Reconciling More Spending on Defense with Long-Term Fiscal Stability | American Enterprise Institute

A disruptive national election in the United States has opened the door to a new course for fiscal and defense policy. It is an opportunity that leaders from both parties should seize, as the nation’s long-term vitality and strength depend on sustaining a stronger commitment to hard military power and consolidating finances elsewhere.

Upon initial inspection, the separate objectives of less debt and more defense appear contradictory. And of course, if nothing else changed, higher expenditures for military accounts would push up federal borrowing even more rapidly than would be the case under current laws and policies. But the reason defense has been squeezed in the post–Cold War period and yet federal debt is still rising is because there are other powerful forces overwhelming all other budgetary concerns.

Specifically, as Congress has approved and expanded large benefit programs that support individual Americans and their families, spending on them has escalated rapidly and without a permanent and growing hike in federal taxes. As pressure has grown, elected leaders have struggled to sustain these programs, fund defense adequately, and keep deficits manageable. By default, Congress has chosen to protect all benefit commitments and sacrifice defense and fiscal stability.

The long-term fiscal deterioration caused by growing entitlement spending, which was already visible in the 1990s, has been further complicated by two global economic emergencies in the past two decades. When times were good, Congress did not provide a budgetary cushion that would accommodate the fiscal expansion needed to mitigate the consequences of the financial crisis during 2007–09 and the COVID-19 pandemic, which began in 2020. All the support Congress approved was thus added to already wide annual budget deficits, with a resulting step-up in total borrowing and net interest costs that have pushed federal debt near to record levels relative to the size of the nation’s economy.

While these successive global crises substantially exacerbated the debt problem, the core fiscal challenge of relentless entitlement spending growth was not unforeseen; it has been building for decades due to population aging and health care cost growth at rates above those of the economy’s expansion. The strong political opposition that has prevented benefit program reform to this point clearly indicates that, if and when policymakers ever approve changes, they will need to be phased in gradually for voters to see them as fair.

That should not be a problem, assuming Congress moves relatively soon. The fiscal challenge is not due to the borrowing needs in any given year. The problem is that there is no clear prospect of annual borrowing requirements lessening over the medium and long term. Indeed, population aging and health care cost pressures are expected to make the problem much worse in the coming years and decades. The risk is that financial markets will conclude at some point that it will be impossible for the US government to meet its debt obligations in an orderly manner—that is, without using inflation to effectively diminish it. At that point, the ensuing economic disruption would hit the real economy hard.

It need not come to that. A phased-in debt-stabilization plan would provide relief relative to current projections that would compound over time and thus create ever-growing space for other priorities. That means it should be possible to move quickly on reinvesting in defense as part of a longer-term reform that makes room for that investment even as it brings total debt down to a sustainable level.

How the US Got Here

The federal budget has undergone an important transformation in the postwar era.

Before the New Deal, creating and managing large programs that provide benefits directly to individual citizens were not seen as major, population-wide federal responsibilities. With the creation of Social Security, unemployment compensation, and aid for poor women and their children in the mid-1930s, the federal government opened the door to a new era. After World War II, Congress vastly expanded direct benefit support to individuals through a series of law changes that lasted until the 1970s.

In this way, the US was moving in tandem with other Western industrialized countries. Just before and after World War II, the governments of these nations were active in building social welfare protection systems, covering health, retirement, unemployment, and income security as a way of buffering the risks and burdens of their evolving economies. It was an inevitable and welcome development.

While a change in the government’s program portfolio was to be expected, it did not follow that a new era of fiscal distress was also unavoidable. The deterioration in federal finances occurred only after many years of programmatic evolution and was a direct result of elected leaders’ choices when building and amending the key programs.

All Western democracies are suffering from the fiscal pressure associated with population aging, but the US has two additional factors that complicate its budgetary outlook.

First, the US became the West’s most powerful democracy in the aftermath of World War II. In the years that followed, as the Cold War era dawned, there was a bipartisan consensus that it was in the national interest for the US to take a decisive leadership role in global affairs. That role has involved investment in an expansive military presence that entailed much higher spending relative to the size of the economy than has been the case in allied countries.

