Until post- WW II government debt in America was largely the legacy of previous wars and typically following each war there was an active effort to raise taxes and retire debt which amounts to a fiscal surplus. Since a fiscal surplus is forced saving that reduces over-all spending, the growth rate of GDP is reduced and hence government debt deleveraging is often deflationary. Post WW II, there were similar concerns of the buildup of the debt to income ratio to about 100% hence the US ran a tight fiscal ship for some time thereafter. In fact, the WW II tax structure was repressive with the lowest marginal bracket at about 20% graduated up to the highest marginal tax bracket of 92%. Other than eliminating the 92% bracket the war time repressive tax structure remained in place until l965 in order to make a conscientious effort to eliminate debt.
However with Keynesian economics emerging fiscal surpluses were considered a threat to economic prosperity so the policy objective become that of balancing the budget each year with a strategy to cap out Government debt growth and grow our way out of the debt problem. In addition to constraining government to a basic balanced budget, Keynesian economics also called for “automatic stabilizers” (spending increases automatically in a recession and the governments tax yield diminishes) that were incorporated into post WW II structures to promote income stability in a recession. This meant we set a course wherein government deficits became the automatic result of recessions which in turn required a philosophy to justify the deficits. The justification became the budget will be balanced over the business cycle and the spending and tax schedules were adjusted to yield a fiscal surplus if there was an economic boom to offset the recessionary deficits. Basically this worked through the l950s with economic growth years generating a fiscal surplus to offset the budget deficits of recessions.
With the Kennedy-Johnson years, while similar Keynesianism ideas were embraced, there was a perception that the government’s commitment to the taxing and trust fund accumulations for Social Security were becoming a fiscal drag for the economy as Social Security was running a surplus at the time. In other words, Social Security funding in essence was conceived to be a balanced budget program over the life of the program but created government surpluses during the years when the Baby Boomer generation was at work rather than in retirement. Hence in l965 the Johnson administration sought to convert the program to “pay as you go.” That means spend the Social Security tax receipts now and worry about funding the entitlements later which was indeed the prevailing attitude. To further deviate from a balanced budget concept the Johnson Administration was successful in getting Medicare passed with inadequate funding for the future. As a result we now face Trillions in unfunded liabilities for this program as will be discussed below.
The Reagan years were interesting in that the candidate pledged to rein in government but inadvertently produced the largest peacetime budget deficit up to that time. With the government running a reasonably balanced budget with the government’s share of spending above 23% of GDP, Reagan’s intent was to downsize government to 19% of GDP hence to run a balanced budget with smaller government. To affect this change, two proposed bills were sent to Congress, one with the tax reduction which Congress gleefully acted on and the other to lower non-military spending which Congress refused to act on. This had the effect of opening a sizable budget deficit which ran for years.
Reagan felt the sizable deficit which in some years approached 6% of GDP as shown below would pressure Congress to act to restrain spending. The standoff continued through Reagan’s entire term in office with the sizable debt accumulation requiring some rationalization. Out of the impasse came two new theories or justifications of the deficit. First, the notion of supply side economics based on restrained tax rates was thought to produce more rapid economic growth that would generated more tax yield as a result and meltdown the debt to income ratio. While it has been shown that GDP growth and tax yields are responsive to lower tax rates this did not produce fast enough growth to eliminate the deficit. With the deficit grinding away year after year, a further justification was needed which became the notion of a sustainable fiscal deficit which was generally thought to be 2% of GDP.
When the structural deficit continued into the George W. H. Bush years with a pledge of “watch my lips, no new taxes,” tremors were felt in the government bond market. That is, the so called Bond Vigilantes began to draw attention to fiscal imbalance and its long term sovereign risk implications of the accumulation of government debt in relation to income. This resulted in the first modern day sovereign risk premiums when the US Treasury was no longer considered to be the “riskless rate.” The relative rising cost of issuing and servicing Treasuries finally caused Bush to call for tax increases. That is, the bond market reined in the government’s inclination to continue to run sizable fiscal deficits which is a phenomenon that is building today.
The Clinton Administration that followed while making further upward adjustments to taxes to contain the deficit none the less were the beneficiaries of a fiscal dividend produced by the tech boom in the late l990s. This serves to show that exogenous stimulus to investment spending can cause an economic boom and generate fiscal surpluses despite the somewhat higher tax rates. The size of the fiscal dividend from the tech boom can also been seen in the deficit graph above and points out that fiscal surpluses can exist side by side with higher taxes if exogenous strong investment influences are at work. If fact, the underlying economic growth was strong enough to create surpluses that allowed the retirement of Treasury debt from 1998 to 2001.
From there the George W Bush years were initially marked by the tech bust that added to the deficit. When the post-tech recession concluded and economic growth resumed, the deficit continued with no effort made to eliminate it and it became called the structural deficit. In the last year of his administration the Great Recession set in and the first Obama fiscal year deficit exploded to 10% of GDP. The prevailing deficit could be considered the cumulative sum of the structural deficit (as would result in times of normal economic growth), the automatic stabilizers set in play by recession, the added stimulus and bailout packages that were forthcoming from 2008 to 2010 and the beginning of the baby boomer entitlement deficits that are just getting underway.