Understanding the Federal Debt Limit

Debt subject to limit has two components: (1) debt held by the public (debt held by any individual or entity that is not the federal government such as a mutual fund, individual investor, foreign government, or a municipal government) and (2) intragovernmental debt (debt the government owes itself such as the Social Security Trust Funds, the Medicare Hospital Insurance Trust Fund, and the Civil Service Retirement and Disability Fund).

Debt held by the public. When revenues received by the Treasury are not sufficient to meet the expenses of the federal government, the Treasury borrows to obtain the cash necessary to meet its obligations. Although much of the federal revenue used to finance government operations is received in the spring when individuals file their annual income tax returns, the federal government incurs a steady stream of operating costs all year long. Consequently, to smooth cash flow and enable the federal government to finance daily operations, the Treasury borrows money by selling securities to the public. These securities comprise the debt held by the public. Debt held by the public rises and falls depending on the government’s immediate borrowing needs. It represents the cumulative amount of borrowing required to finance budget deficits. Because debt held by the public flows through financial markets, it has more immediate relevance to the economy than intragovernmental debt, which is a matter of internal bookkeeping. As of January 26, 2006 debt held by the public totaled $4.7 trillion.

Intragovernmental debt. For the most part, intragovernmental debt consists of trust fund accounts that are credited with dedicated revenue such as Social Security and Medicare payroll taxes (FICA). In theory, surpluses in these accounts are “saved” for future benefit obligations. As of January 26, 2006 intragovernmental debt totaled $3.4 trillion.

This debt increases automatically every year by the amount of trust fund surpluses invested in Treasury securities, regardless of whether the budget is in surplus or in deficit. For example, in every year since 1984 the Social Security program has generated a surplus – the federal government has collected more payroll taxes than it needed to pay current benefits. Surplus payroll taxes are held by the Social Security Trust Fund in the form of special obligation bonds. In addition, the trust fund is credited with interest on its balance in the form of additional bonds. As Social Security surpluses grow, so too does the Social Security Trust Fund, and intragovernmental debt rises. Thus, unlike debt held by the public, growth of intragovernmental debt does not reflect an imbalance in short-term fiscal policy. It represents a very different problem ¾ growing long-term obligations that future taxpayers will have to pay for when the Treasury ultimately has to transform these bonds into benefits.

What is driving the need to raise the debt limit? Unchecked growth in either category of debt will generate pressure to raise the debt limit. In FY 2006, the Congressional Budget Office (CBO) estimates that total debt will go up by $610 billion. Of that, $333 billion (55 percent) is attributable to an increase in debt held by the public and $277 billion (45 percent) is attributable to an increase in intragovernmental debt.[2]

To understand the role of each component relative to the debt limit, consider the brief period in 1998-2001 when four years of budget surpluses allowed the federal government to buy back, or “pay down,” $453 billion in debt held by the public. Over those same four years, intragovernmental debt increased by $853 billion (largely due to substantial Social Security surpluses credited to the Social Security Trust Fund). As a result, the total debt subject to limit rose from $5.3 trillion in 1997 to $5.7 trillion at the end of FY 2001.

When Congress increased the debt limit in 2002 from $5.95 trillion to $6.4 trillion, debt held by the public was actually lower than it had been when the debt limit was previously increased in 1997. The limit was raised to accommodate the increase in intragovernmental debt.

Congress could avoid future trust fund-induced increases in the debt limit if it “saved” trust fund surpluses by running total, or “unified,” budget surpluses equal to the trust fund surpluses and making corresponding reductions in debt held by the public. If the increase in intragovernmental debt, which mostly represents future obligations, were offset by an equivalent reduction in debt held by the public, the budget and the economy would be better prepared to make good on those future obligations.[3] Following this strategy, however, would require substantial budget surpluses and a degree of political cooperation and fiscal discipline that is not currently in evidence.

Does setting a tight debt limit provide an effective check on fiscal policy? Raising the debt limit is essentially a decision to pay the bills. Unlike the now expired budget enforcement mechanisms such as statutory spending caps or the pay-as-you-go (PAYGO) rule for entitlement expansions and tax cuts, the debt limit places no restrictions on specific tax and spending decisions. If deficits result from these policy decisions, or if the economy fails to grow as projected, the debt limit must be increased to prevent a default on the government’s obligations.

However, the need to raise the debt limit does provide an opportunity to assess past fiscal decisions and, if necessary, make course corrections. In the past, major increases in the debt limit have often been accompanied by the enactment of deficit reduction plans such as the November 1990 increase of $915 billion, the August 1993 increase of $530 billion, and the August 1997 increase of $450 billion. In the absence of such linkage Congress has been reluctant to raise the debt limit by more than is necessary to get through a short period of time. Thus, while the debt limit is not, by itself, a fiscal firewall, in the absence of other more effective mechanisms such as spending caps and PAYGO, it is one of the few budgetary speed bumps left to provide a sense of fiscal discipline.

What is the status of Congressional legislation raising the debt limit? When the House adopted the conference report for the 2006 budget resolution (H. Con. Res. 95), it triggered House Rule XXVII (also known as the “Gephardt Rule”). The rule automatically produced a joint resolution (H.J.Res. 47) raising the debt limit to $8.961 trillion (an increase of $781 billion). The resolution, according to the rule, was “deemed” passed and then sent to the Senate as a separate measure in May 2005. To date the Senate has taken no action.