Second, the US has not adopted a fully nationalized health system. Instead, it has put in place four main programs to support enrollment in health insurance: Medicare (for the elderly), Medicaid (for lower-income individuals), tax support of employer-based coverage for working-age persons and their families, and direct premium subsidies, authorized by the Affordable Care Act, for modest-income households not eligible for employer-sponsored plans.

While this patchwork system of insurance has led to most Americans having protection against large medical expenses, the US has not put in place a systematic cost-control mechanism that resembles the budgetary and regulatory restraints seen in other countries. The result is a far higher national bill for health. The Organisation for Economic Co-operation and Development estimates the US devoted 16.7 percent of gross domestic product (GDP) to health expenditures, which was about 40 percent above what Germany spent in the same year (11.8 percent of GDP).¹

Table 1. Budget Aggregates, Historical and Long-Term Projections

Source: Congressional Budget Office, The Long-Term Budget Outlook: 2024 to 2054, March 2024, https://www.cbo.gov/system/files/2024-03/59711-Long-Term-Outlook-2024.pdf; and Congressional Budget Office, “Budget and Economic Data,” February 2024, https://www.cbo.gov/data/budget-economic-data#1.

Note: * CBO did not project this line item to 2054. The figure represents the author’s forecast based on current trends. Totals have been rounded.

The combination of increasingly expansive eligibility rules, the aging population, and substantial upward pressure on health spending per person has pushed federal obligations for the major benefit programs—especially Social Security, Medicare, and Medicaid—to ever-higher percentages of GDP, as shown in Table 1. In 1962, before Congress passed the 1965 law creating Medicare and Medicaid, spending on Social Security was just 2.4 percent of GDP. By 1980, with the major health programs expanding rapidly, total spending on the three largest entitlements had reached 5.9 percent of GDP. In 2023, it was 11.0 percent of GDP, and by 2054, the Congressional Budget Office (CBO) projects it will reach 15.1 percent (assuming that Medicaid, which is not separately projected by CBO, remains relatively stable during this period). It is the growth of these programs, which now dominate the federal budget, that squeezed the fiscal space available for defense appropriations. It also led to significant borrowing.

The US fiscal outlook temporarily improved in the 1990s, when the Soviet Union’s collapse led to a substantial downsizing of certain aspects of Cold War deterrence policy. In the ensuing years, Congress gradually captured this “peace dividend” by appropriating less for military accounts, until defense had fallen to just 2.9 percent of GDP in 2000, down from 5.1 percent in 1990.² Without this budgetary relief, the fiscal pressures from entitlement spending growth would have become acute during those years. As it turned out, the US was able to run a surplus during the later years of the Clinton presidency. (The surplus reached 2.3 percent of GDP in 2000.)

From there, however, the budget outlook has been in a state of continuous and sometimes rapid deterioration. The outlook was already expected to become extremely challenging as the baby-boomer generation headed into retirement, but then the twin shocks of the financial crisis and the COVID-19 pandemic led to substantial increases in emergency borrowing. There has never been the political will to pair this borrowing with renewed fiscal discipline once the crises abated.

The Building Blocks of a Major Fiscal Reset

The federal government is a vast enterprise with hundreds of functions, budgetary programs, and revenue sources, and the electorate expects and deserves careful political scrutiny of every corner of it. No dollar should be wasted.

But stabilizing the fiscal outlook in a way that will make sufficient room for what is required for military strength and deterrence will not come about from closer looks at scores of small- or even medium-sized accounts. Most of these programs are funded through annually approved domestic appropriation bills, which are not the principal sources of today’s fiscal deterioration. Moreover, even with the savings possible from eliminating low-value expenditures, the sum would be minimal relative to the depth of the fiscal hole.

What is required is a concentrated focus on the most financially consequential policies—the major entitlement programs, the defense budget, and taxes—to better align those critical budgetary forces with the objectives of sustained military strength and a long-term decline in federal debt relative to the size of the national economy.

Despite ongoing political paralysis around the budget, there are actually numerous public plans available that would address the first problem, regarding spiraling debt. Indeed, the Peter G. Peterson Foundation has periodically commissioned the development of competing plans from politically diverse research organizations to demonstrate that there are multiple pathways toward a solution. That is an important service, as whatever is done in the end will almost certainly be a compromise that borrows from various ideological starting points. Neither Republicans nor Democrats have demonstrated sufficient political determination to pursue a solution to this problem on their own.

