The Looming Debt Crisis, the Trump Tax Cuts, and Medicaid

Let’s start with a chart to understand the dire fiscal situation we are in as a nation.

Figure 1. Federal Debt Held by the Public as a Share of Gross Domestic Product, 1940-2054

You’re looking at how sizeable federal debt has been and will be relative to gross domestic product (GDP). From 1960 to 2008, the federal debt held by the public averaged thirty-five percent of GDP. Today, we have reached 100 percent. We have hit that ignominious threshold exactly twice before—in 1945 and 1946, when the US borrowed heavily to prosecute World War II. That high-water mark was followed by eighteen years of declining debt-to-GDP levels.

But today, we are facing ever-rising debt. By 2055, our national debt is projected to reach 154 percent of GDP, a figure so extraordinarily high that it should be taken not as a likely occurrence but as a definitive indicator that it is impossible to continue long on the path we are taking.

If that’s not enough to scare you, according to just-out research by my colleague Mark Warshawsky and his coauthors, a more accurate projection would be more than 250 percent, not CBO’s 154 percent.

Given this unprecedented situation, you might expect federal policymakers to prioritize deficit reduction this year. But the recently passed House budget resolution would add around $3 trillion to the debt over the next ten years. That’s the result of prioritizing, instead of federal debt, the extension of the 2017 individual income tax cuts (and the addition of some new ones) without spending reductions significant enough to pay for them. CBO projects that the national debt in 2054 would be 214 percent of GDP with these tax cuts permanently extended.

The single largest spending reduction specified in the House “reconciliation” instructions included in the budget resolution calls for $880 billion in cuts from programs under the jurisdiction of the Energy and Commerce Committee. The committee is responsible (along with the Ways and Means Committee) for Medicare, the main health care program for retired and disabled Americans, which is more expensive than any federal program except social security. However, President Trump has taken Medicare off the table. That means that the anticipated savings reported by Energy and Commerce must overwhelmingly come from Medicaid, the federal-state program that finances health care for low-income Americans.

How should we consider these proposed Medicaid cuts, the expiring Trump tax cuts, and our looming debt crisis? Given its size and cost, Medicaid will need to shrink due to the imperative of avoiding a fiscal meltdown. But it is unwise to use savings from Medicaid to pay for tax cuts, particularly given that the tax cuts will still increase deficits despite the Medicaid reductions.

The Ballooning National Debt Threatens Prosperity

According to Urban Institute researchers, the federal government spent over half a trillion dollars providing benefits and services to children in 2023 ($567 billion). That was almost a tenth of federal spending, with Medicaid the largest component. Yet spending on kids was still fourteen percent less than the interest payments the federal government was compelled to make to pay off its lenders due to rising deficits.

Last year, federal spending on children changed little, but interest payments rose by $223 billion. Put another way, the increase in the cost of borrowing between 2023 and 2024 to pay for one year of federal spending far exceeded the entire Medicaid budget for kids ($135 billion in 2023).

This metastasizing of debt payments is only going to worsen. By 2034, the Congressional Budget Office projects that servicing the debt will amount to $1.7 trillion—nearly twice what it was last year. This difference of over $800 billion, equivalent to interest accumulated on a national credit card after years of falling further behind paying off the bill, would be so large that it would fund a thirty percent increase in the 2034 federal budget for children if we only faced 2024 interest payments.

This crowding out of other priorities is one way our rising national debt threatens the future. But it’s worse than that. The more indebted the federal government becomes, the riskier it is to lend it more money. Already today, there are clear signs that markets are growing wary of longer-term lending to the Treasury. To continue to finance its obligations, the Treasury must offer bond markets higher interest rates to mitigate that risk. Of course, that exacerbates the cannibalization that debt service wreaks on the rest of the budget.

But it also affects the American economy. If creditors can get better terms lending to the federal government, it will make it harder for private borrowers to obtain loans. They must also accept higher interest rates to compete with government borrowing. The result is increased pain for homeowners, students, car owners, those with credit card balances, and other borrowers. Perhaps most importantly, higher interest rates mean worse terms for businesses (or would-be business owners) looking to borrow. Less business activity means fewer jobs and lower economic growth.

In the mid-twentieth century, the federal government relied heavily on one strategy to get out from under its war debt: it tolerated inflation. Since debt repayments are set at the time of borrowing, inflation means that repayment of some nominal amount becomes cheaper. (For example, a recent graduate’s fixed $200 student loan repayment is easier to pay if her salary rises ten percent because of high inflation than if her salary rises only 3 percent.) Today, though, the public has little appetite for inflation. Investors would soon respond to a strategy of inflating away debt by demanding higher interest rates; unlike seventy-five years ago, we will need to keep returning to them to roll over our sky-high debt.

Another solution to our debt problem is practically unspeakable, and for good reason: we could just stop paying back our creditors and default. That would inspire a wholesale global financial crisis and severely damage the nation’s future ability to attract funds to finance what the federal government spends above and beyond the tax revenue it takes in.

