Federal Deficits are the Result of Rising Expenditures and Falling Receipts

Contrary to the partisan narratives of our two dissembling political parties, federal deficits have been growing steadily since WWII through every administration, with the sole exception of the Clinton administration.  The growing deficits have been the result of the federal government spending more of our gross national output and collecting less.  Here is what the record looks like for each administration.  I have offset the data by one year to account for the fact that each incoming administration inherits the budget for its first year from the previous administration.[i]

Democrats will tell you that the deficits are the result of Republicans cutting taxes and Republicans that they are the result of out of control spending.  Both are right and both are wrong.

First, I suspect most of you will be surprised to know that the amount that the federal government has spent and collected in taxes since WWII has moved in fairly narrow ranges.  During that period the most the government has ever spent of the country’s GDP was 24.4% in 2009.  The least was 16.6% in 1965.  For tax collections, 20% was the high in 2002 and 14.6% was the low in 2009 and 2010.

But notwithstanding that the expenditures and collections have moved in these narrow ranges, the trendlines are clear. The federal government has been spending more and collecting less in taxes as a percentage of GDP since WWII.

The effect on federal receipts and expenditures from the 2008 financial crisis is a notable outlier to the general trend and is a cautionary tale about making sure we avoid that type of crisis in the future.

While reviewing the historical record is always a useful exercise, especially when debunking partisan propaganda, it is probably less helpful in considering where the federal budget is likely to go from here.  That is because we are about to enter a period where the cost trajectory of three programs, Social Security, Medicare and Medicaid, is about to explode.

In 2007, those programs cost about $1 trillion.  By last year, they had doubled to just under $2 trillion and accounted for nearly 50% of all federal spending.  The Congressional Budget Officer (CBO) projects that they will rise to $3.6 trillion in the next ten years.  Of the three, Medicare rises most, more than doubling.  These increases are, of course, driven primarily by demographics as our population will grow significantly older in the next ten years.

By comparison, the total amount the federal government spent on all welfare programs last year was about $270 billion, or 27% of the big three and 7% of all federal spending.  Welfare expenditures are up by about $110 billion over the last ten years (about a 70% increase).  The CBO projects that, based on current programs, welfare spending will be relatively flat over the next decade, rising only about 15%.

One chilling metric is the CBO’s projection of the federal government’s interest cost.  Because of falling interest rates, there has been almost no increase in the government’s interest cost in the last ten years (2006 – $227 billion vs. 2016 – $240 billion).  But the CBO projects that the interest expense will more than triple by 2027 to over $800 billion because of the exploding deficits they expect in the next decade.

Both political parties promote narratives to explain the structural deficit in the federal budget that resonate with their respective constituencies and have a grain of truth but ignore the elephant in the room.  Welfare queens or greedy corporations may contribute nominally to the federal deficit, but it is principally being driven by an aging population with the enormous medical expenses that demographic change will drive.  That is the real inconvenient truth that neither party wants to address because the solutions are hard, complicated and fraught with political peril.

[i] All of the data in this article is expressed as a percentage of gross national product.  The gross numbers, because of population growth and inflation, would obviously show much more dramatic increases, but economists almost universally agree that the amount that the government spends and collects as a portion of the economy’s national output is the critical metric.

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Will Tax Cuts Spur Economic Growth?

The assertion that tax cuts will spur economic growth is now Republican orthodoxy, incessantly repeated by the party’s leaders and surrogates.  Most often, these proponents cite the Reagan tax cuts in the 1980s as proof that cutting taxes will boost the economy.  But a close look at the historical record shows there is scant correlation between cutting taxes and economic growth.

Immediately after WWII, the highest marginal tax rate on earned income was 91%.  Johnson lowered the rate to 70% in the mid-60s.  It was unchanged until President Reagan lowered the rate three times, to 50% in 1982, then to 38.5% in 1987 and finally to 28% at the end of his term.  The rate stayed at 28% for only three years.  In 1991, Bush 41, faced with a growing deficit, raised the rate to 31%.  Immediately after Clinton was elected, the top rate was raised to 39.6%.  The rate was temporarily cut in the now-famous “Bush tax cuts” to 35%.  That cut expired in 2013 and the rate returned to 39.6%.

When we graph these changes in the marginal tax rate with GDP growth it is apparent that both have been falling since 1960.  If lowering the marginal rates guaranteed higher growth, we should see these moving inversely, i.e., as tax rates came down, GDP growth should have improved.  But the opposite is true.

