Wednesday, February 12, 2014

More great budget news points to a supply side revival

Arguably, the most under-appreciated statistic today is the unprecedented and ongoing decline in federal government spending. In the 12 months ended January 2014, spending was 4.4% below the level of January 2013. Annual spending has not increased at all since mid-2009. We've lived through over four and a half years of zero net change in spending, and almost three years of steadily declining spending (spending peaked in Q1/11), and the sky has not fallen. Not only is this excellent news, but it is news that has proven to be the exact opposite of what was expected to happen. Spending was supposed to continue to rise for as far as the eye can see, by at least 4-5% per year. 

The still-prevailing Keynesian wisdom (will it ever be vanquished?) holds that a decline in spending relative to budgeted baselines of such magnitude would prove devastating to economic growth. But our new (new in the sense that classical economic thinking is making a dramatic comeback) understanding of how the economy works tells us that less government spending—especially when it comes from a very high level—is very good for the health of the economy. The chart above makes that point: the unemployment rate invariably declines as the level of government spending falls relative to GDP. Regardless of how the money is spent (most of it goes not for infrastructure but rather for transfer payments), the federal government cannot spend money as efficiently or as productively as the private sector. And regardless of how federal spending is financed (by borrowing or taxing), spending always requires taking money from the private sector. At current levels, the bulk of government spending is still a deadweight loss to the economy.

The chart above shows that spending has not increased since mid-2009, whereas revenues have increased a lot. The vast bulk of the increase in revenues has been organic: the result of an expanding tax base (more people working, higher incomes, higher corporate profits), and not the result of higher tax rates. 

Today Congress decided to suspend the debt ceiling until March 2015. Is that a big deal? No, because we no longer have a budget crisis. The federal budget deficit has fallen to a mere 3.3% of GDP, and that's not scary at all. If recent trends continue, the budget deficit could be less than $400 billion by the end of this year, and that would probably be only 2.5% of GDP.

The challenge going forward, at least for the next year or two, will NOT be to rein in spending in order to keep the deficit and the debt from exploding. It will be to reform our tax code, which has become Byzantine in its complexity and suffocating in its progressivity. We have applied so-called "austerity" to spending, and we have succeeded. Now we need to apply policies that represent genuine stimulus, and that means lower and flatter marginal tax rates with fewer deductions and subsidies. Reduced regulatory burdens would also be a huge help (hint: repeal or redesign Obamacare so that market forces are brought to bear on the problem instead of trying to solve things by government fiat).

The biggest problem we face today is that the economy is operating at only 90% of its capacity (see above chart). We need policies that grow the economy, and the best way to do that is to create incentives for the private sector to work harder and invest more. What better way than to slash corporate tax rates and marginal tax rates on incomes (which in many cases are approaching 50-60%)? It's almost a no-brainer, but hardly anyone gives tax reform a chance these days.

As I pointed out the other day, the prospects for tax reform have improved greatly with the CBO's new-found respect for the dynamic effects of changes in marginal tax rates. Tax reform that flattens the tax code by eliminating subsidies and deductions and lowers top marginal rates shouldn't be difficult at all to justify, since it could dramatically boost future economic growth.

Thanks to a huge decline in the burden of government spending and the CBO's introduction of dynamic scoring, supply-side economics is about to experience a long-overdue comeback. We'll probably have to wait for the November elections to see exactly how powerful and imminent this new dynamic is, but a new and healthier direction for policy should be evident even before then, and markets are excellent at discounting that sort of thing.


William said...

OECD Composite Leading Indicators

02/10/2014 - Composite leading indicators (CLIs), designed to anticipate turning points in economic activity relative to trend, continue to show signs of an improving economic outlook in most advanced economies.

The CLIs continue to point to economic growth firming in the United States and the United Kingdom and to growth above trend in Japan. The CLI for Canada indicates a positive change in momentum.

In the Euro Area as a whole, and in France and Italy, the CLIs continue to indicate a positive change in momentum. In Germany, the CLI shows signs of firming growth.

In the emerging economies, the CLIs point to growth around trend in China, Brazil and Russia, and to growth below trend in India.

Benjamin said...

Who would have thought the Obama years would be marked by flat federal outlays?

Great post.

BTW, if you want to cut MTR's on federal income taxes, you have to cut federal agency spending.

Most of the transfer programs are financed through payroll taxes.

The world is safer now than ever, and rural America can make it without subsidies. Cutting agency spending should be Job One.

I advocate a 30 percent cut--a real cut--in federal agency spending, across the board, no sacred cows.

On SSDI and VA "disability" payments we need to think about near total elimination.

Cato Institute has long recommended a 50 percent reduction in military outlays, and they recommended that before real military outlays doubled in the Bush years (and Obama kept them at this artificially high level).