The bottom line is that controlling federal budget deficits is a national imperative. This will require reductions in entitlement spending (including Medicaid) and stronger economic growth (including from tax reform).

The Unsustainability of Fiscal Policy Has Been Caused by Rising Spending, Not Falling Revenues

The explosion of our national debt may be due to increases in spending, falling revenues, or some combination of both. If we were spending about what we always have but bringing in less taxes, would-be tax-hikers would clearly have a strong argument. However, in reality, fiscal trends favor the advocates of spending cuts.

Across the forty years between 1962 and 2001, federal spending averaged 19.8 percent of gross domestic product (GDP) while revenues were 17.7 percent. After 2001, however, spending rose by much more than revenues fell. By 2024, revenues were still 17.1 percent of GDP, but outlays were 23.4 percent. With unemployment averaging an impressively low 4.0 percent last year, federal spending reached levels unseen in the modern era except during the deep recession years of 2009 and 2020 and the inflation-spawning Biden years of 2021 and 2022.

Figure 2. Federal Outlays and Revenues as a Share of Gross Domestic Product, 1962-2055

It gets worse, though. Even if Congress fails to cut taxes this year, so that the individual income tax code reverts to the higher tax rates that preceded President Trump’s first term, tax revenues will badly lag the increase in spending. In that scenario, revenues will rise to 19.3 percent of GDP by 2055. This would be a level exceeded only once since 1962 (in 2000, thanks to the tech boom). Unfortunately, by 2055, federal spending will rise to 26.3 percent of GDP. Obviously, if the expiring 2017 tax cuts are extended, the gap will yawn even wider.

Raising Taxes Would Make Americans Worse Off

Progressives might argue that the spending increases we have seen and will continue to see merit tax increases to pay for them. Perhaps so, but there’s no getting around the problem that tax increases reduce discretionary income and are likely to produce slower economic growth.

It would be one thing if rising spending reflected investment in making the economy more productive. Then, a tax increase to fund that spending might be preferable for growth than cutting the spending. However, the crux of our spending problem involves simple money transfers from non-elderly workers (and purchasers of government debt) to retirees and other non-workers. At any rate, there can’t be many opportunities for government revenue to be spent more productively for growth than would private markets using the same dollars.

You might think that we can just make the rich bear all the burden of tax increases adequate to close deficits. But we can’t climb much out of our hole by taxing only the affluent. For example, what if we tax income above $10 million at a 70 percent rate, as Representative Alexandria Ocasio-Cortez has proposed in the past? Given how much taxable income there is above this threshold, one might naively expect such a tax to raise something on the order of $1 trillion over a decade. But in reality, affluent taxpayers would respond to tax rates this high by reducing their work and other income-generating activities and by shielding their income from taxes in various ways. One analysis accounting for these effects using well-grounded assumptions about the magnitude of these likely responses found that the AOC tax would actually result in a decline in tax revenue.

Moreover, the impulse to soak the rich misunderstands how other countries fund their more expansive safety nets. Looking at how countries in the Organisation for Economic Co-operation and Development (OECD) tax their citizens, the United States stands out—but not in the way you might think. It features one of the most progressive tax systems. Or at least it did 20 years ago, which is, unfortunately, the most recent data available. The concentration of taxes at the top relative to the concentration of incomes at the top was higher in the US than in 22 other countries (all but Ireland). While we can’t be certain what the rankings would look like today, the US federal tax system became much more progressive between 2005 and 2019. (See Figure B18.)

The other way the US stands out relative to other countries is that our tax rates are lower despite being more progressive. The upshot is that if we wanted to look more like social democratic countries in how we fund federal spending, we would need to raise everyone’s tax rates—but more for the working and middle class than for the rich.

Tax Cuts Can Slow Growth, If They Exacerbate Deficits

Even an otherwise growth-promoting tax cut can do more harm than good if it reduces revenues enough while spending growth goes unaddressed. The resulting increase in debt can dampen growth. The tax cuts in the House budget reconciliation instructions greatly exceed their spending reductions, and they are sure to increase deficits.

Given the magnitude of our debt problem, tax reform should focus on increasing economic growth without exacerbating deficits rather than simply extending the earlier Trump tax cuts (and piling on new ones). My colleague, Kyle Pomerleau, along with Donald Schneider, has proposed a revenue-neutral way to extend most of those earlier cuts while strengthening the boost to growth. Doing so would obviate the need to find savings from Medicaid to pay for tax cuts and allow policymakers to address Medicaid’s cost in the context of our debt crisis.

Medicaid Bears Too Much of the Budget Resolution’s Spending Cuts

None of the foregoing should be taken to imply that Medicaid spending is acceptable or that the cuts specified in the House budget resolution are, in principle, unreasonable. However, the Medicaid cuts specified in the House budget resolution are disproportionate to Medicaid’s future impact on deficits.