But before a compromise is even possible, it is important to present and defend concepts built on a set of principles that are internally consistent and compatible. The plan produced for the Peterson Solutions Initiative in 2024 by American Enterprise Institute (AEI) scholars (including this chapter’s author) provides a sensible starting point for considering how to right this ship.³ The AEI plan was one of only two that committed more to defense as part of a debt-stabilization program.⁴

The AEI offering was built around three main principles. First, the plan starts from the perspective that the US must sustain a dynamic and growing economy to have any hope of stabilizing its debt while maintaining its role as global leader of Western democracies. That means the reforms selected must emphasize business formation and investment, free-market competition to promote innovation and productivity growth, and strong incentives for an ever-expanding supply of skilled labor.

Second, as noted above, the plan takes as its most important objective the need to seriously reform the major entitlement spending programs, to prevent spiraling debt and make room for pro-growth tax policy and a higher commitment to defense. Those reforms center on health care and Social Security.

Third, the presumed path for defense spending should be well above what is forecast in today’s baseline, which is a declining commitment relative to the size of the national economy. For all other discretionary spending, there should be no presumption of large-scale savings, as there are just as many legitimate claims for increases as there are opportunities for savings from eliminating waste and low-value expenditures.

These principles were translated into the following specific policy recommendations.

Tax Reform. In 2017, during the first year of President Donald Trump’s first term, Congress approved a major tax cut, called the Tax Cuts and Jobs Act (TCJA), which included many provisions that will expire at the end of 2025. There is now a push to make these tax cuts permanent or extend them into the future as far as politically feasible, without finding offsetting spending reductions or tax hikes. That would be a mistake. At this point, it is plain that the priority should be fiscal consolidation with a tax reform plan that is pro-growth. That means paying for whatever tax plan is assembled rather than continuing tax cuts.

Consistent with that perspective, the AEI plan proposed a tax reform that would produce revenue in the future equivalent to today’s current law baseline—that is, the baseline that assumes expiration of many TCJA provisions will occur as scheduled at the end of 2025. But the reform would be far more pro-growth than pre-TCJA law because it would eliminate scores of tax expenditures to finance the lowest possible rates to taxable income, for both businesses and individuals.

The most significant reforms in the plan are as follows:

• The exclusions and deductions from taxation of interest on municipal bonds, interest paid on home mortgages, state and local taxes, medical expenses above a threshold, and a variety of business preferences would be fully repealed or substantially modified.
• The estate and gift tax would be repealed, but unrealized capital gains (above a threshold amount) would be taxed at death.
• A carbon tax would be adopted to replace the Clean Power Plan and other climate-related regulations.
• The gasoline tax rate would be increased.
• The exclusion of employer-paid premiums for health coverage would be capped.

These provisions would pay for lowering the tax rates applicable under TCJA by another 5 percentage points in each tax bracket.

Health Care. The major focus in health care must be to bring more cost discipline to the provision of services. In the AEI plan, that would be accomplished through several channels.

In Medicare, private plans and the traditional, government-managed benefit implicitly compete with each other, but only imperfectly, as the rules make comparisons difficult. The AEI plan recommends changing these rules based on the premium-support model. This would require the plans offering coverage to Medicare beneficiaries to compete more vigorously based on the premiums they charge for standardized coverage, which would include annual out-of-pocket protection for all beneficiaries and a single deductible across all three parts of the insurance benefit (A, B, and D). Beneficiaries would lower their costs by gravitating to the most efficient plans. The rules for Medigap insurance, which wraps around the traditional program, would be modified, too, to promote competition and lower overall costs.

Medicare spending would be reduced further by raising the general premium rate from 25 to 30 percent, tightening the reimbursement rules for hospital-affiliated clinics (so-called “site neutral” payments), and gradually raising the eligibility age for the program so that it conforms to current law under Social Security (to age 67).

