Will "Efficiency" Fix the Budget?

#130: Opportunities and Structural Challenges of the U.S. Federal Budget.

The unraveling of the United States’ finances in the twenty-first century is undeniable. Persistent deficits in good years and crisis spending in bad years have multiplied the federal debt five-fold. As a percentage of GDP, the debt has doubled. The problem can seem intractable, inconsequential, or existential, depending on your economic perspective and timeframe — and the U.S. is not alone among sovereign offenders.

But the problem is getting worse. Beyond discretionary spending, structural challenges of aging demographics and a growing debt burden make addressing the budget harder than in prior generations. And while fiscal responsibility is more often a talking point of the right, both sides of the aisle have taken turns expanding the deficit through tax cuts and spending hikes. Even with fairly optimistic assumptions, the Congressional Budget Office (CBO) projects both the deficit and federal debt as a percentage of GDP to rapidly expand over the coming decades.

In this backdrop, can a new “Department of Governmental Efficiency” succeed in slashing wasteful spending or is it merely toothless lip service to the elephant in the room?

This week, we dig into the Federal Budget.

Breaking Down the Budget

In Fiscal Year 2024 (ended September 30, 2024), the federal government spent 36% more than it took in, raising just $4.95 trillion in revenue while disbursing $6.75 trillion. The $1.8 trillion deficit, equal to 6.1% of GDP, increased for the third consecutive year despite low unemployment and strong economic growth. (Flipping the causality, large deficits were likely a driver of low unemployment and economic growth).

The total Federal obligated budget for FY2024 totaled $8.7 trillion, significantly higher than outlays due to congressionally authorized spending yet to be disbursed as well as nuances in the accounting of the budget. To get a better sense of where all this money is going, we can break down the $8.7 trillion in several ways: by department, category, and expense type.

To state the obvious, a large majority of the budget is concentrated in several major line items — Social Security, Medicare/Medicaid, Interest Expense, and Defense. These expenses make up 78% of the total budget when split by department, or 72% when split by assigned budget category. This reveals some challenging math. Even if the remaining federal budget was slashed entirely, it would not have eliminated the deficit in 2024.

Nevertheless, let’s first consider the feasibility of efficiency cuts across discretionary categories.

Headcount Reductions

Canning Washington bureaucrats is a publicly appealing approach because it suggests savings without the need to increase taxes or reduce entitlements. But the practical opportunity for savings may be fairly limited.

In total, personnel expenses make up 9% of the budget, but the vast majority are salary and pension obligations for the active duty military, veterans and the Department of Homeland Security.

If we assume that “draining the swamp” doesn’t mean reducing active duty military or restructuring veteran pensions, there is just $141 billion in remaining employee costs to address, just 1.6% of the budget. And while national defense is a major cost, it’s worth noting that defense spending as a percent of total government outlays (state, local, and federal) has continuously declined for decades.

Meanwhile, the direct employee costs at targets of the incoming administration, like the Environmental Protection Agency ($2.7 billion) and the Department of Education ($0.7 billion) are a rounding error. In fact, total Federal employees have remained remarkably stable for years at under three million, shrinking significantly as a percent of total national employment.

While I am sure that there are efficiencies to be gained across both defense and civilian departments, it’s simply disingenuous to think that a Federal firing spree will fix budgetary issues. Real savings must involve cutting grants and contracted services. Reducing such outlays in general require congressional approval of a budget, and therefore broader input from the legislature.

How about the “welfare state”?

Income Security

Spending on “Income Security” is a fairly large discretionary category totaling $677 billion or 8% of the total budget. A frequent target of budget hawks, this category is made up of many different programs across several different departments. A meaningful portion of this amount is government retirement obligations, which account for a third of the category.

Beyond retirement obligations, Income Security includes SNAP benefits, housing assistance, supplemental Social Security, and refundable tax breaks like the Earned Income Tax Credit and Child Tax Credit. Together, these expenses total $460 billion, or 5% of the total federal budget.

Below, I’ve detailed both the broad categories of Income Security as well as the major programs that could be considered income-qualified direct transfer payments or assistance, which totaled $382 billion this past year.

The size, scope, and eligibility criteria of many of these programs remain contentious. But in total, they add up to a meaningful portion of the discretionary budget and have consistently grown over time. When combining Medicaid with other transfer payments (but excluding Social Security and Medicare), the total percentage of all state, local, and federal government payments to individuals has steadily increased over the decades and now make up over 20% of total government spending.

But, again, while a new administration may be able to make certain adjustments to these items unilaterally, much of this spending is statutorily determined by congress. Further, given the sensitivity of these programs socially and politically, material changes are more likely to come through legislative action rather than an “efficiency push”.

Other Spending

There are several other discrete spending items that stick out — many of which are products of the current administration’s executive actions or spending bills that will naturally conclude.

For example, more than half of the Department of Education’s $190 billion budget in 2024 was driven by student debt forgiveness. Similarly, more than half of the EPA’s $46 billion budget in 2024 is allocated to the Greenhouse Gas Reduction Fund, a product of the 2022 Inflation Reduction Act (IRA) that is unlikely to continue. Other spending allocations of the IRA, CHIPS and Science Act, and the Bipartisan Infrastructure Bill will continue to show up in departmental budgets, though with finite lives.

In other policy-sensitive areas, foreign defense aid might decline — though subject to successful diplomatic efforts more than cost-cutting. Meanwhile, migrant and refugee costs totaling $12 billion in 2024 across multiple departments may be reduced, but on the flip side, new administrative priorities will add costs elsewhere, like increasing the $18 billion budget for the Border Patrol.