As for the oft-cited Reagan tax cuts, there was a snapback in GDP growth in 1983 and 1984 from the 1982 recession which occurred just after the reduction in the marginal rate from 70% to 50%.  But after 1984, GDP growth dropped back to historic norms notwithstanding the additional cuts in 1987 and 1988.  By 1991, the country was back in recession.

So, what about cutting the corporate tax rate, which is the centerpiece of the current proposal?  Once again, the effective corporate tax rate has also been trending down since 1960.  So, neither is there any historical correlation between reducing the corporate rate and economic growth.

So, how are we to interpret the lack of any positive correlation between marginal tax rate cuts and economic growth?

First, of course, we should always keep in mind the fundamental rule of statistics that correlation does not equate to causation, and, conversely, a lack of correlation does not disprove a potential causal link.  This is because there are innumerable other economic factors simultaneously at work on outcomes.  For example, at the same time the Reagan tax cuts were enacted in 1982, the Federal Reserve was also dramatically reducing interest rates.  So, it is very difficult to parse out the effect of changes in tax rates from the other background economic activity.

Second, it may be that the marginal rate and corporate rate are not as important as we think.  The Tax Policy Center estimates that the average income tax rate paid by households from 1979-2012 ranged from 17-22%, a much narrower range than the 28%-70% range for the marginal rate during that time.

Also, payroll taxes have been steadily increasing since WWII, both in absolute and relative terms.  That rate has more than doubled, from 6% to 15.3%.[i]  Payroll taxes as a percentage of federal tax receipts have nearly quadrupled from about 10% in 1950 to just under 40% today.

When you add the payroll taxes and income taxes together, the average tax rate since 1960 narrows even more to a range of 29-31%.[ii]  In other words, while the marginal rates have varied widely, the average rate paid by taxpayers has stayed in a pretty narrow range and, as a result, the overall tax burden has changed very little.

Notwithstanding that economists have difficulty quantifying the effects of tax policy on the economy, most nonetheless believe that tax reform, as opposed to just tax cuts, would boost growth.  This is because our tax code is both oppressively complex and creates enormous market inefficiencies.  The real question is whether the proposals now on the table are the kind of tax reform that will lead to growth or whether it is just tax cuts that may benefit some companies and individuals but have little effect on the larger economy.

Whether the tax reductions will spur growth or not is critical because if the growth fails to materialize, the tax cuts will blow an even bigger hole in the federal deficit.  If the tax cuts merely add to the deficit, there may be a short-term sugar high for the economy, but lead to lower growth down the line.

Most economists are skeptical that the proposed tax cuts will even come close to paying for themselves.  Twenty-one of twenty-six top economists surveyed by Bloomberg opined that the cuts would increase deficits.  Even the President’s alma mater, the Wharton School of Business, has released a study which finds the tax bill will add significantly to the deficit.  From what I have read, the consensus among economists seems to be that an increase in growth might pay for about a quarter of the proposed tax cuts.  If that is right, the tax cuts will blow a hole in the deficit and lead to lower growth in the future.

The most persuasive analysis I have seen comes from the Committee for a Responsible Federal Budget (“CRFB”).  It is co-chaired by Mitch Daniels, the former Indiana Republican Governor and director of the Office of Management and Budget under Bush 43, and Leon Panetta, also a former director of the Office of Management and Budget, White Chief of Staff, and Secretary of Defense under Clinton and Obama.    The CRFB disputes that the bill will produce the .4% GDP increase claimed by its backers and projects that the Senate version of the proposed tax bill will add $2.2 trillion to the federal debt over the next ten years.  [Click here and here to read.]  And that is on top of the deficits we are already expecting, largely driven by the acceleration Social Security, Medicare and Medicaid payments as more Baby Boomers retire.

Regardless of the effect of tax policy on GDP, we should always be attempting to minimize the tax burden on the American people.  Every tax dollar collected should be treated as a sacred trust to be spent wisely, efficiently and only for functions for which there is no viable private sector option.  But if we pin our hopes for a dramatic economic upturn from just cutting taxes, history suggests we will likely be disappointed and be passing on an even larger federal debt to our children and grandchildren.


