
—Arnold Kling, The American, May 4, 2010
A major budget and deficit crisis is upon us, yet do you see any corrective
action by Obama and Congress? One only has to understand the deficit
implications of ObamaCare to know the answer is negative.
To gain appreciation of the current size of the Federal debt relative to GDP,
it is useful to remember that after World War II the ratio was over 100% and we
recovered from this war burden.
In 1950-54 the ratio decreased to 59.5% due to a large surplus in 1948 and large
increases in GDP in 1948-49. This latter ratio yet remains the highest in all
five-year periods since then.
Proper calculation of the ratio of Federal debt to GDP does not lie in the
ratio of the Federal interest rate to the GDP growth rate, which implies tax
revenue grows at the same rate as GDP. As Kling reminds us, the correct approach
to computing the Federal debt to GDP ratio requires a comparison of the Federal
interest rate to the growth rate of tax revenue. The interest rate is computed
as the ratio of the period interest expense to outstanding debt at the end of
the previous period.
The first step is to compute the “primary surplus,” which is the difference
between tax receipts and government purchases. A primary surplus reduces the
ratio of government debt to GDP. Also, when the GDP growth rate is higher than
Federal interest rate, the ratio of debt to GDP falls. On the other hand, a
“primary deficit” increases the ratio of debt to GDP. In addition, when the GDP
growth rate that is lower than the interest rate, the ratio of debt to GDP
increases.
The implications of this analysis are not pleasant to behold. In fiscal 2009
the ratio was 53%, but the current CBO estimate is that the ratio of debt to GDP
will be at least 90% by 2020 and increasing thereafter.
We have no history of reducing the ratio of debt to GDP solely through
economic growth. It is therefore essential that we use fiscal discipline and
reform to restore a primary surplus. There are several roadblocks to this in
huge entitlements and also in high taxation at state levels that reduce
potential for tax increases.
John A. Haslem
