Tracing the Roots of Today’s Fiscal Policy

July 19, 2016

US federal debt held by the public is at a peacetime high of 75 percent of GDP, and the Congressional Budget Office (CBO) expects it to reach 86 percent by 2026 before soaring to 155 percent by 2046. Similarly, CBO projects annual deficits to triple in the next decade, from $438 billion in 2015 to $1.36 trillion in 2026. Entitlements and interest are the most widely discussed drivers of this fiscal outlook. However, the roots of today’s fiscal problems go much deeper, both historically and politically.

When looking at the history of deficits and debt, most studies focus on the modern budget era (1974 onward) using either inflation-adjusted dollars or debt as a percentage of GDP. Instead, in our recent Mercatus Working Paper, we present deficits and debt using dollars not adjusted for inflation, going all the way back to the nation’s founding, because the nominal figures offer a way to compare short-term fiscal patterns over a long period. We find that deficit patterns gradually transform from infrequent deficits during emergencies to systematic deficits every year.

 1702–1857

 1858–1914

The first chart shows that for most of the nineteenth century, the pattern was to run deficits only during periods of genuine national emergency (War of 1812, Mexican-American War, financial crises of the 1840s, and Civil War), but to run surpluses during normal times to pay down the accumulated debt. However, as the second chart demonstrates, between about 1880 and 1914, deficits became slightly more routine, and accumulated debt was paid down more slowly. After the exceptional period of the two World Wars, peacetime deficits became even more frequent and grew larger in magnitude, as seen in the third chart. Finally, the modern budget era, in the fourth chart, features large and growing deficits every year since 1974 (except 1998–2001), in both emergency periods and normal times.

 1915–1973

US Federal Deficit and Debt

We trace the political roots of this gradual change to the decades surrounding the turn of the twentieth century. Between about 1880 and 1930, two informal rules that govern fiscal policymakers shifted. First, new norms of federal spending began to emerge in the electorate, as new demands for spending emerged in the areas of economic security at the household level and economic stability at the macroeconomic level. Second, norms began changing within government as well, as elected office transformed from a temporary duty into a career-long endeavor.

By the early decades of the twentieth century, current voters and professionalized politicians had powerful incentives to increase spending. The new informal norms were thereby codified into durable legislation that would determine how future policymakers must spend. This is the root of entitlement programs and debt-financed stimulus, and this is how chronic deficits got their start. Although the modern budget era has seen numerous legislative and constitutional attempts to constrain spending—or shifts in the formal constraints—the reality is that policymakers have difficulty controlling deficits, and federal debt has marched steadily toward unsustainable levels. In short, informal rules have trumped formal constraints.

Whether today’s policymakers intend or realize it, the evolution of informal and formal fiscal rules continues to shape today’s fiscal policy outcomes. This has led to chronic deficits, mounting debt, a dizzying complexity of tax and budget procedures, and unsustainably large unfunded obligations—all leading toward an overall bad and worsening fiscal outlook. Any serious discussion of reform must start by recognizing the current incentive structure embedded in the budget process. Piling on more formal constraints, without addressing the shifts in the informal rules, will be futile.

The Evolution of Federal Budget Rules and the Effects on Fiscal Policy

November 12, 2015

Most discussion of federal government deficits and debt focuses on recent decades and formal budget rules, such as the debt ceiling, sequestration, and balanced budget amendments. However, the underlying deficit problem goes back much further and is driven in part by changes to informal rules.

A new study published by the Mercatus Center at George Mason University argues that, beginning late in the 19th century, the informal rules that govern fiscal policy began to reward policymakers for increasing spending—even for increasing it beyond the capacity of federal revenues, and therefore at the cost of chronic deficits. Despite numerous legislative attempts to constrain spending over the past 40 years, these informal rules have trumped formal constraints, and the deficit problem has marched steadily on.

With this evolution of federal budget rules in mind, today’s reform discussions must address the deeper problem of informal rules driving systematic deficits and unsustainable debt. Otherwise, formal restraints will not work.

