Debt vs. Deficit: What’s the difference?May 14, 2013 12:00 am
There was news recently that the federal government paid down some of its debt for the first time since 2007. I guess you could argue this is good news: it’s better than not paying the debt down, but why it happened is equally as important. It also leads to another question that confuses many people: What is the difference between the federal debt and the federal deficit? Let’s explore some of these questions.
How the Federal Debt was paid down
Just because some of the debt was paid down, let’s not get too excited. We still have an enormous amount of debt. A portion of the federal debt was paid down in the first quarter of 2013 due to the fact that there was an increase in revenues to the federal government while, at the same time, government spending was reduced. This reduction in spending was caused mainly by the effects of Sequestration. Sequestration was the forced government budget cuts of federal spending that began on March 1, 2013. The increased revenues generally came in the form of higher taxes for wealthy taxpayers along with the increase in payroll taxes for most individual taxpayers. Remember, the payroll tax for individual taxpayers was reduced in 2011, but on January 1, 2013, it was put back to previous levels so the government had a revenue increase immediately in the beginning of this year. Another important fact is that the government has not yet paid the bulk of tax return refunds.
But as I said, don’t get too excited- the regular shortfalls will most likely return very soon. According to an article in the Wall Street Journal, the Treasury said it expects to borrow a net $223 billion in the July-to-September period. And the budget deficit will likely hit $845 billion in the fiscal year ending Sept. 30, which is down from more than $1 trillion the prior four years. Some forecast that the deficit will slowly narrow in the next few years, but that remains to be seen.
Confusion about the Federal Debt
Given all the talk about debts and deficits in Washington, I do have people ask what the difference is between the federal deficit and federal debt. In addition, many people do not realize how the federal government incurs so much debt. To illustrate the confusion, a Washington Senator recently stated that if we end the war in Afghanistan, we could use that money to pay down the federal debt. “How is that possible?” I said to myself…the money used for the war in Afghanistan is BORRROWED! If you stop spending for the war, you just stop increasing your debt. It’s not like the federal government has a bank account that it uses to pay for the war and therefore can use that extra savings to pay down the debt.
What is the Federal Deficit and how much is it?
A deficit is when the government takes in less revenue than it spends in any given year. Revenues are generated mostly from tax receipts. Expenditures are the government spending money on purchases and entitlements such as Medicare and Social Security. When we talk about deficits we are talking about just one year’s worth of deficits. For example, if the government takes in 10 trillion in revenues from taxes and other sources but spends 11 trillion dollars, then the deficit is 1 trillion. The deficit has averaged about 1.2 trillion dollars a year for the last 5 years.
So if there is a deficit, what does the government do to make up the difference? It borrows money or prints money. If the Fed prints money, it could cause future inflation because there could be too much money chasing too few goods which may cause prices to go up. A more common approach for the government to make up the difference is to issue bonds, which is a loan to the government, which in turn increases our federal debt.
What is the Federal Debt and how much is it?
The Federal Debt is the amount that the federal government owes to its bondholders. This debt is the accumulation of all the deficits, and the longer deficits continue, the greater the debt becomes each year. Where confusion sets in many times is when someone hears the government is running a surplus and believe incorrectly that the government has no debt. In fact, the media and some politicians have mentioned many times that during the 90s, the Clinton administration ran a surplus and people mistakenly believed that the federal government didn’t have any debt. As many of you have figured out by now, this was clearly not the case.
So where does the federal debt stand now? According to the Congressional Budget Office the U.S. debt stands at approximately $16.718 trillion! This is a mind boggling amount to anyone. The major concern is that if interest rates were to return to what they were during the 90s, both the deficit and debt would increase tremendously. They would both increase because interest owed on the debt would climb by almost two thirds. We are at historically low interest rates and have been for the last 5 years. The potential for a rise in rates continues to grow as the economy stabilizes. In fact, just last week, the 10 year treasury increased from 1.78% to 1.90% which will directly affect the federal government’s cost to borrow money.
Is the Federal Debt and the current Federal Deficit good or bad?
Some would argue that federal debt is not an immediate problem as long as the economy continues to grow. They argue that increased government spending is needed and that it supports current growth. They feel that cutting spending too aggressively could jeopardize the current recovery. Others say that deficits and the debt will hamper any real sustained economic growth in the private sector and will eventually require an increase in taxes which will burden future generations.
The key thing to remember is that when you hear about the spending problems in Washington, where both sides can’t come to an agreement, they are referring to the deficit, NOT the debt. The paying down of the debt in this country in any significant way is probably unrealistic and may not be needed, as long as the economy grows fast enough and the more achievable reduction in deficits IS achieved. So the next time you are at a party and there are people talking about the deficit and debt, hopefully you will be prepared with a little more information!
Richard Anzelone, J.D. is Managing Director and CCO at StrategicPoint Investment Advisors in Providence and East Greenwich. You can e-mail him at firstname.lastname@example.org.
The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Rick’s opinions and comments expressed on this site are his own and may not accurately reflect those of the firm. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.