The net federal debt is about 100% of annual GDP. A high debt to GDP ratio raises interest rates. It makes the United States hostage to the emotions of international investors. The Congressional Budget Office estimates that the deficit is on a trajectory to 118% of GDP by 2035 and that paying interest on the debt will increase from the current 3% of GDP to over 4% of GDP within 10 years. Paying interest on the debt is growing at almost 10% a year, substantially faster than growth in nominal GDP, the combination of real growth plus inflation. Interest on the debt is not a productive use of U.S. resources.
This path is not sustainable. At some point soon, the public market in United States Treasuries will break. Investors will just say “no” to the open faucet of federal spending. Interest rates will spike, and a deep recession will follow. To compound the fiscal crisis that the nation faces, the U.S. Senate is now considering an omnibus Reconciliation bill, which will almost certainly become law sometime in July or August of this year. This Reconciliation bill will make the deficit outlook even darker.
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The size of the federal deficit and the cost of paying interest on the debt raises interest rates across the economy, reduces business investment, and lowers the potential growth rate of the economy. The deficit makes every American poorer. There is no easy path to reducing the deficit, but the least painful route is by instituting pro-growth policies that would accelerate economic output. In addition, a firm commitment to capitalism would help a lot. Washington, D.C., is a swamp of crony capitalism and regulatory capture.
Unleashing the full potential of Artificial Intelligence, modest immigration reform, permitting reform, improved electricity transmission systems, reducing restrictions on residential housing, and increased spending on government-sponsored research and development, R&D, offer a road map to faster economic growth. The U.S. can achieve sustained 3% growth in GDP. However, faster economic growth alone will not solve the deficit problem. Tweaks to tax policy and to entitlement programs will also be necessary.
Put simply, there are no easy fixes. Let’s consider a number of key possibilities in turn.
Artificial intelligence
Fully embracing artificial intelligence (AI) offers the easiest and most efficient route to raising the long-term growth rate from the current level of around 2% GDP growth to 3% growth. If the U.S. economy can grow at a sustained rate of 3%, then the debt-to-GDP level could be stabilized. There are reasons to be optimistic about integrating AI into the U.S. economy and increasing the long-term growth rate.
U.S. business is forging ahead on AI investment. In 2024, domestic private investment in AI expanded to $109 billion, almost 12 times China’s $9.3 billion. In addition, the U.S. has produced 40 superior AI models, significantly more than China’s 15 and Europe’s 3 models. Over the next 20 years, AI could increase long-run productivity growth by 17% and could add $7 trillion to GDP. By itself, AI could dramatically change the path of the federal deficit. Fortunately, President Donald Trump is fully committed to AI.
Immigration reform
Another piece of low-hanging fruit to accelerate U.S. economic output is a modest tweak to U.S. immigration policy. Raising immigration of high-skilled workers, those with advanced math and science qualifications, with so-called H-1B visas, has the potential to increase long-run productivity growth. Currently, H1-B visas are capped at 85,000 per year. Raising the cap on these visas to 200,000 a year could increase domestic GDP by a full 10% over a 30-year period. This should be a no-brainer. America wants the best and brightest because their talents ultimately enrich us all.
Permitting reform
Expediting the permitting process could deliver substantial economic benefits. Permitting reform would lower obstacles to private investment in energy projects and in modernizing the electricity grid infrastructure. It would also provide certainty to capital investment. Private investment would arguably increase for high-return infrastructure projects such as AI data centers, nuclear power plants, and other high-return investments. Reducing significantly the time to approve a major project has the potential to increase private investment in infrastructure by up to 10-fold.
Moreover, a dramatic decrease in the time to approve a major energy infrastructure project would lower energy bills for U.S. households. Lower energy costs would translate into lower inflation and lower interest rates. This would be a winning feedback loop.
Improving electricity transmission
Improving the efficiency of the long-distance transmission of electricity could result in measurable reductions in the cost of energy. The potential gains are significant because energy costs account for almost 7% of GDP. Lowering the cost of electricity will be especially important because of the very rapid growth in AI data centers. AI is very energy-intensive. Efficient long-distance energy transmission and the rapid build-out of AI go hand in hand.
Residential housing reform
The residential housing sector annually accounts for about 15% of total GDP. The U.S. needs more homes. The demand for housing exceeds supply by 4 million units.
The principal impediments to increasing the supply of housing are local government permitting and zoning restrictions. The federal government should use its control over highway funding to “persuade” local governments to eliminate unnecessary restrictions on building more housing. Residential construction would increase. Jobs would be created and as the supply of housing increased, the inflation rate for housing would moderate. Reforming the residential housing market is truly low-hanging fruit.
Government spending on research and development
Since the mid-1960s, with the increase in social welfare spending by the federal government in order to fight “poverty,” federal government outlays on fundamental research and development have declined. Welfare has crowded out productivity-enhancing investments. The data is clear that increases in federal appropriations for R&D over time generate large annual increases in the growth rate of national productivity. The annual productivity growth attributable to increased federal R&D spending is on the order of 0.3% of GDP, or an additional $100 billion in annual output. Increasing R&D spending should be a priority of the Trump administration. R&D spending truly pays for itself.
Tax policy
Tweaks to federal tax laws would substantially reduce the federal deficit over time. For the current fiscal year, which began on October 1, 2024, the congressional Budget Office estimates that total federal revenues will reach just over 17% of GDP, but spending will exceed 23% of GDP for a fiscal deficit of 6-7% of GDP. Spending on Social Security, Medicare and Medicaid is rising at an annual rate of about 8% for each program. Paying interest on the debt is the fastest growing part of federal spending. It is increasing at an annual rate of about 10%.
Increasing federal revenues by just 2% on an annual basis would demonstrate to investors in U.S. Treasuries that the U.S. is committed to reducing the federal deficit. Interest rates for Treasuries would almost certainly fall, after all real returns on longer dated Treasuries are above 2%. Based on historical data, a 2% real return is very attractive.
Entitlements and servicing the federal debt drive the deficit. Raising the retirement age for full Social Security and Medicare benefits to 70 years for individuals under the age of 50 would reduce the long term growth rate of the programs. The people of Denmark just raised their retirement age to 70.
One other very slight change to the Social Security program would also improve the long-term fiscal picture. Currently, the annual Cost of Living Adjustment, COLA, for Social Security recipients is based on the Consumer Price Index, CPI. This inflation measure overstates inflation by as much as 0.5% a year. The Federal Reserve’s preferred measure of inflation, the personal consumption expenditure price index, PCE, more accurately reflects true inflation. Switching to the PCE index would save a lot of money and would not harm the elderly population, after all, the COLA adjustment is designed to reflect actual inflation.
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The U.S. can put its fiscal house in order. It only requires a commitment by the Trump Administration and Congress to pass growth-enhancing legislation.
We should do it. Or accept that when the recessionary storm arrives, we only have ourselves to blame for the great pain that storm carries with it.