U.S. Budget Deficit Worse Than You Might Think. Here's Why

Just what is the structural primary balance?

The budget measure that usually makes the headlines in the United States—a deficit of 8.7 percent of GDP for fiscal 2011—is the federal government’s current balance. That is the difference between the government’s total spending and its total income in a given year, expressed as a percentage of the GDP that the economy actually produced. The structural primary balance differs from the current balance in two main ways.

First, the term “structural” means that it is adjusted to remove the part of the deficit or surplus that is attributable to the state of the business cycle. Right now, partway through an incomplete recovery from a deep recession, the U.S. economy is operating well below its potential level. When output drops below its potential, tax revenues fall, unemployment benefits rise, and certain other automatic stabilizers move the current balance toward deficit even if there are no changes in policy. Similarly, during a boom, when output is above its natural level, automatic stabilizers cause the balance to move toward surplus. The structural balance is the surplus or deficit that would prevail, with given policies, if GDP were right at its potential level. Some economists prefer the term cyclically adjusted budget balance.

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Second, the “primary” part refers to the fact that the SPB, on the spending side, considers only program expenditures. Program expenditures include all government purchases of goods and services and all entitlement outlays, but not interest on government debt. The logic is that policies governing program expenditures, along with tax policies, are causes of budget imbalances, whereas interest on the government’s accumulated debt is a result of past policy imbalances.

For completeness, we should add that the OECD methodology on which the chart is based makes two other adjustments to facilitate international comparisons. One is to include all levels of government in order to allow for differences in the centralization of government from country to country. That adjustment is less important for the topic at hand than it might seem. The U.S. federal government accounts for nearly all of the total government deficit, while most states operate under balanced budget rules. Also, the OECD data adjust for the effects of one-off budget operations like tax amnesties or privatization revenues. Those are important for some countries, but much less so for the United States. The OECD uses the term underlying primary balance to refer to its version of the SPB.

Some basic budget arithmetic

To understand why the SPB is a key indicator of long-run fiscal sustainability, we need to review some basic budget arithmetic. In order to be sustainable, the government’s debt must not grow endlessly as a percentage of GDP. If it did, eventually it would get to a point where interest payments alone used up all available tax revenue. Well before that happened, the government would face the stark choice of either defaulting on its debt outright or defaulting indirectly through hyperinflation.

However, as long as the economy is growing, sustainability does not require that the government stop borrowing altogether. It can issue new debt without increasing the debt-to-GDP ratio up to the point where the rate of growth of the debt equals the rate of growth of GDP.

To take the simplest case, consider a government that has debt equal to 100 percent of GDP. If nominal GDP grows at 5 percent, and the government finances a current deficit equal to 5 percent of GDP with new borrowing, the debt-to-GDP ratio will not change. If it has less debt to start with, the maximum borrowing consistent with a constant debt-to-GDP ratio is lower. If we assume an initial debt of 50 percent of GDP and leave the rate of GDP growth at 5 percent, the current deficit must be held to 2.5 percent of GDP to keep the debt-to-GDP ratio from growing. More generally, if the debt-to-GDP ratio is D and the rate of growth of nominal GDP is Q, the maximum permissible deficit is D times Q.

Looking at the primary deficit instead of the entire deficit simplifies the calculation of the maximum borrowing consistent with a constant debt-to-GDP ratio. The reason is that for most countries, the long-run average rate of growth of nominal GDP tends to be about equal to the average nominal rate of interest on government debt. (You can do the calculation in real terms if you prefer, by subtracting the rate of inflation from both the interest rate and GDP growth.) If that is the case, the debt will remain constant as a share of GDP as long as the primary budget is in balance, regardless of the initial level of the debt.

In practice, the average rate of interest is not always exactly equal to the rate of GDP growth, but the difference tends to be small when averaged over a long period. To the extent that the two are different, the interest rate tends to average slightly higher than the rate of growth. When that is the case, the country needs a slight surplus on the primary budget balance to keep the debt-to-GDP ratio constant.

For example, from 1988 to 2007, the relatively stable 20-year period leading up to the recent financial crisis, nominal GDP in the United States grew at an average rate of about 5.6 percent and the average rate of interest on federal debt held by the public was about 6 percent. If those numbers were to prevail in the long run, the structural primary balance would have to be in surplus by 0.4 percent of GDP in order to keep the debt-to-GDP ratio from growing. For some shorter periods, as in 2004 through 2006, the rate of growth has slightly exceeded the rate of interest. When that happens, the debt-to-GDP ratio can be held constant with the primary balance slightly in deficit. These differences of a fraction of one percent one way or another do not significantly undermine the usefulness of the SPB as a measure of fiscal sustainability.

Finally, we need to take into account the possibility that a country may not want just to hold its debt-to-GDP ratio constant over time, but actually to reduce it. In the case of the EU, budget rules require that countries have a debt-to-GDP ratio of 60 percent or less. A dozen countries, including France and Germany, now exceed that limit. To get their debts back down to the 60 percent mark, those countries will have to keep their SPB well in the surplus range. At least one country has already done so. From 1996 to 2011, Sweden reduced its debt-to-GDP ratio from 84 percent to 49 percent by keeping its SPB in surplus by an average of just under 2 percent of GDP.

The United States, of course, is not subject to EU rules, but many economists think it would be desirable to reduce the net federal debt from its current level of nearly 80 percent of GDP. Doing so will take even greater spending cuts or revenue increases than would be needed just to stabilize the ratio.

Looking for patterns in fiscal policy

We have seen, then, that the SPB must be held at or close to long-run balance to make the debt sustainable and in surplus to reduce the debt over time. However, that does not mean that sustainable policy requires the SPB to be unchanged from year to year. There are three patterns for the SPB that are consistent with the long-term goal of holding the debt-to-GDP ratio constant over time or gradually reducing it.