Rising rates will reverse progress on federal deficits

Copies of President Barack Obama’s proposed budget plan for fiscal year 2014 are on display at the U.S. Government Printing Office in Washington.
Getty Images
Copies of President Barack Obama’s proposed budget plan for fiscal year 2014 are on display at the U.S. Government Printing Office in Washington.

For the moment, it looks like the government is doing a better job managing the way it spends your tax dollars.

But with interest rates expected to start rising soon, the good news is only temporary.

The level of government overspending—usually referred to as the budget deficit—fell by nearly a third during the fiscal year that ended last month, mostly because revenues grew a lot faster than spending, according to a Congressional Budget Office report on Wednesday.

The Treasury collected a little over $3 trillion—nearly 9 percent more than it did a year ago—while spending rose just 1.4 percent to $3.5 trillion, according to the CBO.

That shrank the deficit to $486 billion for the latest year—about $195 billion less than the budget gap in fiscal 2013.

Higher discretionary spending—up $44 billion—was fueled largely by the cost of expanding health-care coverage. And the total paid out in Social Security checks was $37 billion more than last year. Those spending increases were offset by a $30 billion cut in spending by the Defense Department and a $24 billion drop in jobless benefits.

Read MoreFed's Kocherlakota: 'Inappropriate' to raise rates

The improved job market also helped the government collect more money than expected. That's because the expanding pool of jobs boosted overall wages, generating more tax revenue for the government.

"Growth in wages and salaries explains most of the increase in withheld receipts, but almost one-third of it stemmed from changes in law," the CBO said, citing an increase in payroll tax rates that pushed up withholding.

Higher corporate profits also boosted corporate taxes up $48 billion. The Federal Reserve's massive bond buying also generating a pile of interest on those bonds, which the Fed turns over to the Treasury. That added another $23 billion to Uncle Sam's coffersabout 31 percent more than last year.

But interest rates are a double-edged sword for the government; the Treasury also has to pay interest to holders of nearly $18 billion in U.S. debt. Since the Fed began engineering super-low rates following the 2008 financial collapse, the Treasury has been getting a break on those payments. Think of it like a low teaser rate on your credit card.

Those low rates are expected to start rising next year, as the Federal Reserve phases out its bond buying program and allow rates to rise to more normal levels.

Read More'Weak and uneven': IMF cuts global growth forecast

That's one reason the recent progress on trimming the deficit will likely be short-lived, according to economists at Wells Fargo Securities.

They note that spending cuts, known as in Washington-speak as "budget sequestration" are set to expire in 2016. And rising interest rates will boost Treasury payments to holders of U.S. debt.

"Even with only modest increases in short-term interest rates, the year-over-year rise in interest expenses is already materializing," the Wells Fargo economists noted.

Read More'Enormous' rise in global inequality: OECD

They figure on rates rising a little higher than the CBO estimates, an note that Congress is likely to extend tax breaks that could also cut into revenues.

"Interest expenses will begin to play a much more dominate role in the federal budget," they said. "All of these factors set up growing fiscal pressures in the later part of this decade."