Wednesday, September 15, 2010

Federal government finances continue to improve

First, let me be clear: the federal budget is in miserable shape, since expenditures have exploded in recent years and the deficit is a huge percentage of GDP. Nevertheless, on the margin things are improving. One of the most encouraging signs of improvement is the rise in federal revenues over the past five months (see the blue line in the above chart), since that is a sure sign that the economy is doing better. People don't pay more in taxes unless they are earning more.

As this next chart shows, revenues haven't increased much compared to GDP, but at least they are no longer falling. Spending, on the other hand, has not only declined in nominal terms but also relative to GDP, with the result that the federal deficit over the past 12 months is now "only" 9% of GDP. That's still gigantic, of course, equating to fully $1.3 trillion, or just over $100 billion per month

The challenge going forward will be to cut back government spending. Tax rates don't need to rise to fix the budget deficit. Extending the Bush tax cuts would most likely result in a stronger (than otherwise) economy, and that would lift tax receipts even as tax rates remained unchanged. The best way to deal with the deficit is through reductions in spending, since that would likely boost the economy even further (see previous post for an explanation as to why). Growth is the solution to our current problems, and the best way to achieve that is through no tax increase and a lot of spending reductions. The solution is in sight, and it's already working to some extent.

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