[i] This includes the employer and the employee portions.
[ii] The sole exception to this range was 2011-12 when there was a temporary decrease in the payroll tax rate.
 
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Update on Social Security’s Financial Condition

     The Social Security Board of Trustees[i] recently released their annual report on the financial condition of that system.  The report showed a small improvement in the system’s performance from last year, but underscored the longer-term challenges it faces.
     With improved employment, Social Security’s total income increased from $920 billion to $957 billion. It paid $916 billion of benefits and had expenses of $6 billion.  The result was a $35 billion positive cash flow, up from $23 billion last year.  This surplus increased the fund’s reserves to $2.85 trillion.  These trust funds are invested in U.S. government bonds.
     The current projections show that Social Security will continue to have a positive cash flow through 2021.  After 2021, Social Security will have to start dipping into its reserves to pay benefits at the current level.  The negative cash flow accelerates after 2021 as the full brunt of the baby boom retirees is felt.  The reserve is projected to be completely exhausted in 2035.  After the trust fund is depleted, the ongoing income will only cover about 77% of the current benefits.
     I generally find that there is a lot of confusion over the state of Social Security’s finances and its future prospects.  Young people frequently tell me that they are assuming they will never get any Social Security benefits because the system is going broke.  That is clearly not the case.
     Some of that confusion comes from a fundamental misunderstanding of how the system works and some comes from politicians’ hyperbole about the system’s condition.
     One of the fundamental issues when analyzing any retirement system is whether it is a “pay-as-you-go” system or a “funded” system.  In a pay-as-you-go system, no money is set aside from a worker’s current income to pay for future retirement system.  Instead the benefits are paid by future workers.  In a funded system, sufficient income is set aside by each worker to fund his or her retirement.  In other words, retirement systems either rely on income transfers between generations or on savings set aside during the worker’s productive years.
     For most of our history, societies have relied on systems that were essentially pay-as-you-go, with the burden of caring for the elderly mostly being organized by families or tribes.  But as the demographic age pyramid began to steepen and there were fewer younger workers to support a growing number of retirees, we have increasingly moved to systems that rely more on savings and less on intergenerational transfers.  Defined contribution pension plans represent the ultimate expression of the savings model.
     Social Security has some elements of both, but is fundamentally an intergenerational transfer model.  Most of the money we have paid into Social Security has not gone to create a savings account for us, it has gone to pay benefits to our parents.
     However, it was also designed to have a bit of financial cushion to make sure it could weather financial downturns.  So, in most years, Social Security has collected more than it has paid out, which has created the current $2.8 trillion reserve.
     I have never been able to find a calculation of the Social Security’s “unfunded liability” as that measure is calculated for regular pension plans, i.e., the present value of future benefits that have been “earned” by workers less the current reserves.  That is probably because future Social Security benefits are subject to adjustment by Congress where we generally assume that earned benefits in pension plans are sacrosanct (although as public employees are painfully learning, less so every day).
     Social Security has estimated the amount that the present value of its benefits exceeds the present value of its future receipts and current reserves over a 75-year horizon.  The report currently estimates that shortfall at $12.5 trillion, up from just over $11 trillion last year.  In other words, if there is no change in the future to taxes or benefits, we would need to contribute $12.5 trillion to Social Security today to pay the scheduled benefits.
     Of course, making 75-year projections is folly, especially when you consider that very small changes in the assumptions can make enormous differences in the outcome.  But it is clear that we are on an unsustainable course and are either going to have to increase payroll taxes or decrease benefits at some point in the future.
     The report gives some idea of the scale of the needed changes.  It found that payroll taxes would need to be increased from the current 12.4% to 15.2% or that benefits need to be cut by about 17% (or some combination of the two) to close the $12.5 trillion gap.  Those are not inconsequential changes, but they certainly do not amount to a catastrophic burden.
     The report does make clear that the longer we wait to begin implementing changes to Social Security to make it sustainable over the long term, the more painful it will be.  But having an adult conversation with the American people about Social Security and the changes we must make to it is something that our spineless politicians from both sides of the aisle are loath to do.  Much easier to just continue to promise lower taxes and no reductions to benefits.
     You can review a summary of the new report [here] or for a deeper dive the entire report is available [here].

[i] The Board of Trustees is comprised of the Secretaries of Treasury, Labor and Health and Human Services, the Social Security Commissioner and two public members appointed by the President.  The public member seats are currently vacant.
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