Worries about the U.S. federal deficit have turned into a mania in recent years as trillion-dollar deficits have become the norm. Yet the national debate about the deficit has mostly ignored the key driver of our recent deficits: the bloated U.S. security apparatus. Instead, discussion has centered on two other issues: entitlement spending and tax revenue. Many on the political right have strictly focused their attention on reducing “entitlement” spending, particularly Medicare and Medicaid. Meanwhile, the political left spends most of its energy fighting to increase tax revenue by raising rates for wealthy Americans and closing loopholes.

In the course of this posturing, politicians have danced around America’s military- and security-related spending problem. This totaled approximately $900 billion last year, and it will come close to that figure this year despite the recently enacted “sequester” that cut more than $40 billion from this year’s military budget. Without cutting military expenses significantly, the U.S. will not find an acceptable solution to the deficit problem. However, at present, neither party seems willing to accept the political risk of arguing for a leaner defense budget.

Recognizing these competing forces is critical for promoting a healthy national debate about the deficit. It’s also important for investors trying to understand the outlook for the U.S. defense industry. The growing obsession with deficits makes it more likely that eliminating (rather than merely reducing) the deficit will be the country’s ultimate goal. If conservatives succeed in targeting a long-term balanced budget — rather than a smaller deficit, which many liberals prefer — entitlement cuts, while necessary, will need to be accompanied by significant defense-spending reductions.

Entitlement spending: The great canard
The growth of entitlement spending is a long-term problem for the U.S. government. Thus, conservatives who argue for “fixing” entitlements are not wrong, per se: The rapidly rising cost of health care is of particular concern. However, present-day entitlement spending is not the biggest driver of the federal deficit. Spending on the three major entitlement programs — Social Security, Medicare, and Medicaid — is typically blown out of proportion in debates about national fiscal policy. For example, the “Face the Facts” group highlights annual “mandatory” spending of more than $2 trillion as a major cause of federal deficits.

While it is literally true that mandatory spending exceeds $2 trillion, that figure is grossly misleading, because it ignores program-specific revenues. Social Security and Medicare are social-insurance schemes that are primarily funded by payroll taxes. Lots of money passes through those programs, but the net impact on the federal budget is relatively small (less than $200 billion last year).

According to the Congressional Budget Office, Social Security expenditures were $768 billion and Medicare expenditures were $551 billion in 2012. (The Social Security Administration reports spending of $786 billion; I cannot resolve that discrepancy.) However, excluding the effects of the payroll tax holiday, Social Security was overfunded. Revenue from the FICA payroll tax, interest on the Social Security Trust Fund, and …read more
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