Debating the Debt Ceiling

Over the past few months, there has been substantial debate in Congress over raising the ceiling on the national debt. This is an important discussion, but it is hardly new — Congress has raised the debt ceiling 74 times since 1962.1

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The debt ceiling is actually more of a legislative formality than a barrier to government spending. The current debate may be driven in part by the fact that the national debt is approaching the psychologically important milestone of 100% of gross domestic product for the first time since World War II. In contrast, 10 years ago, the debt was less than 60% of GDP.2

Government spending and borrowing affect all taxpayers, so it’s worthwhile to keep track of what happens in Washington. Although many Americans could be adversely affected if Congress decided not to increase the debt ceiling, this is unlikely to happen.

Why Does the Government Have a Debt Limit?

The debt ceiling is the federal government’s legal limit for borrowing money. It was established in 1917 to help finance America’s involvement in World War I. Up to that time, federal borrowing and debt limits were usually tied to specific projects.3

Why have a debt ceiling if Congress just raises it every time the national debt approaches the limit? Checks and balances. The U.S. Constitution gives Congress the power to appropriate money and the executive branch the power to spend it. The debt ceiling is one way for Congress to control the amount of money the U.S. Treasury — an arm of the executive branch — can borrow by selling bonds to investors. Each time the national debt reaches the debt ceiling, Congress and the president must have a public debate over the need to spend more than the government collects in tax revenues. Sometimes the debate takes place quietly; at other times, it captures national attention.

What Happens If the Debt Ceiling Is Not Raised?

Once the national debt hits the debt ceiling, the Treasury can no longer borrow. Because most federal budgets require deficit spending, the government might not be able to pay all of its obligations. This has never happened in the United States, so it’s unclear how the Treasury would be required to prioritize its bill payments.

If the government were unable to pay its obligations, investor confidence in U.S. government debt could be reduced and the government would probably have to pay higher interest rates to compensate for the perceived additional risk. The federal budget is already tight (as evidenced by the need to borrow in excess of tax revenues), so higher interest payments could displace other federal spending priorities and require additional borrowing. Because the interest rates offered by the federal government influence other interest rates, a rate increase could translate to higher borrowing costs for state and local governments, businesses, and consumers.

Among the many people in the United States who rely on the federal government for income are Social Security beneficiaries, civilian and military employees, and federal contractors and their employees. If payments to these individuals were to cease, they may be forced to curtail their spending, which could ripple through the private sector.

U.S. Treasury securities are guaranteed by the federal government as to the timely payment of principal and interest, which is why they tend to appeal to investors seeking income and preservation of principal. A significant portion of the federal debt is held by foreign investors, so if the Treasury were unable to honor its obligations, it could have a global effect.

Of course, there could be some benefits to a reduction in federal borrowing: Capital that previously went to finance government spending could be freed up for investment in the private sector. The percentage of the federal budget consumed by interest payments could fall. The less the government has to borrow, the less reason it may have to justify tax increases. However, although simply capping the federal debt limit might seem like an easy way to stop Washington from spending more than it collects in tax revenues, a federal government that is unable to pay its bills is more likely to cause hardship than reform.

Obviously, the federal government cannot continue to borrow indefinitely, but we can expect Congress to keep raising the debt ceiling until longer-term fiscal challenges are addressed. The debt ceiling is important, but don’t let it distract you from pursuing your own fiscal health and long-term financial goals.

The principal value of Treasury securities fluctuates with market conditions. If not held to maturity, they could be worth more or less than the original amount paid.

1–3) Congressional Research Service, 2011

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent Accounting firm in Naperville. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. © 2011 Emerald Connect, Inc.

Tuesday, June 28, 2011