Wednesday, May 11, 2011

Federal finances are still in awful shape

These charts sum up the problem of the federal budget nicely: Congress is simply spending way too much money.

From the top two charts we see that federal revenues are growing nicely, even rebounding faster now than they did coming out of the 2001 recession, and without the help of higher tax rates (actually, thanks to not raising rates). This would normally have resulted in a shrinkage of the deficit, but that's not happening since spending has surged. It is now becoming obvious that with the help of Bush in 2008 and a massive assist from Obama, Pelosi, and Reid in 2009, federal spending as a % of GDP has effectively grown by fully 25% (i.e., from 20% to 25% of GDP).

Instead of shrinking as it normally would be at this stage of the business cycle, the deficit is growing, and it's almost 10% of GDP. That's a huge number, much bigger than any we have seen since WWII. Very few developed countries have run deficits this large in modern times (think Italy and Japan), and no country with a deficit this large has enjoyed much in the way of prosperity.

Indeed, it would appear that very large deficits that are the result of too much spending are actually one of the causes of poor economic performance, as illustrated in the fourth chart. The more money the government spends, the higher the unemployment rate goes. It's not too hard to understand, really, since the bulk of the increase in government spending has been in the form of transfer payments, which, by redistributing income from those with lots to those with not so much, create perverse incentives: penalizing the hard-working while rewarding the non-working. More government spending and more transfers of wealth also squander the economy's resources, since the money would be much better spent if those earning the money were allowed to decide how to spend and invest the money, rather than letting politicians make the decisions. HT to Brian Wesbury, whose book It's Not as Bad as You Think first tipped me to the remarkable relationship between government spending and the unemployment rate.

As this last chart shows, our federal deficit problem is very unlikely to be solved by raising tax rates. Tax revenues have never exceeded 21% of GDP, even when top tax rates were 90% in 1944. The most important lesson from this chart is that federal tax revenues were about 17% of GDP when top tax rates were about 70% in the mid-1970s, yet federal revenues were even higher, at 18% of GDP in 2006, when top tax rates were only 35%. A lower tax rate is always preferable to a higher tax rate, if both end up collecting the same share of incomes, because lower marginal rates create fewer distortions and reduce the incentive to evade taxes. Income tax revenues are depressed today not because tax rates are too low, but because the unemployment rate is very high and there are 8 million people who lost their jobs a few years ago and haven't gotten them back (and are not paying taxes).

Bottom line: the budget problem must be fixed, and it must be fixed by slashing government spending as a % of GDP. That's not as hard as it sounds, since as I've pointed out several times before, simply freezing spending at current nominal levels would likely result in a balanced budget in about 5 years.


Benjamin Cole said...

I concur wholeheartedly with the sentiments of this post--even more that that. I contend we could get federal spending down to 18 percent of GDP.

There would be some changes to get to 18 percent. Delay Social Security. Reduce federal defense spending (including the odious Homeland Security department). Voucherize the VA. Eliminate all subsidies to rural areas, and the USDA, and the food stamp program (really, all I see are fat Americans. I have never seen a truly starving American, and if I did, I would buy him food immediately, as would 90 percent of my fellow Americans).
Eliminate the Education Department. Eliminate HUD.

Well, it is nice to dream.

My real world sentiments are that Congress will never cut spending, so we need inflation to pay down the federal debt. Ergo, I favor moderate inflation.

mmanagedaccounts said...

Look at that revenue growth from 2004 to 2008. Had it not been for the financial crisis we might be close to another balanced budget by now. Look at the acceleration of government spending post-2007.

There's no question we need more revenue as government reduces its spending, but the way to increase revenue is not to increase taxes but to implement pro-growth, smaller government policies.

We could use a repeat of post-1994.

mmanagedaccounts said...

Bengamin is right on his program eliminations. There is also way too much duplication of programs between states and the feds.

The EPA should be eliminated too. Why not eliminate any program that came into existence after 1964?

My business falls under three regulatory agencies that perform duplicative tasks. Two of them should be eliminated.

Don't we have a new agency being formed by the Healthcare Act?

Look around you. Where is government spending all this revenue? Most are transfer payments, taking from the 49% and giving to the 51% of households that pay no income taxes.

Benjamin Cole said...

Re EPA: Milton Friedman advocated taxing pollution, not regulating it. I always like that idea.

McKibbinUSA said...

Given that austerity measures are unlikely to even scratch the surface of the Federal budget crisis, and accepting that a national default would be catastrophic, that leaves only "printing" money to close the gap between government spending and tax revenues -- those are the facts laid bare...

TradingStrategyLetter - Weekly Summary said...

And we are told it would be 'irresponsible' if we didn't let them spent even more!

Stone Glasgow said...

"The more money the government spends, the higher the unemployment rate goes."

During a recession, GDP falls and unemployment rises. In order to create a graph like this, all that is required is that government spending be relatively unaffected by the changes in GDP

If gov't spending remains constant as GDP falls, the "spending as % GDP" number rises automatically. The graph is confounded by the possibility that government spending does not fall as fast as GDP.

We need to see raw government spending compared to unemployment. I suspect that a raw graph will be disappointing, however, because government spending does not create unemployment, per se. It creates misallocations of resources that are a drag on the potential of individuals to create wealth.

PS Spending on unemployment insurance and welfare is probably correlated to unemployment.

Todd said...

Thanks for that comment (Stone Glasgow) as I was concerned about the fact the correlation does not prove cause and effect. In the graph you refer to (Wesbury's original) changes in unemployment and government spending seem to happen almost simultaneoulsy. But I would think that if the increase in unemployment in this graph was due to misallocation of resources from higher government spending then there would be a longer delay in the response of unemployment.

I am looking for a clear and simple way using empirical data to illustrate that government spending often misallocates resources, which will ultimately affect unemployment. I was hoping this graph was it, but I'm not so sure.

Any ideas?

Todd said...

To follow up, Hauser's Law is impressive and compelling and simple to understand. I'm looking for a similar graph to illustrate the fact that government spending does not stimulate the economy as a whole in the long term.

Stone Glasgow said...


It isn't possible to graph the unseen. Taxation hurts us by reducing both the total amount of wealth created, and also the efficiency of that wealth creation.

For example, imagine a simple island situation where there is no money, but the government simply takes some of the wealth produced. If a man is a home builder, and he builds ten homes per year and the government takes three of them per year and gives them to the poor, we can't know how many homes he would build if the government took none.

How much harder would he work if he knew he could keep everything he made? We can't know. We can only assume that he would work harder, be more excited about developing better methods, and hire more people (possibly the poor?), were it not for government meddling.

We can compare nations and try to correlate GDP to government spending, but that is so full of variables that it would probably be fairly meaningless.