Masking the federal budget deficit

A very good article by my colleague, Ahsan Habib:

By Ahsan Habib
Daily Telegram

ADRIAN, Mich. —

Two things happened on April 21. First, I looked at my copy of the Wall Street Journal. The headline said “Debt Masking Under Fire,” referring to a practice of Wall Street banks.

Second, the 2010 edition of the Economic Report of the President came in the mail. I opened to Page 423, a historical table of government finance. According to the table, in 2009 the federal debt reached an unprecedented level of $1.5 trillion. The same table also shows that during 2009 and 2010, the federal government’s debt increased by about $1.9 trillion dollars not by 1.5 trillion, the size of the deficit.

Why did the debt increase by about half a trillion dollars more than the budget deficit? Is there a debt masking by the federal government as well?

The answer is yes. In 1968 President Johnson signed into law a provision which would let the federal government treat Social Security funds as current year revenue. They gave up the age-old principle of measuring revenue by the taxes collected for current expenditures. Every year the federal government receives some money from the public not as tax per se but as payment for future claims.

There are about half a dozen such accounts. The list includes Social Security trust fund, civil service retirement fund, federal supplementary medical insurance trust fund, federal hospital insurance trust fund, unemployment trust fund, military retirement fund, transportation trust funds, employee life insurance and more. Money in these accounts is not tax revenue for current expenditures. These are payments for the future obligations and are meant to be kept as reserve. That is how these funds operated since their inception, and it continued until 1968.

The net effect of the new reporting rule was to reduce (mask) the federal deficit as long as the trust funds were in surplus. In subsequent years, several attempts were made to reverse the procedure and treat Social Security as an off-budget item. 1986 was set as a target year when this reversal would take place. But in that year, the Gramm-Rudman-Hollings rule threatened to cut many programs. So the federal government found an easy escape from Gramm-Rudman-Hollings mandated cuts by using the trust funds surpluses to reduce a deficit. Similar concerns also prevented another attempt to revert to the old system during early 1990s.

With President Johnson’s proclamation, “reported” federal deficits went down. But some people were not happy with that. That is why they refused use it in showing the debt level of the government. As a result, the economic report of the president reports two types of federal debt: one that is held by the public and the other, the gross federal debt. Clearly the latter is larger than the former. To see why the latter is the true measure, ask anyone what is our current national debt. No one will say it is $7.5 trillion, which emerges if we ignore intragovernment debts. Rather, everyone will say that the federal debt now is about $12 trillion or about 83 percent of our GDP.

This masking of federal budget deficit also explains the paradox of how we had federal budget surplus for three years during the time of President Clinton, but our national debt still increased every year. This happened because in each of those so-called surplus years the federal budget would have shown a deficit if the intragovernment debts were not counted as current revenue.

In March of 2010, an unprecedented thing happened. For the first time, Social Security paid more than it collected in revenue. Which means instead of adding to the Social Security trust fund and hence lowering the federal budget deficit, it will actually increase the federal budget deficit. This will make the people in Washington very uncomfortable.

My prediction is that sometime in the future, either by President Obama or by a future president, rules of the game will change again. Instead of including Social Security funds in the current budget, they will propose to treat the funds as off-budget item, the way it was prior to 1968.

Perhaps the practice of debt masking will be clear from the following example. Say my monthly income is $600 and each month I spend $800. I have a monthly deficit of $200. But suppose my brother gives me $250 each month to save for his son’s college education. I use that money to mask my deficit and claim to have a surplus of $50.

Looks great until my nephew goes to college. Then I will have to come up with a huge sum of money to start the payback phase of my life. It appears our federal government has now entered its payback phase.

Ahsan Habib is a professor and chair of the economics department at Adrian College.