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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.

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