You are walking to your sunny destination on a beautiful spring morning when you notice a huge can obstructing your path. You kick the can down the road and notice it is quite heavy. When you come upon the can again, you kick it and notice it is much heavier. This happens repeatedly until the can is so heavy it barely budges. You kick the can so hard you break your foot; the can bursts open, spilling its contents: the ever-increasing federal debt and the interest payments on it.
Murad Antia
We are getting closer to that breaking point. Until about a few years ago, we could manage this challenge. But generous tax cuts combined with spending increases are growing the debt at an unsustainable rate. Since 2000, net government debt—debt outstanding minus U.S. Treasury assets — has tripled as a percentage of gross domestic product. Higher interest rates, driven by rising inflation and higher debt levels, make the debt riskier and will increase interest payments exponentially.
Because of rising inflation, the Federal Reserve raised interest rates in September. The 10-year Treasury rate is at 5.3% and mortgage rates are around 7.4%. Another dynamic is that rising interest rates are driving $500 billion in debt borrowing by the AI industry to build data centers. Economists estimate up to $1 trillion of additional borrowing by 2030. Private debt is crowding out government debt.
As older debt matures, the government issues new debt at higher interest rates, increasing the debt it issues to pay for higher interest payments, which in turn raises debt levels and interest rates. You get the snowballing picture. A worst-case scenario forecasts that interest payments could almost triple to $2.7 trillion by the end of the decade if interest rates keep rising.
Optimists contend that AI will turbocharge economic growth and collect enough tax revenue to solve our fiscal challenges. Many jobs will disappear if this scenario unfolds. Income taxes collected will decrease because far fewer people will be paying income, Social Security and Medicare taxes. These tax declines will have to be offset by collecting far more taxes from corporations, whose profits are currently taxed at 21%.
Individuals contribute about 87% of taxes collected while corporations contribute about 8%. The former will decline, so the latter will have to increase significantly. Marginal corporate tax rates could rise to 70% at high profit levels. Why? For one, to compensate for the decline in all taxes collected plus generous unemployment benefits for the long-term or permanently unemployed. Over the past year, pre-tax corporate earnings have grown by 30%, but taxes on corporate profits have declined by about 30%. Why? Because corporations can deduct capital spending — plant, equipment, and software — immediately rather than depreciate it over its useful life.
So, we will face challenges in the future, but certainly not a hellscape. Sweden dramatically reduced deficits as a percentage of GDP in the 1990s by cutting spending and increasing taxes. The fiscal deficit and the outstanding level of federal debt relative to GDP need to decline, but not disappear. Renowned investor Warren Buffett proposed limiting the federal deficit to 3% of GDP. So, the deficit, currently $2 trillion (around 6% of GDP), would need to halve to $1 trillion.
Reducing the deficit will require a combination of tax increases and spending cuts, mostly on high-income earners. Taxes collected from labor — income and payroll taxes — are far greater than taxes on capital, which include corporate profits, dividends and capital gains. This discrepancy should reverse. If AI-related profits are colossal, corporate taxes collected would be enormous.
Spending can be cut by means-testing Social Security and Medicare. Cerulli, a provider of wealth-management industry research, projects that baby boomers will transfer $73 trillion to the next generation through 2048. What if we used $15 trillion of that amount to reduce the national debt to a manageable level? The recipients of this largesse did virtually nothing to earn it.
Data for this article were gathered from The Economist, The Financial Times and other reliable sources. Murad Antia, now retired, taught finance at the University of South Florida’s Muma College of Business. In a prior life, he was a money manager for 15 years.