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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.

Thoughts on the rally

The rather spectacular rally in equity prices since Mar. '09 continues. As we close in on the pre-recession highs in the stock market, I think it's important to stress once again that one of the major causes of the economic and financial crash of 2008-09 was fear: fear of deflation, of depression, of a collapse of the global banking system, of massive corporate bankruptcies, of a housing market meltdown, of a future with staggeringly high tax burdens, and of a significant increase in the size and burden of government. Both the Vix index and swap spreads soared in late 2008 as fear mounted.

The rally has been propelled by the diminishing likelihood that these fears will be realized. It has also been driven by Fed policy which keeps short-term interest rates near zero.

When the interest rate on cash and cash-subsititutes is essentially zero, then one can reasonably refrain from purchasing riskier and higher-return assets only if one is convinced that the worst fears of the market are going to be realized. When it turns out instead that the economy improves and the potential for catastrophe recedes on almost a daily basis, equity prices have nowhere to go but up. Moreover, for the past several months the potential for very constructive change in fiscal policy has improved significantly. The first part of the rally was thus driven by a decline in catastrophe risk, and now the second part is being driven by the rebirth of optimism. There are lots of reasons to be optimistic today, yet key prices (e.g., PE ratios, credit spreads, implied volatility, Treasury yields) have yet to reflect any sign of optimism regarding the outlook for growth and prosperity.

The evidence of rising inflation is appearing

The evidence is building to support the notion that we have seen the low in inflation for the current business cycle. The charts above compare the headline and the core version of both the CPI and the PPI. On a year-over-year basis, all four measures of inflation are rising from their post-recession lows, with the Core CPI bringing up the rear.

On a 6-mo. annualized basis, the numbers are more striking. On a headline (total) basis the CPI is up at a 3.2% annualized rate, and the PPI is up at a 7.9% annualized rate. Much of this pickup, of course, is due to rising food and energy prices, since the core versions of both are registering only 1.5% (PPI) and 0.9% (CPI). Unfortunately, it is not possible to ignore food and energy completely or forever, since we can't live without either one.

But to insist that inflation is low and not a concern because core measures are still in the range of 1% plus or minus a little is a stretch. On the margin, most measures of inflation are showing a pickup. Plus, sensitive asset prices (gold, commodities, the dollar) continue to reflect a significant deterioration in the dollar's purchasing power, which in turn is the fundamental definition of inflation. All this, at a time when the economy still suffers from a supposedly large degree of "slack," or idle resources. The economy is clearly operating below its potential, but this is not keeping all or even most prices stable, subdued, or quiescent. Conclusion: the traditional (i.e., Phillips Curve) theory of inflation is not doing a good job of explaining events.

Inflation is beginning to pick up. It's taken longer than I would have expected, but then the lags between monetary policy and inflation are "long and variable," as Milton Friedman taught us many years ago.

I continue to believe that the last place you will see evidence of rising inflation is in the CPI.

The PPI is arguably a better forward-looking indicator of inflation trends. Note that the PPI registered lower inflation than the CPI all throughout the 1990s. We now know that inflation was trending lower during that period, and it reached a low point in 2002-3, and the reason for the lower trend was very tight monetary policy from the Fed. Since then, the Fed has been generally easy, and the PPI has registered significantly more inflation than the CPI; I think that is a good sign that inflation in the current decade is headed higher. The only question is how much and how fast measured inflation will rise. As an investor, I think the reasonable answer is that inflation will rise by more than the market expects. Currently, the market expects inflation to be in the range of 2-3% for the foreseeable future.

Investors can seek protection from higher-than-expected inflation by buying assets whose cash flow will rise with rising inflation (e.g., equities), and assets whose cash flows will become more certain with rising inflation (e.g., corporate and emerging market bonds, since paying back debt with cheaper dollars is much easier). I have a tough time rationalizing the purchase of precious metals, since their prices seem to have risen significantly already in anticipation of rising inflation. Meanwhile, although real estate is a classic inflation hedge, real estate prices appear to be at least somewhat depressed relative to other prices, on top of being shunned by all those who are severely underwater, so it might not be a bad addition to one's portfolio.

The limits of Constitutional Authority

This is a nice ad that was published by Cato in several papers yesterday, and it speaks for itself.

Continued signs of 3-4% inflation at the producer level

Inflation remains alive and well at the producer level. Headline (total) prices are rising at roughly a 4% annual rate for the past two years, and although the core measures dipped below  1% early last year, it has now risen at a 3.5% annualized pace over the past three months. The very strong performance of virtually all commodity prices is definitely having an impact on the early stages of the production process (prices of crude goods are up 10% in the past year, and intermediate goods are up 6%), and it is reasonable to assume that at least some of this will be passed on to the consumer. For that matter, the last place that "inflation" will show up is in the CPI. We have plenty of warning signs that it is going to happen, and it would seem that the only unknown variable is by how much inflation will rise.

The housing correction has run its course

The housing correction started about 5 years ago, and that sounds like enough time for a correction to take place. After falling by an astounding 75%, housing starts have held at very low levels for the past two years. Although there is no sign yet of an upturn—the fact that January starts were up 15% from December, and much higher than expected, could well be due to seasonal noise—I have to believe that the decline in residential construction has run its course. Now it's just a waiting game to see when activity starts to improve, and I would think that should happen before the year is out.

Commodities: onward and upward

Copper is making a new all-time high today, and it looks like the rest of the commodity complex continues to move higher. I note that gold and the dollar haven't been going anywhere over the past 3 months, so that would lead me to believe that the rise in commodity prices is due to either a) a strengthening global economy and/or b) a lagged response to the monetary stimulus that has been applied in the form of QE2. In either event, this rules out deflation as a concern, and it stokes the fires of recovery, and that ends up being bullish for risky assets in general.

Blogging will be light this week since I am skiing with friends at Keystone, Colorado.