In fiscal year 2023, spending on Medicaid constituted 10.1 percent of federal outlays. That was lower than social security (22.0 percent) and Medicare (13.7 percent). It was only slightly lower than net interest payments (10.6 percent) and not much lower than the entire discretionary defense budget (13.2 percent).

Medicaid (along with the related Children’s Health Insurance Program) is projected to account for twelve percent of the increase in non-interest federal spending over the next ten years. However, the $880 billion from Energy and Commerce makes up fifty-nine percent of the $1.5 trillion in savings specified by the budget resolution. Even if we take social security and Medicare out of the picture (since they are off the table), Medicaid spending will be just 35 percent of remaining spending through 2034.

What if we wanted to reduce Medicaid spending in proportion to its impact on increased federal non-interest spending over the next ten years? In that case, twelve percent of $1.5 trillion in savings is about $181 billion in cuts. That’s about one-fifth of what the budget resolution calls for.

Medicaid should not be paying for deficit-increasing tax cuts, but that does not mean we don’t need to find considerable savings from the program. The national debt will rise by seventy-six percent in the next ten years. If we assign Medicaid nine percent of the blame (its share of total federal spending including interest), that’s $2 trillion dollars—well over twice the $880 billion the reconciliation instructions contemplate and equivalent to a twenty-four percent cut in Medicaid spending over ten years. That’s the kind of debt trouble we’re in.

Where Does That Leave Us?

If you leave with one takeaway, I hope it is a somewhat alarmed conclusion that deficit reduction is badly under-prioritized by both Republicans and Democrats. One solution is to increase economic growth rates in various ways so that however fast interest rates may rise, the economy grows faster. That would keep borrowing costs under control. Of course, we should try to increase economic growth anyway, but that is easier said than done.

Or we could raise taxes. But meaningfully lower deficits would require a broad increase in taxes that would hit the working and middle classes, too, even if the high progressivity of the American tax system were kept in place. Democrats will have to accede to an unappealing middle-class tax hike if they genuinely want to advocate for tax increases to reduce deficits. No more holding harmless families with less than $400,000 in income.

Or we can cut spending. Given that rising spending is much more to blame for the looming debt crisis than falling revenues, reducing federal outlays should play a more prominent role in averting a crisis than increasing revenues. Social security, Medicare, Medicaid, the Children’s Health Insurance Program, and Obamacare premium subsidies will account for sixty-three percent of the projected growth in federal non-interest spending over the next twenty-five years. Social security and Medicare alone will make up forty-nine percent of the increase. Republicans who want to advocate for spending cuts responsibly to reduce deficits will need to put less of the burden on Medicaid and more on social security and Medicare.

The most serious effort in Congress over the past 20 years to address federal deficits in a way consistent with the analysis here was the multi-year project by Congressman—later Speaker—Paul Ryan. In a series of budget proposals spanning several years, Ryan proposed deficit reduction mainly through reductions in entitlement spending, including specific reforms to social security, Medicare, and Medicaid.

Many Democrats castigated Ryan at the time he proposed these measures. They declared him a bad and heartless person, in much the same vein as many progressives more recently painted all Trump voters as deplorable and everyone to the right of their avant-garde cultural agenda as hopeless reprobates. Today, Democrats have Trump again and are badly in need of an image makeover. They might seriously consider becoming the party of debt-crisis avoidance.

Alternatively, if progressives continue to demand that tax increases are legitimate only if they are levied on the rich and that spending cuts cannot involve social security or Medicare, then that’s just saying that they don’t care about the looming debt crisis at all. Meanwhile, they are playing a dangerous game of political chicken if they think Republicans will not slash Medicaid to pay for tax cuts (a game Democrats have facilitated by castigating social security and Medicare cuts in the past).

Republicans are perhaps more justified in objecting to any tax increases as a way to reduce deficits. But given the looming debt crisis, it is highly questionable whether they should cut taxes further. What would make far more sense is reforming the tax code to more optimally promote economic growth in a revenue-neutral way.

If the GOP intends to worsen the debt problem by $3 trillion, it may as well take Medicaid reductions off the table and worsen it by $4 trillion. It is better to have a debate later about deficit reduction and health policy than to take potential funds that could reduce those deficits and make them unavailable without some broader plan for avoiding a debt crisis. Whether the federal debt held by the public in 2034 is $53 trillion or $54 trillion instead of just $50 trillion—let those figures sink in—hardly seems to matter at this late stage.

The Senate passed a smaller budget resolution this winter to address immigration, and the two chambers must now find a workable compromise. That deal could end up being the worst of all worlds. Several Senators have indicated interest in using a "current policy baseline," which would blithely declare that the TCJA extension was already accounted for and would incur no additional costs (even though, absent new action, the tax cuts would expire and reduce deficits). A compromise relying on irresponsible gimmicks, poorly thought through Medicaid savings, and unaffordable tax cuts would be a wholesale abdication of congressional responsibility.

Scott Winship is a senior fellow and the director of the Center on Opportunity and Social Mobility at the American Enterprise Institute. He is a contributing editor to Civitas Outlook.