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Federal budget update

This chart includes the January data released today. Revenues continue to decline, falling to just under 14% of GDP, a level not seen since the early 1940s. Expenditures (both on a rolling 12-month basis) have also declined in recent months, but that mainly reflects the running off of the intense spending associated with bailouts a year ago. Despite the recent declines, spending over the 12 months ended January was about 24% of GDP, a level not seen since World War II.

The deficit over the past year was $1.46 trillion, about 10% of GDP. There have been several industrialized countries that have lived with and survived deficits this large (e.g., Italy and Japan), but that doesn't mean that a deficit of this magnitude is OK. Indeed, I can't think of any country that has enjoyed healthy growth with such a large deficit. The deficit we have now—far from being stimulative as Obama keeps insisting—acts as a big drag on the economy, mainly because it comes entirely from a surfeit of spending and an orgy of expanding government programs and mandates. When government controls so much of our national income it can only do so much less efficiently than the private sector can. Also, with our extremely progressive tax system that calls on the top 10% of income earners to shoulder over 70% of the income tax burden, the incentives to work, invest, and take risk become very distorted.

One of the often-overlooked problems (call them unintended consequences) that come with a very progressive tax system that—like ours does now—relies heavily on things like tax rebates, earned income tax credits, and direct subsidies to lower-income workers, is that it inevitably leads to extremely high marginal tax rates at levels of income that affect a good portion of the middle and lower-middle class. (See my earlier post on this subject.) This means that a person who tries to raise his standard of living may end up paying a marginal rate of 80% on every additional dollar he makes, because at higher income levels he loses his subsidies and rebates. Why work twice as hard if you can only end up with 10 or 20% more? While appearing to help the poor and disadvantaged, it ends up trapping many of them near the bottom rungs of the income ladder.

It would be far better if our tax system relied on a relatively low, flat tax with few or no deductions.

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