Revisiting the deficit

With the deficit more in the news than ever, it seems to me appropriate to revisit a post last October on the subject of where it came from and how it might be dealt with. There isn't too much new data available since then, but the political climate has of course changed enormously, and lots of new proposals are on the table. Sadly, very few of them have much to do with the underlying facts. The issue is on my mind because I took a question about it after a lecture yesterday, and having reviewed the data, I would have to revise my answer somewhat, although not fundamentally.

It is something of a shock to discover, first of all, that the budget situation improved significantly in the fiscal year that ended last September 30. The deficit, which had been projected once again to exceed 10% of GDP, fell by an entire percentage point of GDP in comparison to fiscal 2009, from 10.0% to 8.9%. The improvement reflected a fall in outlays owing to the collection of substantial TARP repayments and much lower payments to Fannie Mae and Freddie Mac, while revenues remained stable. Revenues will be worse this year, however, because of the 2% cut in Social Security payroll taxes put through by the Obama Administration last December.

Just ten years ago, in fiscal 2000--the last year fully within the Clinton Administration--we had a surplus of 2.4% of GDP. This still ranks as a financial revolution comparable to what happened from 1933 to 1950, or from 1979 to 1991 or so, and given how heated issues of government finance have become, it behooves us to ask how all this happened. Unfortunately, since I can't find more disaggregated data for the last complete fiscal year, I will have to use the data I used last October, which reflected a deficit for fiscal 2010 that was a full percentage point higher.

Budgets, of course, are composed of revenues (mostly taxes) and expenditures. Let us begin with taxes. In fiscal 2000, federal taxes brought in 20.6 % of GDP, including 10.2% of GDP from federal personal income taxes, 2.1% from corporate income taxes, and 6.6% from Social Security taxes. This year they are estimated to bring in 14.8% of our GDP, that is, almost 6% less. Judging from figures from the last pre-recession year of fiscal 2007, about half of that 6% is due to the Bush tax cuts and the other half is a result of our economic collapse. The composition of that 14.8% has also changed dramatically: only 6.4% of it comes from personal income taxes, 1.1% from corporate, and 6.0% from Social Security taxes. In 2000 the progressive income tax brought in about 66% more than the regressive social security tax. Now they bring in nearly the same amount of money. In short, restoring the Clinton-era level of taxation would significantly reduce the deficit, in and of itself. Howard Dean is the only political figure I have heard suggesting going back to the Clinton tax rates as a solution for everyone, however.

While taxes have gone down, outlays have gone up--way up. Federal spending was 18.2% of GDP in 2000; it is 25.4% of GDP now. We can disaggregate this 33% increase in the budget as a share of GDP. The defense budget took up 2% of GDP in 2000; it now takes up 4%, or twice as much. Most of the increase can be chalked up to the occupations of Iraq and Afghanistan, undertakings of most dubious utility. Spending on human resources has gone up more, from 11.4% of GDP to 17.1%, a 6.7% increase. Within that 6.7%, medicare, other health spending and social security have each added about 1% of GDP to the total, and "income security" payments have added 2% more. Those refer apparently to Supplemental Security Income, a little known program that pays disabled and poor elderly Americans from general revenues. The remaining 1% or so of the increase is divided among veterans' benefits and education.

One astonishing item caught my eye--one that certainly needs more explanation. Thanks to George W. Bush's impact on the budget, the national debt is more than twice what is was in 2000--yet interest payments are actually down as a share of GDP, down an entire point from 2.3% to 1.3%. Thanks to the growth of our economy and above all, I would guess, to the lowest interest rates in history over the last decade, we hardly pay more to service our debt now than we did ten years ago.

The source of our deficit, then, is pretty clear. About 1/4 of it is the responsibility of the Bush tax cuts and the recession, and another 1/6 is the fault of the Afghanistan and Iraq War. Yet another 1/6 comes from rising health care costs, and another 1/4 from increased social security payments and other government income maintenance. TARP initially helped balloon the deficit but TARP is now going to show a profit. And what about the notorious Obama stimulus? As of March 30, 2011, that program had included about $260 billion in tax relief--we have already accounted for that money--and $374 billion in spending over two years. The $187 billion annual spending per year amounts to about 1.2% of GDP, or about 1/8 of the total deficit.

What is to be done? We should stop talking about eliminating the deficit. Cutting it in half, to 4.5% of GDP, would bring it to roughly the normal level under recent Republican administrations, even in good times. A convenient table making this point is here. The easiest way to cut expenditures is to bring the troops home from Iraq and Afghanistan and put other limits on the growth of defense spending, which no one is talking about very much now. We must do something about health care costs, which the Obama Administration made a weak and probably unsuccessful attempt to do, and we have to change the formula for social security benefits to bring their increases in line with increased revenues. But above all, we have to raise taxes--not only by returning to the Clinton-era rates, but by raising the cap on taxable income for Social Security over the current $100,000 or so.

Indeed, the table I linked reveals a profound mystery. The recession has had a much worse effect on federal tax revenues than it has on GDP. GDP in constant dollars is now equal to what it was in 2007, but federal taxes are taking only 15% of it instead of 18% of it. Why is this? Is it because incomes are increasing at the high end of the scale, and those increases aren't being reflected in federal tax revenues? This is a mystery we need economists to answer.

The Ryan budget would make the deficit worse and take away the safety net for the elderly in another ten years. The good news is that, like Newt Gingrich's Medicare cuts in 1995-6, it seems likely to burst the Tea Party's political bubble and give the political edge to the Administration. But the Administration has also failed to make any serious proposal to deal with a very real fiscal crisis. The White House seems terrified of conforming to Republican stereotypes of Democrats as soft on defense and strong on taxes--even though right now, the country needs a smaller defense budget and, yes, higher taxes.