The U.S. National Debt Dilemma

Introduction

Economists, investors, and lawmakers are again raising alarm bells about the U.S. national debt. Years of elevated budget deficits, exacerbated by massive federal spending during the COVID-19 pandemic, have taken the debt to historic levels: totaling more than $26 trillion in 2023, U.S. federal government debt is now at its highest percentage of gross domestic product (GDP) since World War II. Equally alarming to many experts is the debt’s unsustainable trajectory, as spending is projected to continue outpacing revenues under current law. 

Today, the national debt is almost the same size as the entire U.S. economy, and the debt is on track to double within the next thirty years. Some economists say that could expose the country to a number of dangers, including a budget crisis, rising interest rates, greater economic instability, and a diminished global leadership role. Reducing the debt will require Congress to make politically difficult decisions to either curb spending, raise taxes, or both. Other experts say the United States can safely afford to continue borrowing at present levels because it pays relatively little interest due to its unique position in the global economy.

How did the debt get where it is today?

The United States has run annual deficits—spending more than the Treasury Department collects in taxes—almost every year since the nation’s founding. (The deficit is a yearly measure, while debt refers to the cumulative amount that the government owes. Measuring both as a proportion of GDP is a standard way of comparing spending over time, because this method automatically adjusts for inflation, population growth, and changes in per capita income.) The end of World War II, after which the United States emerged as a global superpower, is a good starting point from which to examine modern debt levels. Defense spending during the war led to unprecedented borrowing, with the debt skyrocketing to more than 100 percent of GDP in 1946.

Over the next thirty years, sustained economic growth gradually reduced the debt as a percentage of the economy, despite expensive wars in Korea and Vietnam and the establishment of major entitlement programs, including Medicare and Medicaid. Overall, debt as a percentage of GDP bottomed out in 1974, at 24 percent.

In the 1980s, the Ronald Reagan administration vastly increased defense spending and enacted sweeping tax cuts, ushering in a new period of rising debt. During the 1990s, a combination of tax increases, defense cuts, and an economic boom reduced the debt as a percentage of GDP. In 1998, President Bill Clinton and a Republican-controlled Congress oversaw the first of four consecutive years of budget surpluses—the first such streak in forty years.

Deficits returned under President George W. Bush, who led a period of tax cuts, war spending in Afghanistan and Iraq, and major new entitlements, such as Medicare Part D, which added prescription drug coverage to the program. Annual deficits hit record levels—more than $1 trillion—under President Barack Obama, who, in response to the Great Recession, continued the Bush administration’s bank bailout program and provided hundreds of billions of dollars in fiscal stimulus.

What does the government spend money on?

What are the primary drivers of debt growth?

In the immediate future, interest payments on the debt are also expected to increase dramatically in relation to GDP. They have recently risen to their highest levels in more than twenty years as the Federal Reserve raised rates to combat inflation sparked by the pandemic and the Russian invasion of Ukraine. In fiscal year 2023, net interest payments on the national debt reached $659 billion—about 2.5 percent of GDP—and they are projected to surge to nearly 7.5 percent over the next thirty years. On the other hand, discretionary spending—including, for example, spending on defense and transportation—is expected to remain constant as a share of GDP.

The steady growth in federal spending in the coming decades is expected to occur while government tax revenue remains low relative to the size of the economy. In 2017, President Donald Trump signed off on the Tax Cuts and Jobs Act, the most significant tax legislation in a generation. Trump and some Republican lawmakers said the bill’s tax cuts would boost economic growth enough to increase government revenues and balance the budget, but many economists disagreed. The CBO said the law would actually increase annual budget shortfalls and add another roughly $1.8 trillion to the debt over the next ten years. 

The national debt swelled during the COVID-19 pandemic as the government spent trillions of dollars to boost the flagging economy, including on stimulus checks for citizens and aid for businesses and state and local governments. These measures increased the federal deficit to $3.1 trillion in 2020, about 15 percent of GDP—the highest level since World War II. 

President Joe Biden has signed into law several initiatives that are projected to increase the debt, including an infrastructure bill the CBO projected will increase the federal deficit by more than $250 billion over the next decade and landmark climate legislation that independent experts say will add $750 billion to the deficit over the next decade. (CBO and independent models initially projected that legislation would reduce the deficit by almost $250 billion).  Biden has also forgiven $127 billion in student loans, though a wider forgiveness plan was rejected by the Supreme Court. Meanwhile, U.S. foreign-assistance spending reached a seventy-year high in 2022 as the United States provided Ukraine tens of billions in aid to fight off Russia’s invasion, though it remains less than 1 percent of total government spending. As of September 2023, the deficit measured as a proportion of GDP was larger than in any fiscal year in which the United States did not face war, recession, or another emergency.

