So the debt ceiling fiasco is behind us, but are we facing a debt Armageddon?
To me it was fairly clear that it was unlikely the Republicans would take this too far, because previously when they did that, it hurt them at the elections. However, they were able to squeeze an effect of 12-month freeze in the growth of spending. But why not more? Why is this such a difficult problem?
As a quick summary, there are three types of spending. There’s mandatory spending, discretionary spending, and interest on the debt. You could add a fourth type, and we call that tax code spending.
Mandatory spending is two-thirds of the budget. It is written in the law. Social security, Medicare, Medicaid, it’s untouchable. Discretionary spending is 23%. One half of that goes to the military, and these are uncertain times. The remaining that’s discretionary is 11% of the budget.
It’s not a lot to work with when every single time there’s a squeeze, that’s where the cuts are. And anyone who’s dealt with the FAA, with the FDA, with the IRS already knows those agencies are squeezed so badly that it’s actually getting inefficient to squeeze them anymore. A little money would actually be more efficient for the operation of these organizations.
And then finally, interest on the debt is about 5% of the total budget. And that’s largely because interest rates are so low. Long-term rates even today are relatively healthy. This is not something that continues though, if the deficit continues to grow. And in the last 12 months, we have a half trillion dollar spending deficit in the face of a strong economy. So what’s going on?
Well, before we talk about that, in the last section is what we call Tax Code Spending. And this doesn’t get the attention it deserves. These are the deductions, exemptions, and loopholes that are deliberately built in the code to favor a specific group. It is equal to all of the discretionary spending, not just the non-military. It’s a large number.
The challenge for both parties is electoral. And what do I mean by that? Well, two thirds of mandatory spending, social security, Medicare, Medicaid, a few other things, benefits overwhelmingly the 50-plus age group, the demographic that votes. And they vote aggressively.
Military, it is a dangerous world. I don’t think many people are challenging military spending. And again, overwhelmingly the 50-plus demographic would support this. Discretionary spending, 11%, is literally everything that runs the government. The FAA, safety agencies, FDA, all of those agencies and many more come under that small rubric. And there’s a point that every business owner knows when you cut too far, you’re actually hurting the effectiveness, and the efficiency, and the return on investment. We’re well past that point for most of these agencies. And anyone who deals with these agencies knows that. Try calling the IRS and getting an answer in less than two hours.
Now, tax code spending, that’s 23% of the budget. But each break was written to target a specific electoral group, the middle class and retirees overwhelmingly benefit from these groups. So anyone who wants to hold their job in Congress, be they Republican or Democrat, attacks this at their own risk.
So what’s the fix? There are three areas that really are ripe for fixing. First are the mandatory spending items, social security, Medicare, those items. The challenge with mandatory spending is demographic. A lot of these items came along when there were four workers per beneficiary. Today, there are three workers per beneficiary. Before long, it’ll be two workers per beneficiary.
So even if these things only grow with inflation from a taxpayer perspective, or a working taxpayer perspective, those items are doubling in expense. And they’re getting no greater increase in benefit. This is dynamite. And what’s going to happen is, as the baby boomers start to die out and the working generation becomes more electorally aware, it will become easier for politicians to start taking serious action to limit these benefits. Because with only two workers per beneficiary, they cannot continue as they go. Luckily, I’m not running for office.
The second area are tax code spending. Almost every economist will agree that the vast majority of tax code expenditures make no economic sense whatsoever, and they don’t benefit the people who most need it. A great example, mortgage interest deduction. Most Americans don’t itemize. The standard deduction is so large that it adds no value. It’s an upper middle class benefit that costs the treasury an enormous amount of money. There are many, many more items like that. And again, fortunately I’m not running for election.
Third, tax hikes. How they’re going to fix this deficit without tax hikes in the near-term is beyond me. Because these other issues are not fixable in the near-term. And the unwillingness to raise taxes, or better yet, bring in new types of taxes that make economic sense. Consumption taxes are less distorting than income taxes.
These are very difficult problems to solve, and any party that shuts down the government when, in truth, there is no way to solve them overnight, would’ve been crucified at the election.
We wish you the best of investing’s success.
Paul is the founder and CEO of Avion Wealth, LLC. He leads a team of wealth managers in building and executing financial plans for high net worth individuals and families. Contact Avion Wealth to speak with a financial advisor.