As you move deeper into the weeds, the expense items naturally become more obscure and less obviously essential, but also immaterial in terms of total budget impact.

Government Efficiency?

There are clearly ways to reduce discretionary spending on the edges, including federal job cuts, contracted service cancellations, and grant reductions — but the composition and cooperation of congress is key. When combined with the roll-off of one-time authorized outlays, there is perhaps several hundred billion dollars of savings to be had in the near term — far from bridging the budget, but not immaterial.

Further, increased asset values in 2023 and 2024 are likely to lead to an increase in capital gains tax receipts in the coming two years as we saw in 2022 after the prior bull market. For all these factors, the deficit may well shrink in the immediate year ahead.

But focusing on discretionary cutbacks and short-term wins ignores the greater structural challenges in mandatory spending.

Structural Woes

Two major structural issues plague the largest components of the budgets, and they will only get worse over the long term. First, an aging population is putting significant pressure on both Social Security, Medicare/Medicaid, as well as the various government/veteran retirement obligations noted above. Second, the accumulation of federal debt combined with a normalization of interest rates is greatly exacerbating the net interest expense — now over $1 trillion and the second largest specific line-item after Social Security.

The CBO’s long-term budget projections make the consequences painfully clear despite its generous assumptions. Its projection assumes an increase in total revenues as a percent of GDP driven by individual tax hikes (based on the now doubtful assumption of a 2017 Tax Cut and Jobs Act expiration). Further, it assumes discretionary spending is reduced, already taking credit for some level of “efficiency” or “cost cutting”. Finally it assumes long term borrowing costs of just ~3.5% perpetually, despite the fact that the entire U.S. Treasury yield curve trades above 4.3% today.

Even still, the increase in mandatory spending on Social Security and Healthcare will expand significantly in the years ahead. Interest expenses meanwhile are projected to double from today as a percentage of GDP by 2054. Even with a consistent primary deficit of 2%, the total deficit is only projected to increase from here.

Social Security / Healthcare

Social Security has already reached an inflection point. In 2008, disbursements began to exceed total payroll contributions to the Social Security Trust. In 2020, disbursements began to exceed the total income of the trust (which includes contributions, interest income, and taxes paid on disbursements). As a result, the Social Security Trust is now in decline.

While the decline seems gradual so far, it will accelerate as the funding gap widens. The CBO estimates that the fund will be depleted by 2033 — less than a decade away. Rebalancing Social Security through the end of the century would require either an immediate 41% hike in payroll taxes from 12.4% to 17.4%, or a 26% permanent reduction in Social Security benefits. If Trump succeeds in his campaign promise to eliminate tax on Social Security, the Trust depletion will occur even faster, and the required adjustments will be even greater.

The CBO also projects that government provided Healthcare costs will increase 7% annually over the next decade both due to greater enrollment (aging) and rising medical cost, double the growth rate of GDP. This would continue the decades-long trend of outsized growth in Medicare and Medicaid expenses relative to the economy.

Attempting to address either of these issues would require a hard conversation about both taxation and the scope of government benefits. Instead these outlays are likely to be funded through debt — debt that is increasingly unaffordable.

Net Interest

For 40 years from 1980 to 2020, declining interest rates caused net federal interest expense to decrease as a percent of GDP despite total debt increasing. But the consequence of an ever-growing debt pile is increased sensitivity to interest rates.

As inflationary pressures (driven in large part by deficit spending) pushed interest rates higher, net interest expense has doubled — growing from ~$550 billion in 2021 to $1,100 today, or 3.8% of GDP. Interest as a percent of GDP has not yet broken into uncharted territory, but the current predicament is far different from the past.

• In 1980, when interest expense equaled 3.8% of GDP, the average interest rate on government debt was nearly 12%.

• In 1999, when interest expense again crossed this threshold, the average interest rate was over 6%.

• Today, the average interest rate is just 3.3%, but growing as federal debt is refinanced at market prices.

Of course, short-term rates are being cut — perhaps we return to the ultra-low interest rates of the past decade. But even the Fed’s estimate of the long-run neutral rate has been continuously revised upward in the past year, a stark reversal of the prior decade’s trend. Again, there is a circularity to the stimulative effects of government debt, economic growth, and inflation.

Simply put, the government can’t afford to pay over 5% on its debt without blowing out the deficit far beyond the already dour long-term projections of the CBO. Ultimately, fiscal dominance — monetary policy accommodating fiscal policy — may be the likely solution, with unknown consequences.

Conclusions

I do think that it is possible for sharp-elbowed outsiders to make the federal government more efficient, trimming fat here and there and helping to improve the country’s finances on the margin. I generally welcome this effort.

But the budget this year or next is not the main issue. Addressing the long-term structural challenges are necessary for the decades to come. If these core issues of demographics, entitlement spending, and overall revenues are to be addressed, it won’t be from executive-appointed cost cutters. Rather, it will require wholesale legislative changes, with implicit buy-in from the population.

At the outset, I called this problem intractable, inconsequential, or existential. Some say this topic is simply irrelevant, governments can print forever — just look at Japan! Some cite Ray Dalio’s Changing World Order and claim the nation is in decline. Some simply accept reality and enjoy the stimulative benefits to the private sector today.

For me, I look at math — and the math is only getting tougher.

Until Next Week,

The Last Bear Standing