The good and bad of federal finances

Good news: January's federal budget statement showed that federal revenues continue to exhibit strong growth, rising at an 8-9% rate. The bad news, however, is that federal spending is once again growing, at a 5-6% rate, after five years of no growth. Unless Congress manages to rein in the growth of entitlement spending, the budget deficit is going to start growing again. It's a difficult task, given the huge constituency that thrives on transfer payments, which increased 5.6% last year (in contrast to a 2.1% increase in CY 2013), and which now make up almost 20% of disposable income and consume over 71% of federal spending.

Conventional wisdom has held that the absence of growth in federal spending from 2009 through early last year was a significant drag on growth, since it reflected "austerity." Supply-siders see things differently: zero growth in spending meant a shrinkage in the burden of government on the private sector, and this was a stimulus to growth. A shrinking public sector allfowed the private sector to manage more of the economy's scarce resources more productively than the government could, and this served to strengthen the economy. This shrinking-government "tailwind" to growth is now beginning to fade, albeit very gradually. But if left unchecked, growth in entitlement spending could become a huge problem in the years to come.

Flat growth in spending coupled with strong growth in revenues resulted in a huge reduction in the federal budget deficit. If the deficit were to never grow beyond its current level, we wouldn't have a problem. A deficit of 2-3% of GDP is eminently sustainable, and is arguably even necessary in order to ensure the continued liquidity and efficiency of the Treasury debt market—which serves as the backbone for the world's bond and stock markets. 

Strong growth in federal revenues was driven primarily by individual income tax receipts, which in turn were driven by the growth in jobs, as the chart above shows. In short, economic growth is the main source of revenues for the government.

The chart above shows federal transfer payments as a % of disposable income. This is now by far the largest component of federal spending, comprising 71% of federal outlays. Transfer payments have mushroomed from 32% of federal spending in 1968 to more than twice that today, and from 5% of disposable income in 1951 to almost 20% today. They will continue to rise as baby boomers retire and healthcare subsidies increase, not to mention the myriad other entitlement programs which always seem to exceed expectations (e.g., student loans, food stamps, disability insurance, medicare).

The chart above shows the contribution to the burden of our national debt (total debt held by the public divided by nominal GDP) that can be attributed to various presidential administrations. As of December, 2014, the increase in the federal debt burden under the Obama administration was 26.5 percentage points, rising from 47% when Bush left office to 73.5% today. That was almost as much as the net federal debt burden accumulated by all the presidencies prior to Nixon (29.3%). (Note that the red bars in the chart represent increased debt burdens, while the green bars represent reductions in the debt burden.) In all of our nation's history, today's debt burden was surpassed only by the WWII-related debt burdens of the 1940s which were substantially paid off during the 1950s.