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Federal budget trends: more and more redistribution is less and less likely

The Office of Management and Budget's FY 2012 Budget document contains some fascinating historical data on the long-term trends in taxation and spending. John Merline of AOL News has an excellent discussion on the subject here (HT: Glenn Reynolds), which Mark Perry recaps here.

I've put together some additional charts, which follow.

In the above chart, I note that federal income taxes have averaged about 8% of GDP for the past 50-60 years, while taxes for social security, medicare and retirement-related revenues appear to have maxed out at just under 7% of GDP for the past 30 years. Corporate, excise and other taxes have dwindled for years, totaling about 3% or so of GDP in recent decades. It's tough to imagine that income tax revenues could ever exceed 8% of GDP by much, no matter how high tax rates were (see below for justification). It's also tough to see how the middle class could be squeezed more by raising the threshold on social security taxes, since that threshold has been raised repeatedly over the past few decades, yet revenues have failed to rise relative to GDP. And we can't realistically raise corporate tax rates, since they are already among the highest in the developed world. The only way the federal government is going to raise significant tax revenues is by broadening the tax base and increasing the incentives to work, invest, and take risk, and that involves lower marginal tax rates, fewer deductions, and fewer exemptions.

The next chart (above) shows how the composition of federal spending has shifted massively to "transfer payments," and away from defense-related spending. Payments to individuals now account for about 65% of total federal spending! Thanks to historically low interest rates, net interest payments are still very small relative to GDP, even though the federal deficit is at a post-War high relative to GDP. It's tough to see net interest payments not rising if and when the economy improves, since it is virtually certain that the Fed will raise rates as the economy improves. Defense could probably decline further relative to GDP, as it did in the Clinton years, but the only thing that is going to make a real dent in the burden of government spending is to curtail transfer payments. That means tackling entitlements (social security, medicare, etc.), and that, in the end, is what the next several years are going to be all about. If we don't throttle back entitlements, then government spending is going to keep rising relative to GDP and that is going to suffocate the economy. We are on an unsustainable trajectory (that's the bad news), but that means that it won't be sustained (that's the good news).

This next chart breaks down federal spending into defense and nondefense spending. Again, it is noteworthy just how little of what the government spends today is defense-related, and how much goes for other things.

The chart above shows how the federal government increasingly relies on "the rich" (the top 10% of income earners) for income tax revenues. The top 10% pay about 70% of all income taxes. This is a vindication of the Laffer Curve, since it demonstrates that reducing the top marginal tax rate from 70% in the 1970s to 35% in recent decades (see chart below) has not resulted in a 50% decline in tax receipts relative to the size of the economy. Lower rates have reduced the incentive to evade taxes, and increased the incentive to work and invest, thus broadening the tax base by enough to largely offset the lower tax rate. And as I have noted before, federal tax revenues are currently growing at just over 10% a year, and that means that tax revenues as a percent of GDP are quite likely to rise back to their long-term average of about 18% in coming years, assuming no adverse policy shifts.

To fix our awful fiscal mess, there is no need to raise tax rates. Indeed, lower tax rates and fewer tax deductions would likely be of great help, since they would stimulate the growth of the private sector. As for spending, I think the numbers show that we have reached the limit: there is no alternative to finally addressing the runaway nature of entitlement spending.

The fix is not that terrible, as men such as Gov. Walker of Wisconsin, Gov. Christie of New Jersey, and Gov. Daniels of Indiana are explaining daily. We've got to impose tough restraints on public sector unions and on public sector pay and retirement benefits; it's past time that the public sector went through a severe belt-tightening. We've got to introduce market incentives to healthcare, by changing the tax code to allow either everyone or no one to deduct healthcare expenses—thus eliminating the third-party-payer problem, by allowing individuals to buy healthcare policies from insurers in other states and by pursuing tort reform. Finally, we've got to face actuarial realities by raising the retirement age for social security, and indexing benefits for inflation instead of for the growth in wages. And of course, we need more politicians who are less concerned about their individual power and perks, and more concerned about doing what's right for their country. The rise of the Tea Party is our best hope on that front.

I fail to see how the American people could refuse to understand these basic but very powerful concepts. Therefore I remain optimistic that a solution to our problems is not only possible but likely.

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