How does U.S. debt compare to that of other countries?

The pandemic sharply increased borrowing around the world, according to the International Monetary Fund. Among advanced economies, debt as a percentage of GDP increased from around 75 percent to more than 80 percent. As of 2023, the United States’ debt-to-GDP ratio is among the highest in the developed world, behind only Japan and Italy.

However, the United States has long been the world’s largest economy, with no record of defaulting on its debt. Moreover, the U.S. dollar has been the world’s reserve currency since the 1940s. 

High domestic and international demand for the dollar has helped the United States finance its debt. This is because many investors, including central banks around the world, hold dollar-denominated assets, such as U.S. Treasury bills, notes, and bonds, due to their relative safety (low risk), the unparalleled size of the U.S. debt market, and more recently, the opportunity to generate a higher yield than on safe euro- or yen-denominated securities. (These Treasurys are the primary financial instruments that the U.S. government issues to finance its spending.) 

Who holds the debt?

The bulk of U.S. debt is held by investors, who buy Treasury securities at varying maturities and interest rates. They include domestic and foreign investors, as well as both governmental and private funds. 

Foreign investors, mostly governments, hold more than 30 percent of the total. Japan holds the most, with more than $1 trillion; China, which was the United States’ largest creditor for much of the last decade, holds the next most, though its reported holdings have fallen in recent years. Apart from China, Japan, and the United Kingdom, no other country holds more than $500 billion. An increasing share of foreign holdings now comes from governments with large financial-services industries, including Belgium, Ireland, Luxembourg, and the Cayman Islands.

How much does rising U.S. debt matter?

The sheer volume of accumulating deficits, alongside a long-running lack of political will to raise revenue or cut spending, has renewed debate over the peril posed by the national debt.

Some economists fear that continued growth of the national debt could undermine U.S. global leadership by leaving fewer dollars for U.S. military, diplomatic, and humanitarian operations around the world. Other experts worry that large debts could become a drag on the economy or precipitate a fiscal crisis, arguing that there is a tipping point beyond which large accumulations of government debt begin to slow growth. Under this scenario, investors could lose confidence in Washington’s ability to right its fiscal ship and become unwilling to finance U.S. borrowing without much higher interest rates. This would result in even larger borrowing costs, or what is sometimes called a debt spiral. A fiscal crisis of this nature could necessitate sudden and economically painful spending cuts or tax increases. 

What is the debt ceiling?

The debt ceiling is the congressionally mandated limit on how much the Treasury Department can borrow, including to pay debts the United States already owes. Since it was established during World War I, the debt ceiling has been raised dozens of times. 

In recent years, this once-routine act has become a highly partisan game of brinkmanship that has brought the United States near default on several occasions. Experts such as CFR’s Brad W. Setser argue that the United States has both domestic and international incentives to scrap the debt ceiling, which they view as an unnecessary risk. The only other advanced economy to have one is Denmark, and it has never come close to reaching its ceiling.

What are the policy options for dealing with the debt?

Politicians and policy experts have put forward countless plans over the years to balance the federal budget and reduce the debt. Most include a combination of deep spending cuts and tax increases to bend the debt curve.

Cutting spending. Most comprehensive proposals to rein in the debt include major cuts to spending on entitlement programs and defense. For instance, the 2010 Simpson-Bowles plan, a major, bipartisan deficit-reduction plan that failed to win support in Congress, would have put debt on a downward path and reduced overall spending, including for the military. It also would have reduced Medicare and Medicaid payments and put Social Security on sustainable footing by reducing some benefits and raising the retirement age. Economists including CFR’s Benn Steil have called on Congress to create a new bipartisan commission similar to the Simpson-Bowles model.

Raising revenue. Most budget reform plans also seek to raise tax revenue, whether by eliminating deductions and other tax subsidies, raising rates on higher earners and corporations, or introducing new taxes, such as a carbon tax. Simpson-Bowles would have raised more than $1 trillion in new tax revenue. However, more than 80 percent of Republicans in Congress have signed a pledge never to raise taxes, limiting lawmakers’ ability to find compromise on revenue generation. 

Some optimists believe that the federal government could continue expanding the debt many years into the future with few consequences, thanks to the reservoirs of trust the U.S. economy has accumulated in the eyes of investors. But many experts say this is simply too risky, and that time is running out to get the debt under control. Economists at the Penn Wharton Budget Model estimate that financial markets cannot sustain more than twenty additional years of deficits. At that point, they argue, no amount of tax increases or spending cuts would suffice to avert a devastating default. “The debt doesn’t matter until it does,” says Maya MacGuineas, president of the bipartisan Committee for a Responsible Federal Budget. “By taking advantage of our privileged position in the global economy, we may well lose it.”