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With tax season just wrapped up, many of us are still scratching our heads over the bizarre math of government. At present, taxes actually fund only 64% of government operations, with the balance coming from increases in government debt (borrowing). While the financial crisis and its aftermath have helped to balloon deficits, the primary drivers of government spending remain:

Defense (All Federal Security-Related Spending): $905.3 Billion (2011)
Health Care (Medicare, Medicaid, and Other Federal Insurance Programs): $855 Billion (2011)
Social Security: $725 Billion (2011)

These three areas account for almost 70% of all US government spending, and have collectively risen 250% since 2000, irrespective of governing party. None of this is news for those who follow US politics and government spending. But what happens when this spending begins to hit the wall? At some point budget deficits will cause a combination of inflation and rising interest rates, as ongoing debt issuance makes its presence felt in bond and money markets. Inflation and rates might not rise if the US falls into a Japan-style grinding disinflation, but that is likely the worst outcome!

An alternate scenario might unfold if the federal government is able to bring the deficit down to more sustainable levels. While this would no doubt involve some combination of painful spending cuts and tax hikes (or loophole reductions), longer term stability might serve to promote growth. Here’s one way the scenario might unfold:

While such a scenario would likely provide an overall boost in consumer confidence and the economy, certain sectors might suffer under the weight of fiscal cuts. The health care and defense sectors will feel the brunt of spending cuts, as deficit reduction is close to impossible otherwise. The health care sector in particular is accustomed to health care inflation rates staying significantly above CPI – were this trend to change, it would greatly impact investments in the sector. The defense establishment has also become complacent after a decade of record growth – it’s not clear how well defense stocks can handle 0% defense spending growth. Both of these sectors are traditionally considered less risky – so it’s important to consider how future government spending plans could have an outsize impact here!

Source: Taxes, Deficits, And The Inevitable