Federal finances continue to improve

The federal budget outlook is still dismal, but—believe it or not—there has been substantial progress. Federal spending in the past three years has increased by a total of only 1.5%, while federal revenues have increased by a total of 22.7%, despite a 2-year payroll tax holiday and no increase in tax rates!

The chart above shows the 12-month running total of federal spending and revenues. Note that since the end of 2009, spending has been almost flat, while revenues have increased steadily. Congressional gridlock gets the credit for slowing spending growth, while the economy's ongoing recovery—regardless of how unimpressive it has been—gets the credit for boosting tax revenues. It is unfortunate that President Obama has placed so much importance on increasing tax rates for the rich in order to address the still-yawning budget gap, when tax revenues have been rising quite impressively without any assistance from higher rates. Economic recovery has once again proven to be the best source of tax revenues for the federal government. The public has not gotten this message.

This next chart shows spending and revenues as a % of GDP. Note that simply stopping the growth of nominal spending is enough to bring about a fairly impressive decline in the burden of government (i.e., spending as a % of GDP). No actual cuts are needed to effectively shrink the size of government.

This chart puts the current situation in a long-term historical perspective. Note that spending as a % of GDP is still substantially higher than its post-war average, whereas revenues are only slightly below their post-war average. In order to achieve a balanced budget, this strongly suggests that the heavy lifting of policy should be focused on restraining the growth of spending while promoting economic growth. Higher tax rates are not needed. Unless, of course, President Obama's intention is to permanently increase the size of government, and increasingly it looks like it is.

We are very fortunate as a nation that the federal deficit has declined significantly in the past three years, from a high of 10.5% of GDP in late 2009 (a level that was clearly unsustainable) to less than 7% today. 7% is still very high, but it is not unsustainably high and it is on a downward trajectory.

As this next chart shows, gains in federal revenues have accreted throughout the year. Every month in 2012 showed higher revenues than the same month in prior years.

This next chart shows how there is a fairly reliable correlation between the level of government spending, as a percent of GDP, and the unemployment rate. A stronger economy reduces the need for spending of the "social safety net" variety, that much is clear. What is perhaps not so clear nor well documented is that as the relative size of government shrinks, this allows the private sector to keep more of the fruits of its efforts, and this strengthens the economy while increasing employment and reducing unemployment. This chart fairly screams its message: if we want the economy to get stronger, we need to cut back on the relative size of government! Bigger government brings with it a weaker economy, while smaller government opens up the possibility of a stronger economy. To put it another way, the private sector can spend money more efficiently and more productively than the public sector. Shrinking the public sector allows the private sector to expand, and that in turn results in more productivity and more growth.

Federal debt held by the public (including the debt that has been "purchased" by the Fed, but excluding the debt that is owed to social security and other trust funds) is now $11.6 trillion, or about 72.5% of GDP. Total debt is now $16.4 trillion, about 103% of GDP. 

At the current rate, the burden of federal debt held by the public (i.e., debt as a % of GDP) will have increased by almost 25% of GDP during President Obama's first term. That handily eclipses the increased debt burden under the two terms of President G.W. Bush (15.3%) and the two terms of President Reagan (15%).