Rising Interest Costs Increase Pressure on the Budget

Policy Memo
Tuesday, February 07, 2017

With interest rates in recent years far below traditional levels, it has been easy for American taxpayers and their political leaders to overlook one of the chief drawbacks of the federal debt: the borrowing costs.

But as Congressional Budget Office (CBO) officials have made clear recently, there is good reason for elected officials and the public to start paying more attention to what the government pays in interest -- and how rapidly these payments will rise in the coming years unless big changes are made in the federal budget.

In testimony last week on Capitol Hill, CBO Director Keith Hall said that net interest payments this year would be the fastest-growing component of the projected increase in federal spending.

If interest payments rise as projected over the next decade, they will make it even more difficult to put the federal budget on a responsible and sustainable path.

Two factors are driving the current and projected growth in federal interest costs:

  • Interest rates are on their way up. As explained in a CBO blog post last week, the budget office expects rates to rise gradually over the next few years. Given the amount of money involved, however, even small rate increases will translate into substantial additional costs for the government. And CBO estimates that an interest rate increase of one percentage point above projections each year would increase cumulative deficits by $1.6 trillion over the next 10 years.

  • As it continues to run deficits each year, the government is paying interest on ever-larger amounts of accumulated debt. The federal deficit began rising again last year, and CBO projects that under current law Washington will add trillions to the debt over the next decade. A helpful analogy: It is increasingly difficult for individuals to deal with heavy credit card debt when they are continually charging more purchases.

“Because of rising interest rates and, to a lesser extent, growing federal debt held by the public, the government’s interest payments on that debt rise sharply over the next 10 years -- nearly tripling in nominal terms and almost doubling relative to GDP,” Hall told lawmakers last week.

Interest payment costs already claim a significant slice of the federal budget. They amounted to far more than what the nation spent, for example, on education, international affairs and the environment combined in 2015.

Under current law, CBO projects that interest costs will rise from $270 billion this year to $768 billion in 2027.

Absent reform, things would get worse from there. According to the CBO’s most recent long-term budget outlook, interest payments would rise from 1.4 percent of the economy (GDP) last year to 5.8 percent in 2046.

As interest costs rise, an aging population and rising health care costs will further increase pressure on the federal budget, making it increasingly difficult to fund other important national priorities, from defense to medical research.

Within a few years, Hall warned lawmakers, “continued growth in spending -- particularly for Social Security, Medicare, and net interest -- would outstrip growth in revenues, resulting in larger deficits and increasing debt.”

Among the negative consequences of that would be an increased risk of a fiscal crisis that, among other things, could drive interest rates even higher. As Hall explains:

“There would be a greater risk that investors would become unwilling to finance the government’s borrowing unless they were compensated with very high interest rates; if that happened, interest rates on federal debt would rise suddenly and sharply.”

To avoid such risks to our economy and the nation’s future, elected officials must pursue broad fiscal reforms soon.

Interest costs are not something that lawmakers and the president can control directly. Avoiding a dangerous upward spiral in those costs in the future will require greater fiscal discipline throughout the federal budget.

Particular attention must be paid to the government’s largest and most rapidly growing programs (entitlements) and an inefficient tax code that drains large amounts of federal revenue to subsidize various special interests. But all parts of the budget should at least be on the table for careful review.

The longer Washington continues to procrastinate on budget reforms, the more taxpayers today and in the future can expect to pay more just to service the growing federal debt.

That’s not the path to prosperity.