It is a Spending Problem AND a Revenue Problem
In the fiscal year beginning October 2008 (the 2009 fiscal year), federal government spending exploded from 20.8 percent of GDP to 25.2 percent of GDP. This was due to a confluence of factors including a decline in GDP due to the recession, an increase in automatic expenditures such as unemployment insurance, the $750 billion Toxic Asset Recapitalization Plan (TARP) that was passed late in the Bush Administration, and the $800 billion stimulus plan that was passed early in the new Obama Administration. Federal spending remained elevated relative to GDP at 24.1% during each of the subsequent two fiscal years (2010 and 2011) in part due to the fact it took some time to deploy the stimulus. Then, last fiscal year (FY 2012, which ended last September), the ratio of spending to GDP fell to 22.8 percent. Furthermore, the supposedly non-partisan Congressional Budgeting Office (CBO) projects further decline the spending ratio and an average over the next ten years of about 22%. This is only about 1 or 2 percent over the long-term average.
So, it looks like what happened was a spike in spending (the stimulus and the TARP added $1.5 trillion to spending, or about 10 percent of GDP). It took three years for this spending to take place and this accounts most of the elevated spending to GDP ratio for the fiscal years 2009-2011.
Now along comes $87 billion of budget cuts for the coming year due to the “sequester” (actually, since the fiscal year is roughly half over, the effect during the current fiscal year will be about $40 billion). This represents about 2 percent of total federal spending and ½ percent of GDP. Republicans assert that this is a drop in the bucket (except they decry the disproportionately large cuts in defense spending), while the Democrats argue that any spending cuts will be extremely harmful. The predictions for the impact on the economy if the sequester is implemented range from negligible to about one percent for real growth in 2013.
What is interesting to me is that it does not take much spending restraint to get us back to the long-run average of federal spending to GDP, at least in the short-run (next five or ten years). The mandated $87 billion of cuts is about half of what we need.
On the tax side, federal tax revenues collapsed during the financial crisis from its historical average of 18% of GDP down to 15% of GDP. The revenue share has increased in the past three years but is still one percent below the long-term norm. If tax revenues were at the historical average then the near-term deficit would actually be reasonably manageable at 3-4% of GDP.
Of course, an important factor is that we are benefitting massively in the short-run by the extremely low level of interest rates. The Treasury yield curve (yields on various maturities of Treasury debt) ranges from 0% for short-term bills to 3% for 30-year bonds. If interest rates were normalized, say at twenty year averages of 2-3% for bills and 4-5% for bonds, then the interest burden would be much greater and growing much more rapidly. The condition for debt to become unmanageable is when the interest rate on outstanding debt exceeds the growth rate of nominal GDP. In that case, absent surpluses aside from interest, the debt burden (outstanding debt/GDP) will explode.
Despite the apparent incompetence of our political leaders, the short-run federal government spending, deficit and debt problems do not appear to me to be unmanageable. However, in the long-run the situation is more difficult. First, thanks to rising longevity entitlement spending will increase much faster than GDP. Second, eventually interest rates will normalize.
Thus, it is imperative that the long-term gap between expenditures and revenues be closed. In theory, this can be done either by reducing expenditures or by raising revenues. But in practice it will have to be a combination. My own preference would be to implement tax reform that broadens the tax base and generates 18-20% of GDP even with lower marginal tax rates, combined with tweaking entitlement programs so as to keep spending at 20-21% of GDP.
The alternate strategy, apparently preferred by the Democrats, is to find ways to dramatically increase tax revenues relative to GDP. This cannot be achieved simply by closing loopholes and raising tax rates on the rich. It can only come from imposition of a new broad based tax, like a consumption tax or VAT (Value Added Tax) or maybe a carbon tax. This would enable continued operation of the entitlement programs, but at the possible cost of imposing long-term economic lethargy and risking the economic and political turmoil that is currently on view in Southern Europe.