The budget for dummies

February 17, 2011: 10:27 AM ET

Forget about what's being cut and what's being funded. The key to understanding Obama's budget is to look at a few simple numbers that tell the whole story.

It's hardly surprising that America's taxpayers are thoroughly confused by President Obama's new budget, since pundits and politicians are calling it everything from a model of fiscal prudence to a shameless manifesto for Big Government.

So here's my version of the Budget for Dummies, meaning intelligent people who lack the time or expertise to analyze the 1300 page document, but want to get past the headlines to understand what it means for our economic future.

Here are the five big questions that Americans should ask, and the answers that the U.S. budget for fiscal 2012 provides.

What's the trend in "Total outlays?"

That item -- the total amount the government spends every year -- is by far the most important single number in the budget. The bond investors anxiously monitoring America's fiscal health care little about which categories of spending we raise or lower. What matters to them is the total. And surprisingly, the total is scheduled to rise sharply in the future.

After a 2% decrease in 2012, spending pushes upward at a rate of 5.2% annually for eight full years, from 2013 to 2020. Remarkably, the outlays line is almost precisely the same as the budget "baseline" for the same period. Hence, the President's new proposal shuffles the components, but does virtually nothing to reduce the total spending already in the pipeline. To be specific, the proposed budget spends $41.97 trillion from 2012 to 2020 and the baseline calls for just $190 billion more than that, a difference of just 4 tenths of 1%.

So what about the reductions in discretionary spending? They exist on paper, but mainly because the budget reclassifies two types of outlays, the Pell Grants for education and transportation spending, as the "mandatory" or entitlement outlays. Plenty of new spending more than offsets the meager savings that remain, including such items as tripling childcare entitlements for the states, and big subsidies for high-speed rail. Needless to say, the main source of the spending increases -- Social Security, Medicare and Medicaid -- remain untouched.

By 2020, spending would reach 23.7% of GDP. That's 15% higher than the average of 20.6% from 1980 to 2008. And as we'll see, the administration is projecting extremely optimistic growth rates for the future, especially considering the tax and debt burden the economy will be carrying. If the CBO's lower GDP projections are correct, the Obama budget would lift outlays to 25% of GDP -- near its post-War record in the stimulus years.

How much of the "deficit reduction" comes from spending cuts vs. tax increases?

We've pretty much answered that question, but it's still a big one. In the new budget, some 92% of the total deficit reduction from 2012 to 2020 comes from tax increases. Counting on bigger revenues, as opposed to lower spending, sends a dangerous signal to the markets for two reasons. First, it's extremely difficult to forecast how much higher rates on existing levies, as well newly-imposed taxes, will actually collect. Higher taxes tend to dampen future growth; as the economic pie shrinks, so do the expected receipts. We'll examine whether the huge surge in tax revenues the administration predicts will actually materialize in a minute.

Second, reductions in spending tend to be far harder to achieve, far more durable, and far more predictable in generating dollars for deficit reduction, than increases in taxes, where forecasts are often wildly optimistic, and radically wrong.

How reliable are the outlay numbers?

This is perhaps the most difficult question to answer. The budget projects that discretionary non-defense spending, on everything from education to transportation to Health and Human Services, rises at less than 1% a year over the next decade. If those numbers are adjusted for inflation plus economic growth, the deficit would be $300 billion or 30% higher in 2020.

The budget also promises to find $321 billion in unspecified savings from 2014 to 2021 to offset the annual "doc fix" that increases budgeted Medicare payments to physicians, and another $150 billion over the next decade from eliminating waste and fraud, without identifying the waste to be eliminated.

Another big unknown is the true cost of the new healthcare bill. Starting in 2014, all workers who aren't insured by their employers are eligible for subsidies of as much as 80% of their families' insurance premiums. The administration and the Congressional Budget Office are forecasting that few companies will drop their coverage -- a highly questionable assumption.

So the spending numbers are both growing rapidly and unpredictable. The only certainty is that outlays will be higher, possibly far higher, than the budget forecasts.

How reliable are the revenue numbers?

Here, the budget faces two problems. The first we've already touched on. Even with new taxes and higher tax rates fully in place, the actual amounts collected are hard to forecast. The administration is making extremely optimistic assumptions on that score. It's forecasting economic growth averaging 3.4% from 2012 to 2020, well above the 2.9% projections from the CBO. Higher growth means higher incomes, and bigger receipts, and that's just what the administration is counting on. In fact, the budget sets the percentage of revenues to GDP at over 19% from 2016 to 2019.

That's an enormous number that will only materialize in a booming economy.

It's highly possible that the higher taxes and ever-growing debt load will drive up interest rates and hobble the economy, driving receipts in the opposite direction.

Second, the administration is counting on new types of taxes that may not materialize. For example, it's assuming that the Bush tax cuts for high earners expire in two years, generating a windfall in revenue. It's also planning to cap deductions for affluent Americans and impose a number of new corporate taxes including levies on coal and other energy companies. Congress failed to embrace those taxes in the past, so whether they'll ever be enacted is not just uncertain, but unlikely.

What's the general message?

Now that we've examined the numbers, let's try to decipher what this budget is really telling us. Here, the message is clear. To understand what makes our economy grow, let's imagine that the entire GDP is the holdings in your 401k. You want that money grow as quickly as possible, without taking undue risk. So you place your 401k dollars and the gains they generate in investments that keep compounding in value. To do that, you buy securities promising strong positive returns, dividend paying stocks, say, or emerging market bonds.

The administration wants to "invest" a bigger and bigger share of GDP in high-speed trains and other transportation systems, green energy, and in maintaining government jobs. The President argues that those investments are the best way to enhance America's competitiveness, and keep GDP compounding at a rapid rate. And that's the thrust of his new budget.

The opposite argument, advanced by conservatives such as Congressman Paul Ryan, (R-Wis) is that steering a larger and larger portion of GDP into the private sector is the best way to make economic growth compound at a rapid rate.

The 2012 budget takes precisely the opposite position. The debate couldn't be more fundamental. So, America's taxpayers-cum-voters, where do you want your money reinvested? The value of your own 401k, the cost of your mortgage, and even your job may depend on which course you, and your government, choose to follow.

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About This Author
Shawn Tully
Shawn Tully
Senior EDITOR-AT-LARGE, Fortune

Shawn Tully has been writing feature stories for Fortune since 1980. He's covered stories as varied as the Vatican's finances, the exile of fugitive commodities trader Marc Rich, and the disastrous merger between Guidant and Boston Scientific. He specializes in banking, federal budget and spending issues, and health care. Tully holds a B.A. in English from Princeton University, an M.B.A. from the University of Chicago, and a master's in Applied Economics from the Universite Catholique de Louvain in Belgium.

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