In Medicaid, the emphasis would be on straightening out the federal and state governments’ financial responsibilities. Instead of today’s matching system, which leads to program-integrity problems, the federal government would provide states with a fixed amount per Medicaid enrollee (sorted by eligibility categories). In addition, the permissive rules governing the use of provider taxes to satisfy the state-matching requirement would be substantially tightened.

Social Security. The plan proposes a sweeping overhaul of Social Security to move the program toward more secure old-age protection for low-wage earners and a less generous benefit for upper-middle-class households. The plan, based in part on the successful model adopted in Australia, has the following elements:

• Over a long transition, new entrants to the system would receive a flat dollar benefit based on a universal formula, not tied to workers’ individual earnings records. The benefit would assure all participants of an income in retirement above the elderly poverty threshold. The flat amount would grow each year with increases in the national average wage.
• All workers would be automatically enrolled in fully portable employer-managed retirement accounts, with a minimum contribution of 3 percent of earnings. These accounts would fund supplements to the flat benefit.
• To encourage workers to stay employed as long as possible, the payroll tax would be eliminated for earnings starting at age 62.
• The early eligibility age for benefits would be phased up from age 62 to 65.
• For disability benefits, employers would pay an experience-rated tax based on the number of workers they employ who become disabled and qualify for benefit payments.

Defense. The plan did not attempt to support a specific program of improved military readiness and resilience. Instead, its budget forecast assumed a steady increase in annual defense appropriations of 10 percent through 2030, after which the funding boost would be steadily eliminated. This increase remains well below what is likely required for rebuilding an effective deterrence against multiple emerging national security risks.

Nondefense Discretionary Appropriations. The plan assumes no savings in the sliver of the budget devoted to domestic appropriations, as the opportunities for reductions are matched by legitimate claims on more resources among programs that perform well but receive inadequate budgets for their missions.

The Plan’s Effects. When this plan is pulled together in a comprehensive projection of budget totals, the results, reflected in Table 2, are encouraging.

The plan’s major emphasis is a substantial moderation in long-term spending on the major entitlement programs. The reforms aimed at these major line items ease fiscal pressure sufficiently to begin reducing debt even as federal revenue is held to baseline levels. The plan also benefits from a boost in expected economic growth from tax reforms that incentivize business investment and an expansion of the labor force.

Table 2. Budget Aggregates, Current Law vs. AEI Proposal (Peterson Initiative)

Source: Congressional Budget Office, The Long-Term Budget Outlook: 2024 to 2054, March 2024, https://www.cbo.gov/system/files/2024-03/59711-Long-Term-Outlook-2024.pdf; and Joseph Antos et al., “A Balanced Plan for Fiscal Stability and Economic Growth,” in Solutions Initiative 2024: Charting a Brighter Future, July 2024, Peter G. Peterson Foundation, https://solutions2024.pgpf.org/plans/aei/.

Note: * CBO did not project this line item to 2054. The figure represents the author’s forecast based on current trends. ** The AEI plan did not separately project defense and nondefense in presented data for these years. The figures represent the author’s estimates based on trends. Totals have been rounded.

When all the various policies are pulled together, the effect on federal borrowing is substantial and positive. As shown in Figure 1, under current law, federal debt is projected to reach 166 percent of GDP in 2054. By contrast, under the AEI proposal, debt would rise modestly in the coming decade and then begin a gradual decline until it reached 85 percent of GDP in 2054—a level not seen since 2019.

Figure 1. Debt Held by the Public, CBO Baseline vs. AEI Proposal (Percentage of GDP)

Source: Congressional Budget Office, The Long-Term Budget Outlook: 2024 to 2054, March 2024, https://www.cbo.gov/system/files/2024-03/59711-Long-Term-Outlook-2024.pdf; and Joseph Antos et al., “A Balanced Plan for Fiscal Stability and Economic Growth,” in Solutions Initiative 2024: Charting a Brighter Future, July 2024, Peter G. Peterson Foundation, https://solutions2024.pgpf.org/plans/aei/.

Providing Additional Fiscal Space for Defense

The plan submitted by the AEI team to the Peterson Solutions Initiative was written to demonstrate that serious entitlement reform combined with a pro-growth tax plan could boost economic growth and stabilize federal borrowing at levels that would lessen the risk of a debt-induced economic rupture. The plan included an acknowledgment that the allocation to defense in current projections is inadequate and therefore requires a boost, but the amounts provided in the plan were small compared to what national security experts are now stating is required to build an effective deterrence against multiple security threats.

