It wasn't too long ago that the federal budget deficit was projected to run into the trillions of dollars per year for as far as the eye could see, and that years of federal budget deficits in excess of 10% of GDP could end up destabilizing the world's largest economy. Fortunately, the future didn't turn out to be nearly as awful as many thought. Federal spending has been essentially flat for the past 5 years, while federal revenues have increased by 50%. As a result, the deficit has collapsed by almost two thirds, and is now a mere 2.8% of GDP. As I mentioned in an earlier post this week, and as I've been reiterating for years, the future has turned out to be much better than the market's gloomy expectations, and that's an important reason why the stock market has done so well and continues to climb. Markets are moved when the unexpected happens.
The October budget figures released today show continued gains in revenues, which have risen by fully 50% in the past 4-5 years. Most of this increase is due to an expansion of the tax base: more jobs, higher incomes, more capital gains, and more corporate profits. Higher tax rates can only account for a portion of these gains. In fact, revenues might have been stronger had tax rates not been increased. Today's very high marginal tax rates are almost certainly contributing to the disappointingly slow recovery.
Income taxes and payroll taxes account for the lion's share (about 80%) of federal revenues. We could easily afford to slash or even eliminate corporate tax rates, and that would almost certainly result in more business investment, more jobs, higher incomes, higher capital gains taxes, higher dividend income, and perhaps not much (if any) of a net loss in total federal revenues. If we simply kept federal spending from increasing for another few years, the budget would be balanced and we'd all be happier. Except, of course, the politicians who love to buy votes by passing out other people's money.
The chart above shows the dramatic turnaround in the federal budget deficit. The current deficit is just under 3% of GDP, and that is not a problem at all. Barring a dramatic increase in spending and/or another recession, the deficit is likely to continue to decline for the next several years, both in nominal terms and relative to GDP.
Looking ahead, I'd like to think that in the next few years a new Congress is likely to pass a variety of pro-growth policies that help unlock the economy's full potential. Already it seems that the Keystone Pipeline is likely to pass, with many Democrats, led by Mary Landrieu, deserting the White House's opposition to it. Obama's vow to veto legislation he doesn't like may turn out to be as resolute as the various lines in the sand he drew in the Middle East.