Below is a summary of this analysis. To read the entire study and learn more about its authors, Peter T. Calcagno and Edward J. López, please see “The Evolution of Federal Budget Rules and the Effects on Fiscal Policy: How Informal Norms Have Trumped Formal Constraints.”

TODAY’S FISCAL CHALLENGES

The federal government is suffering from an unsustainable fiscal condition. Under conservative assumptions, the Congressional Budget Office projects that, after temporary, near-term declines, federal budget deficits will increase to 150 percent of their current magnitude by 2023. Federal debt held by the public will exceed $18 trillion within that same decade, according to the Congressional Budget Office’s estimates, and the outlook is even worse if assumed budget disciplines are relaxed.

  • Overspending is driving the long-term fiscal problem more than inadequate taxation. Federal revenues and spending both averaged about 3 percent of GDP from 1792 to 1929. But from 1930 to 2013, average expenditures jumped to 18.5 percent while average revenues increased only to 16 percent. More recent decades show a worsening of the imbalance. Since 1952, for example, federal spending has settled into an average of about 19 percent of GDP, while tax revenue has stayed at 16 percent. The obvious result of this imbalance is chronic deficits.
  • At the same time, fiscal policymaking has become more complex and fragmented and less predictable. As deficits spiked in the first few years after 2000, for example, fiscal policymakers increasingly relied on emergency and supplemental spending bills that evaded spending limits and the formal budget process, while also enacting temporary tax provisions that raised uncertainty in markets and compromised economic growth.
  • The growth of mandatory spending on entitlement programs—which run automatically without annual review or appropriation—has exerted even more deficit pressure, as has the burden of debt service. From 1962 to 2014, mandatory spending has increased from 25 percent to 65 percent of the budget, while discretionary spending has correspondingly dropped from 68 to 34 percent. This trend is projected to continue, with mandatory spending expected to exceed three-fourths of the budget by 2020, according to Office of Management and Budget projections.

THE EVOLUTION OF FISCAL POLICY RULES: KEY SHIFTS IN NORMS

Beginning late in the 19th century, the federal government’s fiscal policy has been driven by two gradual changes to informal rules: a shift away from the balanced-budget norm and the emergence of the career politician.

  • By the early decades of the 20th century, fiscal policy was drawing away from the balanced-budget norm that had prevailed since America’s founding, and toward using the budget to underwrite a stronger safety net for economic security and to manage macroeconomic performance. As the decades passed, these two sets of expectations exerted pressure for increased federal spending, not only during times of national emergencies, but also under ordinary conditions. This led to the acceptance of increased federal spending even at the cost of deficits, rather than balanced budgets, as the new policy norm.
  • During this time, norms in the government were shifting as well. The elected class mutated from a high-turnover group of temporary officeholders into a body of career politicians. In addition, the organization of Congress, political parties, and the executive branch led to a diffusion of budget access and authority within government.

The shift from the old balanced-budget norm to the modern deficit-as-policy norm, coupled with the professionalization of elected office, began to exert enormous pressure on policymakers to increase federal spending. They responded by codifying these new norms into formal law, laying the groundwork for chronic deficits and unsustainable debt.

FROM CODIFYING DEFICITS TO CONSTRAINING OVERSPENDING: 

EVOLUTION OF THE FORMAL RULES

Following these two shifts of informal fiscal norms, numerous changes to the formal rules of fiscal policy emerged. The salient theme in the evolution of formal rules has been the struggle to balance the need for fiscal discipline against the demands of a professionalized government expected to use its budget to promote economic security and macroeconomic management.