In his letter to Congress, Secretary Snow stated that even if Treasury takes “all available prudent and legal actions to avoid breaching” that limit, “we anticipate that we can finance government operations no longer than mid-March.”[4] For this reason, Congress will be forced to make the debt limit an agenda item soon after it reconvenes in late January.

In the wake of Congressional inaction, what are the options the Treasury has to avoid breaching the debt limit?The U.S. Treasury can employ a few financial maneuvers to avoid breaching the debt limit and defaulting on the national debt. These transactions are benign and completely legal, but in the wake of the corporate accounting scandals in 2002 they are a source of unease among lawmakers and the public. Moreover, all of these machinations merely postpone the inevitable – an increase in the statutory debt limit.

Specifically, the Treasury can:

• Suspend reinvestment of government securities in federal trust funds such as the G-Fund of the federal employee’s Thrift Saving Plan (TSP) or the Civil Service Retirement and Disability Fund (CSRDF). Such action prevents this part of the intragovernmental debt from growing. Manipulating retirement funds may sound ominous, especially to federal employees, but laws enacted in the 1980s require the Treasury to restore all due interest and principal to the fund as soon as it can.

• Delay or suspend the auction of public debt instruments. This action prevents debt held by the public from growing. Individuals and institutional investors regularly purchase Treasury securities for investment purposes. The revenue from the sale of securities is then used to manage the cash flow needs of the federal government. Therefore, suspending the sale of T-bills can be very disruptive to domestic and international financial markets as well as the operations of the federal government.

Has the Treasury resorted to similar tactics before? Yes. The Clinton Administration undertook similar measures in 1995 and 1996, and the Bush Administration resorted to such tactics in 2004, 2003 and twice in 2002. Now Treasury finds itself again in familiar territory as it seeks to avoid default while it waits for Congressional action.

How did we get to this point? In the spring of 2005, debt subject to limit was $7.718 trillion – $467 billion below the statutory debt limit. Recognizing the likelihood that it would need to raise the debt limit in the not-too-distant future, Congress included provisions in the FY 2006 budget resolution to raise the debt limit by $781 billion to $8.965 trillion. Because raising the debt limit is a political “hot potato” – a vote that many legislators seek to avoid – the budget resolution contained special procedures and protections to expedite action on the debt limit and minimize the political risk in approving the increase. However, the different procedures for increasing the debt limit in the House and Senate – and the desire by both chambers to avoid such a vote – put the two chambers at odds with each other.

When the House passed the FY 2006 budget resolution, the Gephardt Rule allowed the House to pass a separate increase in the debt limit without a recorded vote (legislation increasing the debt limit was “deemed” passed with passage of the budget resolution). The conference report for the budget resolution also contained reconciliation instructions directing the Senate Finance Committee to report a reconciliation bill that would provide for a $781 billion increase in the debt limit to $8.965 trillion.[5]

Thus, the Senate now has two ways to deal with the debt limit issue. It could pass its own standalone legislation under the protection of reconciliation, which the House must then approve by recorded vote – a scenario House leaders would prefer to avoid. Alternatively, the Senate could take up the House-deemed legislation under regular order without reconciliation protections – subjecting the legislation to amendments (including politically motivated amendments as well as amendments to impose budget controls) and damaging extended debate – a scenario Senate leaders would prefer to avoid.

Simply phrased, lawmakers’ aversion to a debate and a recorded vote raising the debt limit has created a procedural stalemate that, to date, neither chamber has been eager to break. Adding to the stalemate over the debt limit was a late summer surge in federal tax revenue that reduced estimates of the FY 2005 deficit. A statement from Treasury officials in August 2005 said that the Department was “reasonably confident that the debt limit will not be reached in 2005,” but rather during the first quarter of calendar year 2006.[6] With the pressure off, Congress turned its attention to other matters.

If the past is a guide, Senate leaders may stall until mid-March and then bring up the House-deemed debt limit increase. At that time, Treasury will have exhausted nearly all its cash management options and Congress will be eager to adjourn for a planned recess. This combination of events could effectively preclude any opportunity for lengthy debate or amendments and ensure swift passage of an increase in the debt limit. This scenario is remarkably similar to what the Senate did in 2003.

What should Congress do? Political leaders must rise above partisan gamesmanship and increase the debt limit to avoid a damaging and unnecessary debt crisis. Approval of a debt limit increase is necessary to maintain the full faith and credit of the United States government. Failure to approve an increase would have dire consequences for government finances and financial markets. Delaying action on an increase until the last possible moment, forcing Treasury to utilize extraordinary measures to avoid a default, is unnecessary and irresponsible.

However, with budget deficits projected for “as far as the eye can see,” The Concord Coalition believes that no large scale increase in the debt limit should be approved until Congress and the President agree on a new plan to restore fiscal discipline. In December, bipartisan leaders of The Concord Coalition called on Congress and the President to develop a specific and realistic plan to put the country on a sustainable long term fiscal path and reinstate discretionary spending caps and PAYGO rules for both entitlement expansions and tax cuts.7 The rationale for this trade-off is clear: greater flexibility to increase the debt is allowed, but only within the context of a fiscally responsible budgetary framework.

The Concord Coalition also believes that both the House and Senate should debate and vote on the debt limit. If Members of Congress find it embarrassing or distasteful to vote on a debt limit increase, the remedy is to enact more responsible fiscal policies.