by Rebecca Patterson, Vice Chair, Bretton Woods Committee
United States President Donald Trump’s One Big, Beautiful Bill, signed into law 4 July, is fueling an already heated debate over the US fiscal outlook. Prospects for continued deficit spending to push US government debt levels to record highs led to a sovereign credit rating downgrade by Moody’s Ratings. The administration insists that the bill, together with other policies, will boost growth and reduce the budget deficit as a percentage of GDP.
What is driving the increase of US government debt?
In contrast to budget surpluses between 1998-2001, the U.S. has seen persistent deficits since 2002. This has caused government debt held by the public to increase from about $3.6 trillion in 2002 to nearly $29 trillion at the end of 2024, or from 32% of GDP to nearly 100% of GDP. Less tax revenue and greater government spending on social safety net programs like unemployment insurance adds to deficits during recessions. What’s striking about the last few decades, however, is that the deficit increases were incurred when economic activity was robust. These increases have been driven by tax cuts that reduced government revenues, such as the 14 percentage-point corporate tax-rate cut in 2017, and increased spending, such as $1.2 trillion incurred in the 2021 Infrastructure Investment and Jobs Act. The current administration’s Big, Beautiful Bill is estimated by the Yale Budget Lab to add $3 trillion to the debt by 2034, not including the possibility that some temporary tax cuts are extended. Even before this latest bill, the Congressional Budget Office estimated that debt held by the public would reach 150% of GDP by 2055.
Why does the size of the debt matter more now versus the past?
Economists have voiced worries over the US fiscal situation for decades. Former Federal Reserve Chairman Alan Greenspan was among them in 1988, when the debt was less than half of what it is today as a percent of GDP. To date, the Treasury market’s unique depth and liquidity, plus the leading role of the US economy and a belief in US institutions, have led investors to buy US government bonds even when the U.S. itself was the source of macro stress, such as the 2008 Great Financial Crisis.
While the global dominance of the United States’ economic and financial market position persists, at least two factors make debt fears more serious today. First, foreign investors who own about 30% of US government debt may prove less enthusiastic about absorbing an ever-greater supply of Treasuries. More supply without a similar increase in demand would contribute to higher bond yields, which would weigh on growth through higher corporate and household borrowing costs. Second, larger debts (especially if accompanied by higher interest rates) would increase the cost of servicing that debt. That means more of the revenue the government takes in would go to interest payments instead of policies supporting economic activity. The nonpartisan think tank, the Committee for a Responsible Federal Budget, estimates that interest payments will increase to $1.8 trillion by 2035 from about $950 billion in 2025.
How does the recent US credit downgrade play into these fiscal challenges?
Moody’s Ratings announced on May 16 that it would remove the final major Triple-A credit rating for the US federal government. It cited successive bipartisan failures to address growing deficits and forecast that the US budget deficit could rise to 9% of GDP in the coming decade from 6.4% in 2024. The loss of the AAA rating increases the possibility that global investors will re-examine how much US asset exposure they want to have, potentially reducing holdings.
What fiscal choices could reduce the deficit?
Simply put, the government needs to increase revenues (i.e., taxes) and/or cut spending to reduce the deficit, both politically unpopular options. Spending becomes even more problematic considering that mandatory spending programs that do not require annual approval, such as Social Security, Medicare, and Medicaid, account for about 60% of total spending and are growing quickly because of the nation’s aging population. Defense spending, meanwhile, accounts for about half of all discretionary spending and is perceived as largely untouchable by policymakers. That leaves only 15% of total spending that is more likely to come under scrutiny for possible cuts (see graphic).
Going forward, pressure is likely to build on policymakers to make meaningful structural changes to Social Security, not just because of overall fiscal dynamics, but also because the program itself is expected to be exhausted within the next decade sometime as the baby boom generation retires and the ratio of social security recipients to workers increases. Several reforms that could be phased in have been proposed but not successfully pursued in Congress, from means testing to raising the retirement age and introducing private accounts.
Can the U.S. stabilize its debt trajectory without fiscal austerity?
Most economists believe tighter fiscal policy is a necessary piece of the puzzle to address US debt dynamics. However, faster economic growth can also help slow the rise of the debt/GDP ratio. While it’s too early to have confidence in timing or degree, many analysts believe broadening use of Artificial Intelligence (AI) will support the economy in the years ahead through faster productivity growth.
Even without help from AI, the White House’s Council of Economic Advisors believes that the administration’s policy platform, including the One Big, Beautiful Bill’s tax and spending changes, along with deregulation and tariffs, will boost GDP growth and in turn reduce the primary budget deficit by $5.11 trillion over the coming decade (relative to policies in place before Trump’s inauguration). If successful, they forecast this would cut the debt/GDP ratio to 94% by 2034.
Featured author:
Rebecca Patterson, Vice Chair, Bretton Woods Committee