Saturday, February 19, 2011

Federal budget trends: more and more redistribution is less and less likely

The Office of Management and Budget's FY 2012 Budget document contains some fascinating historical data on the long-term trends in taxation and spending. John Merline of AOL News has an excellent discussion on the subject here (HT: Glenn Reynolds), which Mark Perry recaps here.

I've put together some additional charts, which follow.

In the above chart, I note that federal income taxes have averaged about 8% of GDP for the past 50-60 years, while taxes for social security, medicare and retirement-related revenues appear to have maxed out at just under 7% of GDP for the past 30 years. Corporate, excise and other taxes have dwindled for years, totaling about 3% or so of GDP in recent decades. It's tough to imagine that income tax revenues could ever exceed 8% of GDP by much, no matter how high tax rates were (see below for justification). It's also tough to see how the middle class could be squeezed more by raising the threshold on social security taxes, since that threshold has been raised repeatedly over the past few decades, yet revenues have failed to rise relative to GDP. And we can't realistically raise corporate tax rates, since they are already among the highest in the developed world. The only way the federal government is going to raise significant tax revenues is by broadening the tax base and increasing the incentives to work, invest, and take risk, and that involves lower marginal tax rates, fewer deductions, and fewer exemptions.

The next chart (above) shows how the composition of federal spending has shifted massively to "transfer payments," and away from defense-related spending. Payments to individuals now account for about 65% of total federal spending! Thanks to historically low interest rates, net interest payments are still very small relative to GDP, even though the federal deficit is at a post-War high relative to GDP. It's tough to see net interest payments not rising if and when the economy improves, since it is virtually certain that the Fed will raise rates as the economy improves. Defense could probably decline further relative to GDP, as it did in the Clinton years, but the only thing that is going to make a real dent in the burden of government spending is to curtail transfer payments. That means tackling entitlements (social security, medicare, etc.), and that, in the end, is what the next several years are going to be all about. If we don't throttle back entitlements, then government spending is going to keep rising relative to GDP and that is going to suffocate the economy. We are on an unsustainable trajectory (that's the bad news), but that means that it won't be sustained (that's the good news).

This next chart breaks down federal spending into defense and nondefense spending. Again, it is noteworthy just how little of what the government spends today is defense-related, and how much goes for other things.

The chart above shows how the federal government increasingly relies on "the rich" (the top 10% of income earners) for income tax revenues. The top 10% pay about 70% of all income taxes. This is a vindication of the Laffer Curve, since it demonstrates that reducing the top marginal tax rate from 70% in the 1970s to 35% in recent decades (see chart below) has not resulted in a 50% decline in tax receipts relative to the size of the economy. Lower rates have reduced the incentive to evade taxes, and increased the incentive to work and invest, thus broadening the tax base by enough to largely offset the lower tax rate. And as I have noted before, federal tax revenues are currently growing at just over 10% a year, and that means that tax revenues as a percent of GDP are quite likely to rise back to their long-term average of about 18% in coming years, assuming no adverse policy shifts.

To fix our awful fiscal mess, there is no need to raise tax rates. Indeed, lower tax rates and fewer tax deductions would likely be of great help, since they would stimulate the growth of the private sector. As for spending, I think the numbers show that we have reached the limit: there is no alternative to finally addressing the runaway nature of entitlement spending.

The fix is not that terrible, as men such as Gov. Walker of Wisconsin, Gov. Christie of New Jersey, and Gov. Daniels of Indiana are explaining daily. We've got to impose tough restraints on public sector unions and on public sector pay and retirement benefits; it's past time that the public sector went through a severe belt-tightening. We've got to introduce market incentives to healthcare, by changing the tax code to allow either everyone or no one to deduct healthcare expenses—thus eliminating the third-party-payer problem, by allowing individuals to buy healthcare policies from insurers in other states and by pursuing tort reform. Finally, we've got to face actuarial realities by raising the retirement age for social security, and indexing benefits for inflation instead of for the growth in wages. And of course, we need more politicians who are less concerned about their individual power and perks, and more concerned about doing what's right for their country. The rise of the Tea Party is our best hope on that front.

