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Why is America’s Budget Deficit So Large?

CAMBRIDGE – America’s enormous budget deficit is now exceeded as a share of national income only by Greece and Egypt among all of the world’s major countries. To be sure, the current deficit of 9.1% of GDP is due in part to the automatic effects of the recession. But, according to the official projections of the United States Congressional Budget Office (CBO), even after the economy returns to full employment, the deficit will remain so large that America’s national debt-to-GDP ratio will continue to rise for the rest of this decade and beyond.

Understanding how to achieve US fiscal consolidation requires understanding why the budget deficit is projected to remain so high. Before looking at the projected future deficits, consider what happened in the first two years of President Barack Obama’s administration that caused the deficit to rise from 3.2% of GDP in 2008 to 8.9% of GDP in 2010 (which in turn pushed up the national debt-to-GDP ratio from 40% to 62%).

The 5.7%-of-GDP rise in the budget deficit reflected a 2.6%-of-GDP fall in tax revenues (from 17.5% to 14.9% of GDP) and 3.1%-of-GDP rise in outlays (from 20.7% to 23.8% of GDP). According to the CBO, less than half of the 5.7%-of-GDP increase in the budget deficit was the result of the economic downturn, as the automatic stabilizers added 2.5% of GDP to the rise in the deficit between 2008 and 2010.

The CBO analysis calls the changes in the budget deficit induced by cyclical conditions “automatic stabilizers,” on the theory that the revenue decline and expenditure increase (mainly for unemployment benefits and other transfer payments) caused by an economic downturn contribute to aggregate demand and thus help to stabilize the economy.