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Thoughts Beyond the Fiscal Cliff

As Congress and the President work together to avoid the looming fiscal cliff, a more intransient problem remains in the background: the United States’ structural budget deficit. The nation’s long-term budget problem cannot be solved by eliminating waste, fraud, and abuse, domestic discretionary programs, and foreign aid alone. All aspects of the budget should be on the table during the fiscal cliff deliberations, and again in 2013 as lawmakers hammer out a longer term fix to our budget mess.

Setting the Stage

In late 2010, three different non-partisan organizations released plans that would put the U.S. on a path toward a balanced budget, using a combination of revenue/tax increases and spending cuts to achieve that goal. These organizations are:

  • The President’s National Commission on Fiscal Responsibility and Reform (commonly known as Bowles-Simpson);
  • Bipartisan Policy Center (commonly known as Rivlin-Domenici); and
  • Pew-Peterson Commission on Budget Reform.

They all generally agreed that there are no easy answers and no quick fixes. Both Democrats and Republicans populated the three commissions. Some hold (or once held) elected office, while others served in the federal government or were on the boards of the many think tanks in and around Washington. All were focused on finding bipartisan solutions to the problem.

In early November 2012, the non-partisan Congressional Budget Office (CBO) released a report called “Choice for Deficit Reduction,” which “reviews the magnitude and causes of the federal government’s budgetary imbalance, various options for bringing spending and taxes into closer alignment, and criteria that lawmakers and the public might use to evaluate different approaches to deficit reduction.”

In general, the three commissions (and the CBO) concluded that in order to successfully tackle the longer term deficit problem, formerly politically untouchable areas must be on the table in any serious negotiation. These areas include:

  • Social Security;
  • Defense spending;
  • Farm subsidies;
  • Medicare;
  • Medicaid;
  • Personal and corporate tax rates; and
  • So-called tax expenditures, more commonly known as personal and corporate tax deductions (e.g., home mortgage interest, state and local real estate tax, or charitable contributions).

The plans put forth by the three deficit commissions did vary on the amount of revenue increases (via some combination of higher tax rates, fewer deductions, and more income subject to taxation) relative to spending cuts (across all categories of federal spending) needed to achieve a long-term path toward fiscal stability.

Slicing and Dicing

The federal budget can be sliced and diced several ways. One way to look at the budget is by function or cabinet post, such as the Department of Labor, Department of the Interior, Department of Defense, etc. Another way is to group the spending categories together by legislative mandate — mandatory spending and non-mandatory spending (also known as discretionary spending). Mandatory spending is all spending that is not controlled through Congress’ annual appropriation process. For the most part, mandatory spending is based on eligibility criteria and benefit of payment rules set into law. Examples include Social Security, Medicare, Medicaid, the Affordable Care Act, and interest on the public debt. In recent fiscal years, mandatory spending has accounted for nearly two-thirds of all federal spending, and this slice of the pie is set to rise dramatically in the coming decade. Therefore, curbing mandatory spending, or changing the way mandatory spending is funded, holds the key to addressing our long-term budget issues. Discretionary spending is what Congress agrees to spend each year on things like national defense, education, Veterans Affairs, the national park system, etc. We will leave the discussion of mandatory spending for another time, and focus this week on defense spending.

Defense Spending: A Sizable Portion of the U.S. Budget

In fiscal year 2012, defense spending was close to $640 billion and is one of the largest categories of discretionary spending. In recent years, defense spending has accounted for between 50% and 55% of discretionary spending, 4.5% of gross domestic product (GDP), and about 20% of overall federal government outlays. During the Reagan administration at the end of the Cold War, defense spending accounted for 65% of total discretionary spending, 6% of GDP, and nearly 30% of all federal government outlays. After the fall of the Berlin Wall in 1989, defense spending as a percent of discretionary spending fell swiftly — bottoming out in 2001 at under 48%, 3% of GDP, and 15% of total federal outlays — just as the “war on terror” and the wars in Afghanistan and Iraq began.

Because defense spending is such a large part of federal outlays, it is often discussed as an area to cut in order to reduce the long-term deficit. Although there is likely some kernel of truth in oft-cited media reports of $600 hammers and $300 toilet seats being purchased by the Pentagon, eliminating all waste, fraud, and abuse from the defense budget, while a worthwhile endeavor, would only make a small dent in overall spending.

Some of the proposals put forth by the deficit commissions and the CBO regarding defense spending include:

  • Freezing defense spending at current levels of GDP;
  • Cutting the rate of increase in defense spending; and
  • Finding savings within the Department of Defense’s procurement system.

The three plans (and the CBO) are clear, however, that simply reducing troop deployment as the wars in Iraq and Afghanistan continue to wind down would not likely be enough to substantially reduce defense spending in the coming years. Thus, in the coming months and years, policymakers face difficult choices about where and how much to cut defense spending. In the report previously cited, the non-partisan CBO summed up the policymakers’ dilemma surround the defense budget:

“Cuts in defense spending could be targeted toward personnel levels, pay rates, and benefits; training and supplies; day-to-day operating and administrative costs; procurement, operation, and maintenance of existing weapon systems; or research and development aimed at producing more advanced weapon systems. However, large and sustained reductions in funding in those areas could have substantial effects on military capabilities and thus could require changes in broad strategic objectives, with significant implications for national security.”

We share the view of the three fiscal commissions that in order to successfully tackle the longer term deficit problem, formerly politically untouchable areas — including defense spending — must be on the table in any serious negotiation.

There will be winners and losers in these negotiations.  They will certainly impact our investments.  As we know more we will make adjustments as needed.  However we are not inclined to make changes until we have some more definitive answers and direction.  Please be aware we have our eyes on the ball and are watching it closely.

Tyler and Troy