Washington needs to control spending, not raise tax rates

Federal government finances have been terribly unbalanced for the past four years, but the good news is that things are looking better, even as we approach the dreaded "fiscal cliff." The budget deficit peaked at $1.47 trillion in December 2009, equivalent to 10.5% of GDP. As of last month, the 12-month deficit had fallen to $1.1 trillion, or about 7% of GDP. That's welcome progress, and it has come about thanks to very slow growth in federal spending and a decent recovery in tax revenues spurred almost entirely by a growing economy.

As the chart above shows, the Great Recession was responsible for a 22% plunge (about $575 billion) in tax revenues. Since 2009, however, revenues have risen 22%, or about $455 billion. From the beginning of the Great Recession through today, federal spending has increased about $800 billion, while tax revenues are down only $120 billion. By far the largest factor driving the budget deficit, therefore, has been the surge in spending. Fortunately, that surge has not continued, but neither has it reversed, whereas the decline in revenues has reversed almost entirely.

As the chart above shows, individual tax receipts are up about $305 billion from the recession lows, accounting for two-thirds of the increase in total revenues. Corporate profits taxes have doubled over the same period, adding $120 billion to total revenues. All of this without any increase in tax rates.

The big message here is that federal revenues are highly sensitive to the health of the economy. They have risen strongly since the recovery began, despite the payroll tax holiday instituted almost two years ago, and revenues are likely to continue to increase as the economy continues to grow. It is spending that is still out of line. If Congress can control the growth of spending going forward, then the budget mess we're in will be resolved without the need for higher taxes on anyone. This is a very important point, since higher tax rates could jeopardize the health of the economy, and that in turn would slow or even reverse the ongoing gains in tax revenue. Balancing the budget only requires that we restrain the growth in spending; going forward, that will be especially important as concerns entitlement spending.