Page last updated at 23:47 GMT, Thursday, 15 January 2009

Why is the US budget deficit so big?

By Steve Schifferes
Economics reporter, BBC News

US Budget deficit

When George Bush leaves office on 20 January, one of the legacies he will leave behind is a soaring budget deficit which reached $455bn ($311bn) last year and is set to top $1 trillion in the current financial year.

This huge deficit will make it tricky for the Obama administration to implement its ambitious programmes in health, education, and the environment.

We have no choice but to act aggressively to expand aggregate demand and address the macroeconomic crisis. That will necessarily imply even larger deficits in the near term
Peter Orszag, Obama budget director

Yet when Mr Bush took office, there were four years of budget surplus.

Why has there been such a big turnaround, and whose fault is it?

The Economic Slowdown

While the economic slowdown is an important factor, there are also deeper structural reasons for the deficit.

Increased debt costs for government
Increased risk of inflation
Long-term pressure on dollar
Could lead to higher taxes and spending cuts later

The sharp slowdown in the economy - which the Congressional Budget Office (CBO) projects to shrink by 2.2% in 2009 - will deepen the budget deficit.

Tax revenues are expected to drop by $166bn, or 6.6%, as incomes decline.

Meanwhile, spending on unemployment benefit is expected to nearly double to $50bn.

The Cost of the Bail-out

The cost of the financial bail-out is also causing the deficit to soar.

Congress allocated $700bn to help banks and other financial institutions, of which $350bn has been spent.

Some of this money will be recovered by the government, but the CBO estimates that the real cost of these measures will be about $180bn.

Lehman headquarters in New York
The cost of the financial bail-out has soared

It says that the budget deficit should also include the cost of bailing out the troubled mortgage giants Fannie Mae and Freddie Mac, which were effectively taken over the by government, and could add $240bn to the budget deficit in 2009.

President-elect Barack Obama's plan to spend up to $800bn over two years on recovery will add to the total.

"Nearly every leading economist agrees we have no choice but to act aggressively to expand aggregate demand and address the macroeconomic crisis," Peter Orszag, his budget director says.

"That will necessarily imply even larger deficits in the near term."

But some conservatives argue that the huge deficit is enough of a stimulus on its own.

"We have an unprecedented deficit already in the works," Peter Levy of the American Enterprise Institute says.

"How far beyond unprecedented do we need to go?"

Tax Cuts

Even before the slowdown, two factors created the deficit: tax cuts and the cost of the Iraq war.

President George W Bush
President Bush pushed for tax cuts in his first term

The Bush administration introduced two tax cut packages in 2001 and 2003. As a result, income tax revenues received by the government dropped by $200bn, from $1 trillion in 2000 to $800bn in 2004.

The Obama administration has said they will repeal, or allow to expire, some of these tax cuts, especially for the rich, but keep the tax cuts for people with incomes below $250,000.

The CBO estimates that if all the Bush tax cuts were extended after 2010 it would increase the budget deficit by $3 trillion over 10 years.

But it is still not clear whether the new administration will offer some permanent tax cuts, and how big they might be, in a bid for bipartisan support.

The Iraq War

British, American and Iraqi troops
The Iraq war lasted far longer than planned

The war in Iraq has proved much more expensive initially thought by the Bush administration.

Annual spending on defence nearly doubled during the Bush administration, from $295bn in 2000 to $547bn in 2007, and is higher than spending on all discretionary domestic programmes combined.

The cost of the Iraq war alone is now running at $144bn per year, and is likely to exceed $1 trillion - and by some measures, could reach $3 trillion when all the indirect costs are included.

But a key question is how rapidly the Obama administration intends to wind down its troop effort in Iraq, and how many of them might be redeployed to Afghanistan.

Pork Barrel Spending

During the campaign, much attention was focused on the elimination of wasteful spending, especially "earmarks"- special projects for their home districts that individual Congressmen add to legislation.

The most famous example was the "bridge to nowhere", a project to link a small airport to a town in Alaska at a cost of more than $200m, sponsored by the now-defeated Republican Senator Ted Stevens.

Even Mr McCain's economic advisor, Doug Holtz-Eakin, accused the Republicans in Congress of of busting the budget and bringing "shame and disgrace" on the party.

But in fact the size of earmarks is relatively small in the Federal Budget.

A study by the CBO showed that earmarks accounted for no more than $50bn out of a budget of more than $2 trillion.

To reassure the public - and conservative Democrats - Mr Obama promised to "take a scalpel" to wasteful spending and has appointed a chief performance officer to carry out this task.

Entitlement Programmes

US government spending

In the long-term, by far the largest increase in government spending has been for the two big entitlement programmes, Medicare and social security, which provide health care and pensions for the elderly.

These made up two thirds of all Federal spending, or $1.6 trillion out of the $2.7 trillion budget in 2007.

The projected yearly increase in Medicare spending alone is more than total spending on earmarks.

And this spending in this area has increased dramatically over the last 40 years, when entitlements were only one third of the budget.

Mr Orszag admits that the budget is now on an "unsustainable path."

And he says "the situation is expected to grow even worse as health care costs continue to rise and the baby boomers retire."

But although Mr Obama's health care reforms may save money in the long-term, they could be expensive to implement.

So will not be surprising if the budget crisis leads to a postponement or slower pace for such reforms.

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