Before the Congress gets mired in the fight to cut the deficit, it is critical that Americans know where the government spends taxpayer dollars and from which sources the government generates most of its tax revenue. Let’s face it. Any rational person will admit that cutting the deficit cannot be done through tax increases alone (the Democratic way) or entirely through budget cuts (the Republican way). There must be some combination of the two.

At some point, I will take a look at the revenue side of the tax equation. But for now, I will focus on areas where the government should make cuts. Some might argue that there is no reason to make cuts. In fact, cuts could jeopardize an economic recovery. In the short-term, I agree with this logic given how delicate the economy is today. However, the government needs to start making cuts as soon as one to two years from now because its growth is simply unsustainable.

Don’t believe me? Below is a chart showing the percentage of government outlays as a percentage of GDP – a proxy for the relative size of the government to the size of the U.S. economy. Since 1930, the relative size of government was largest during World War II with the top three years being 1943, 1944, and 1945. Guess which year was the fourth largest? You guessed it: 2009.

Since 1930, the average government outlays as a percentage of GDP hovered around 19%. However, the chart below shows that this percentage is trending upwards.

Source: U.S. Government Publishing Office

What Programs Should Government Cut?

The simplest way to start is by looking at where the government spends most of our tax dollars. Where’s that? The short answer is social security and defense. In 2009, 17.3 cents of every federal dollar went into defense and 17 cents went into social security. For every dollar of GDP the U.S. economy produced, defense and social security each consumed 4.8 cents. Health, Medicare, income security programs (e.g., the Earned Income Tax Credit, welfare, SSI Disability, etc.), and net interest combined consumed an additional 36% of the federal budget in 2009. In total, these six items consumed about 70.4% of the federal budget in 2009. Any reasonable approach to balancing the deficit must include one or more of these items to have any meaningful impact.

Defense Declining as Share of Budget and GDP; Social Security Increasing

While the defense budget stood at a whopping $690 billion in 2009, its share of the budget is much lower than its historical average of nearly 37% since 1940. In contrast, social security’s share is higher than its historical average of almost 15% and it is rising. The charts below show the trend of these six major budgetary items as a percentage of federal outlays and GDP.

Source: U.S. Government Publishing Office

Source: U.S. Government Publishing Office

My Modest Proposal: Four Pillars of Spending Cuts

To achieve a rational policy on deficit reduction, the government must use a combination of tax increases and spending cuts. On the spending side, the government should focus on four areas.

1. Pay Down Debt

The most obvious way to address the budget deficit is to reduce interest payments. The best way to do that is by paying down debt. The problem is funding this pay-down. One way to fund it is to increase taxes. Another is to cut spending. Let’s assume a rational government does a mixture of both.

2. Reform Social Security

When social security made its first payouts in 1940, the retirement age was 65, but the average life expectancy for a 65-year-old man was 11.9 years. In 2010, the retirement age for Americans born after 1960 was 67. However, by 2007, the average life expectantly rose to 16.7 for men and 19.2 for women. At the very least, the retirement age should be indexed to 1940 numbers (“See Will Washington Dare Raise the Retirement Age for Social Security?”). For example, the government could reset it once every five or ten years for various age cohorts such that the average retiree has a life expectancy of ~12 years. In addition, there should be some form of an income means-test for receiving social security to prevent an unfair wealth transfer from poorer, younger Americans to older, wealthier ones. The current system just does not make any sense. For instance, according to the U.S. Census Bureau, only 3.8% of married couples under 35 had a net worth of $500,000 or higher, but 27.8% of couples ages 65 or older fit into this category in 2004. Why must a secretary subsidize the retirement of a CEO?

3. Review and Reform Healthcare

It is no mistake that Obama chose this issue as his marquis program in the first two years of his administration. In 2009, health and Medicare cost the government a combined $784 billion and constituted nearly 20% of the budget – more than either defense or social security. Medical costs continue to rise rapidly. The key question today is whether Obama’s cure for the problem is worse than the disease. Only time will tell.

The problem with the current policy is that the public has no idea what is in the law. Few experts can predict how it might work in practice. This probably explains why Obamacare is unpopular with a plurality of American voters. According to a November Pew Research Center poll, 48% of voters support repealing the healthcare law, 31% want to expand it, and 16% want to keep it as is.

The bottom line is that the 112th Congress should revisit the healthcare law, but in such a way that results in reduced costs for the government. Simply repealing the Act and then ignoring the problem is not a rational solution.

4. Reduce Defense Spending

I am a defense hawk and believe in a strong national defense. That said, the only way to move the country forward is through compromise. Given that defense is typically the first or second largest federal budgetary item each year, cuts must be made for any serious attempt to balance the budget to be successful. Fortunately, Defense Secretary Gates is already moving in this direction. He is meeting with Congressional leaders today to outline his plan for saving $100 billion over the next five years.

Let’s hope the new crop of politicians in Congress focus on reducing the deficit rather than jockeying for the next Presidential election. I have my doubts.