  • At the household level, the single most profound change came with the 1935 Social Security Act. Over time, the act centralized responsibility for public assistance and social insurance programs, and started a permanent demand for increased spending on a comprehensive range of social insurance and public assistance programs.
  • Other policy initiatives expanded the government’s role in trying to boost economic performance. The Federal Reserve Act of 1913 centralized responsibility for financial stability and the supply of liquidity during financial crises. The 1946 Employment Act set the objectives of stabilizing unemployment, output, and inflation. The Full Employment and Balanced Growth Act of 1978 (commonly known as the Humphrey-Hawkins Act) extended the Federal Reserve’s macroeconomic goals.
  • In addition, the economics profession began to support the use of budget deficits as a policy tool for achieving macroeconomic stability and avoiding a repeat of the Great Depression. By the mid-20th century, the mainstream positions in academia, the media, and the intelligentsia had accepted the case for countercyclical policy articulated in the 1930s by John Maynard Keynes.
  • In the early 1970s, following a standoff between Congress and President Nixon, lawmakers tried to coordinate their budget activities with the Congressional Budget and Impoundment Control Act of 1974, which put the final touches on the modern budget process. The Budget Act built on the existing committee structures in the House and Senate, but created the Budget Committees to supervise and coordinate the budget process, and a Congressional Budget Office to provide Congress with its own independent fiscal analysis.
  • Because the Congressional Budget Act repeatedly failed to control fiscal outcomes, Congress made numerous other attempts to constrain spending. These included the Omnibus Budget Reconciliation Act of 1981—with its explicit goal of reducing spending—the Balanced Budget and Emergency Deficit Control Act of 1985, the Budget Enforcement Act of 1990, and the Omnibus Budget Reconciliation Act of 1993. These attempts to constrain spending added layers of complexity to the fiscal policy process.
  • Yet despite these efforts, every annual budget since 1974 has experienced a deficit, with the exception of 1998–2001. In sum, by the time Congress was beginning to take serious steps to rein in the budget, the systematic tendencies toward deficit-financed overspending had already been cemented into place.

WHY THE DEFICIT-AS-POLICY NORM TRUMPS FORMAL SPENDING CONSTRAINTS

The diffusion of spending authority among numerous committees of Congress has led to higher transfers, deficits, and debt. This, coupled with other forces, has ingrained the deficit-as-policy norm in federal budgeting.

  • Each committee allocates funds for its segment of the budget—e.g., agriculture, defense, commerce—but when the several appropriations are aggregated, the sum is greater than anyone intended and more than available revenues can offset. Thus, the federal government generates deficits as a matter of routine, regardless of whether emergency conditions are at hand.
  • Meanwhile, safety net programs for the elderly, children, and the unemployed have evolved into permanent entitlements that now absorb two-thirds of federal spending. Relief of economic hardship has motivated historic expansions of unemployment benefits, food assistance, and other safety-net programs.
  • Economic experts argue that increased deficit spending is needed to promote economic growth and that more spending carries only minor tradeoffs because Treasury yields and debt service levels remain low. This deficit-as-policy norm also has effectively granted any group with a good cause access to the federal budget.
  • On the financing side, there is intense pressure to avoid the burden of financing additional expenditures. The lack of future taxpayers’ representation in current policy choices creates a bias in favor of financing current spending through future, rather than current, taxes—that is, a bias toward debt-finance. In the era of professional politics, politicians have a career interest in taking credit for the benefits of additional budget outlays. This incentive creates a systematic tendency toward increased spending, both in good times and in bad.

LESSONS FOR REFORM

The deficit-as-policy norm and the professionalization of politics have become ingrained in American politics and will be difficult to reverse. Serious reform discussions must focus on the fundamental, underlying institutional rules of the fiscal game, including and especially the relevant informal rules. Only then will the people with a seat at the table have the incentive to act systematically to promote fiscal discipline.

Formal constraints on spending—such as a balanced budget rule or fixed spending limits—may be helpful, but will not work unless the public begins to change its view that programs such as Social Security and health care are entitlements. This is a huge challenge that requires gradual changes in attitudes, but the reality is that meaningful fiscal reform does not stand a chance without some further evolution of norms beyond deficit-as-policy.

Reform discussions must start by recognizing that current fiscal challenges are rooted in these deep institutional changes. Effective reforms must focus on institutional rules, both formal legislation and informal norms. Most importantly, changes in public attitudes are needed to move the American political culture more toward a balanced-budget norm—recognizing that the abilities of the federal government are limited, as should be its spending authority.