To provide more space for a sustained defense-funding boost over a longer time span (such as two decades), incoming leaders should consider budget reforms that go beyond what AEI’s plan contains. Given the size of the current hole in military funding, leaders may choose to push the commitment in the coming years by 1 to 2 percentage points of GDP above what is contained in the plan described in the previous section. That could mean annual defense funding reaching, and staying at, somewhere between 4 and 5 percent of GDP each year.

Given the already substantial reforms recommended for the major entitlements in the AEI plan included in the Peterson report, there is little room there for recommending additional restraint. That plan, however, did not call for a net tax increase, which means more revenue is a realistic option.

There are many options for raising revenue, but two stand out because of the compelling need to shift from current practice.

A Carbon Tax with Slightly Higher Individual Rates for Upper-Income Households. In the plan AEI scholars submitted to the Peterson effort, a new tax on carbon emissions was advanced as one line item that would allow for pushing individual tax rates down as much as possible (with a top bracket set at 35 percent). To generate more revenue, this tax, which was set in the plan at $25 per metric ton of CO₂ equivalent in 2025 and then indexed to inflation plus 2 percentage points annually, could generate higher overall revenue instead of paying for a revenue-neutral reform. It could also be adjusted as needed to generate even more revenue than is assumed in the current AEI plan.

The potential for a boost in tax receipts is substantial. According to the International Monetary Fund, carbon taxes could generate revenue equal to about 1 to 2 percent of national GDP.⁵ The tax can also be designed to apply fairly to the pricing attached to imports and exports (as the AEI plan called for).

A carbon tax has a further additional benefit in that it is consistent with a climate strategy built on apolitical oversight of the energy market. That is much less possible with mitigation predicated on the allocation of subsidies to relevant industries and stricter energy regulations. With a carbon tax, market participants will have strong incentives to balance all the objectives they must weigh when trying to maximize their profit, including the price effects of tax on carbon emissions. There would be no need for excessive political interference in such decisions, which invite favoritism and corruption.

Higher Payroll Tax Revenue for Medicare. An important and largely unnoticed factor in the past few decades’ fiscal deterioration has been the steady rise in the burden Medicare imposes on the Treasury’s general fund. Parts B, for physician and outpatient services, and D, for outpatient prescription drug coverage, are heavily subsidized by annual transfers from this fund. When the government is running large overall deficits, as it is today, these transfers effectively force the Treasury to borrow more in public markets than it would otherwise.⁶

This dependence on Treasury subsidies runs contrary to how Medicare was originally presented to the public: as a program that would not become a fiscal burden because it would be financed largely from new payroll taxes (like Social Security). That turned out to be only partially true and, as the years passed, less and less of an accurate depiction of the program’s financial effects. In 1980, the general fund transfer to Medicare totaled only 0.4 percent of GDP. By 2023, it had reached 1.6 percent, and the Medicare trustees expect it to reach 2.8 percent of GDP in 2050.⁷

As part of a significant fiscal reset, policymakers should consider lessening Medicare’s dependence on the general fund by financing more of the program from traditional payroll tax receipts. The shift in program financing could be calibrated to meet fiscal goals associated with making more room in the federal budget for defense spending. One goal might be to limit the general fund commitment to Medicare in future years to what it was in 2023—1.6 percent of GDP. That implies increasing taxes to provide about 1 percentage point of GDP to the program as a replacement source of revenue. While it would be most straightforward to simply increase today’s Medicare payroll tax rate of 2.9 percent of taxable wages, Congress could choose instead to place more of the burden on high-wage workers to avoid placing new financial burdens on lower-wage households.

There are of course many more ways besides these two options for raising revenue. However, these two were selected because they have compelling policy rationales beyond the need to increase revenue for defense funding. Medicare’s financing model is now outdated and should be modernized, and Congress will need to settle soon on a long-term strategy for climate change mitigation. Raising more revenue with the changes described here would therefore satisfy multiple public policy objectives.