Ron Paul has it right.

Hans said...

Ben Jamin, I did not know that military spending increased that much!

William said...

Scott - it seems to me to be a question of whether the chicken or the egg came first.

Does the decrease in unemployment (and thus Unemployment Benefits, Medicaid and Food Stamps spending) cause a decrease in government spending? Or, as you suggested, the decrease in government spending causes the decrease in unemployment through a mechanism which is not intuitive to me?

How do you refute the first possibility I mentioned?

Scott Grannis said...

The decline in unemployment benefits is only partiy responsible for the decline in government spending relative to baseline.

Federal government spending has declined by 220 billion per year since its peak in early 2011.

Total spending on unemployment benefits has dropped from about $125 billion per year in early 2011 to about $55 billion per year currently. That's a net reduction of $70 billion per year in spending on unemployment benefits, which only accounts for about one-third of the total decline in government spending since its peak.

Meanwhile, Medicaid is running over $400 billion per year and has been increasing steadily.

Food Stamp spending is running about $75 billion a year and has not declined in recent years.

I'm not arguing the decline in spending has caused the decline in unemployment or vice versa. My main point is that the decline in spending (which is mostly due to factors unrelated to unemployment) has certainly not weakened the economy (otherwise unemployment would have risen) and instead has likely helped strengthen the economy.

Lawyer in NJ said...

"Spending was supposed to continue to rise for as far as the eye can see, by at least 4-5% per year."

This is false. The spike in spending that accompanied the financial crisis that Obama inherited was due mainly to transfer payments that were always viewed to be temporary, declining as the economy recovered.

That is precisely what we have seen.

It is also true that those payments helped to stabilize the economy as it reached its depth because the beneficiaries, largely having no other source of funds, spent those funds, thereby attenuating the decline in demand that accompanies a balance sheet induced recession.

Scott Grannis said...

Lawyer: You have one valid point. I should amend my statement, since the late-2008 emergency spending and a good portion of the 2009 stimulus spending was indeed expected to roll off. But once it rolled off, spending was expected to increase by approximately the rate of growth in nominal GDP.

Check the CBO's budget projections made in Jan. '11 and you will see that federal spending was $3.5T in '10, and was projected to be $3.7T in 2011, $3.7T in 2012, $3.8T in 2013, $4.0T in 2014, and higher in every subsequent year. Annual increases from 2013 on were expected to be between 4-7%.

Instead, federal spending was $3.6T in 2011, $3.6T in 2012, and $3.4T in 2013. Spending last year was more than 10% below what CBO thought it would be in its Jan. '11 projections. I would argue that virtually no one expected spending last year to be as low as it turned out to be.

As for the impact of the transfer payments, real GDP has been much weaker, and the unemployment rate much higher, than CBO and the administration projected beginning in 2009 when they argued in favor of the stimulus package. Government spending stimulus in the 2008-2010 period far exceeded anything we have seen in prior recoveries, but this has proven to be the weakest recovery ever. No one can prove the counterfactual, but my read on this is that stimulus probably retarded rather than stimulated economic growth.

Benjamin said...

The explosion of federal agency spending after 9/11 was a porkfest. It became another permanent layer of fat.

Benjamin said...

OT: Dr. Copper...maybe needs to check himself in for a full physical...I won't even mention Nurse Aluminum...

William McKibbin said...
This comment has been removed by the author.
William McKibbin said...

I am looking for a country that pays me to be an honored citizen -- is there such a country?

Hans said...

Thank you, Mr Grannis, for the easier word code!!!

Flowers, now that was easy to read and type!

Steve D said...

Benjamin said: "I advocate a 30 percent cut--a real cut--in federal agency spending, across the board, no sacred cows."

GDP = federal spending + non-federal spending = net exports.

Well then, more (private) debt servitude eagerly awaits you and millions of other of the clueless (just to maintain GDP). Duh, Govt money ("deficits" paid for by those who spend LESS of their income/ "the SAVERS") actually gets spent and INVESTED in the very same private sector. Who woulda thought?. The always ethical fattest cow of them all , the corporatocracy, needs more of your money. What a dream world you faux libertarians occupy. Benjamin said:Most of the transfer programs are financed thru payroll taxes. You are dead wrong. Federal taxes finance nothing. They exist just to make people like you look foolish. The federal govt spends by sending instructions to mark up bank accounts. It can do this endlessly, as long as real resources are available.
1. A growing economy requires a growing supply of dollars. (GDP=Federal Spending + Non-federal Spending + Net Exports)
2. All deficit (public or private)spending grows the supply of dollars.
3. The limit to federal deficit spending is an inflation that cannot be cured with interest rate control.
4. The limit to non-federal deficit spending is the ability to borrow.