I fail to see how the American people could refuse to understand these basic but very powerful concepts. Therefore I remain optimistic that a solution to our problems is not only possible but likely.


Anathemata said...

I enjoy this post very much, but I have some reservations, As a fraction of GDP, defense spending, logically, should decrease. If our economy doubles in size, but our defense needs remain the same, then defense spending should be cut in half, relative to GDP.

The Cold War is way over--meaning that defense spending should consume shrinking percentages of GDP every year. It speaks to infinite volumes of waste and Congressional meddling that we have not been able to radically curtail defense outlays.

Other agencies could be eliminated, including the USDA, the VA (privatized), Commerce, Labor and HUD. The Post Office could be run profitably, but would have to curtail rural deliveries.

I see no chance hoard sacred cows will be gored--we have to somehow grow our way our of this mess, ala the 1990s.

I would like to see the corporate income tax abolished, and replaced with a gasoline tax.

Benjamin said...

BTW DJI nearing 12,40-- my prediction of 13k on the DJI by the World Series may be tame.

Dr William J McKibbin said...

Persuasive and instructive, yes...

Mr. Kowalski said...

There are three "rocks" in this debate: The Republicans, who will not stand for any more tax hikes, the Democrats, who will not stand for reductions in Soc Sec and Medicare, and the mathematics of the Bond markets. So far, the path of least resistance is the bond markets, and so we borrow like there's no tomorrow.

One day soon enough this will have to be dealt with. Or will it ? We need to remember the exceedingly dangerous situation other nations are in.. namely Europe and Japan. It's my honest guess that the "Day of Reckoning" will occur in either Europe or Japan before it reaches our shores.. and if it's serious enough, it might just crash our own economic system thanks to overleveraged banks and CDS's.

Gene Prescott said...

The Federal Tax Shares chart is interesting as the 10% increase in tax paid by the top 10% of income earners was actually paid by the top 1% of earners.

Thomas said...

I agree

Benjamin said...

You know, I reread this excellent post.

If you look at the top chart, the people who should be "mad" are not those who pay income taxes (about the same take as ever, as percent of GDP) or corporate income taxes (long-term decreasing as fraction of GDP) but payroll taxes (long-term increasing as percentage of GDP).

Do you get the impression that the Republican Party is complaining about payroll taxes? Are they talking payroll tax cuts?

These are workers and employers who pay payroll taxes. In other words, productive people.

Seems like a huge misfit between Republican Party posturing, and what has really happened to taxes in the last 30 years.

It is hard to have faith in either party these days.

randy said...

It's true that payroll taxes, as a percent of total income, are much higher for lower income workers. However, according to a CBO analysis, social security is actually a significantly progressive tax. This conclusion is reached by analyzing taxes paid and benefits received.

"The Social Security system is progressive: the ratio of lifetime benefits to lifetime taxes declines significantly as lifetime earnings rise. As shown in Figure 1, the benefit-to tax ratio is above 100 percent for the bottom earnings quintile (that is, the 20 percent of individuals with the lowest lifetime earnings) in all birth cohorts; that is, on average, those individuals receive lifetime benefits that exceed their lifetime taxes. The ratio is close to 100 percent for the middle earnings quintile in all birth cohorts: on average, those individuals receive benefits that are roughly equal to their lifetime taxes. The ratio is consistently less than 100 percent for the highest earnings quintile: on average, higher-earining individuals receive less in Social Security benefits than they pay in taxes over their lifetime. The ratio for the bottom quintile is almost three times that for the top quintile."

Of course there are many that argue otherwise, with the most persuasive argument being that taxes and benefits are two separate issues and it's unfair to lump them together to measure progressivity.

Progressive or regressive - is academic. What really matters is that the payroll taxes collected from poor and rich alike have all been spent on other things, and we've promised far more in entitlements than could possibly be paid. The only way out is reduced benefits.

Scott Grannis said...

Benjamin and randy are both right: the value received from payroll taxes is an abomination. Virtually everyone would be better off if they were allowed to invest their FICA taxes in a real investment account. To begin with, the money would be their property, whereas no one has a legal claim on their supposed social security benefits. Social security is basically a very progressive tax masquerading as an annuity. An annuity, furthermore, that is designed and run by politicians and not actuaries.