Sunday, January 30, 2005

Why do we have a budget deficit?

The Club for Growth's Social Security phase-out website posted an item, You Can't Fix Social Security by "Taxing The Rich" , which postulates that federal revenues "began a scary decline during the last days of the Clinton administration, and that the 2003 tax cut "for the rich" has brought in more, not less, revenue.

The chart below shows a plot of federal spending and revenues for the "on budget" portion of the budget, which for practical purposes means the part of the budget paid for by income taxes. The graph plots these figures as a fraction of GDP. The plot in green shows revenues, while the red shows spending.

The most notable feature of this graph is that income tax revenues really fell off a cliff the past three years, compared with historical norms. If you review the spreadsheet data above, you'll find that on-budget revenues have not been this low since World War II, by a wide margin. Yet, as you can see from the chart, spending, which was constrained from 1993 through 2001, has grown considerably since then. Thus we have a combination of higher than average spending, along with abnormally low revenues.

This abnormally low revenue continued through the third year of an economic recovery, when revenues ought to be back to normal. Revenues finally seem to have hit bottom, but are growing now from an extraordiarily low level. Simply put, we're bringing in a much smaller fraction of GDP in revenues, while our on-budget spending as a fraction of GDP is now above the post-WWII average

The Club for Growth believes that if we restore the top marginal tax rate to the level Clinton set, federal revenues would go down, not up, because the top 1% of earners will stop working, stop investing, and go sulk in a hole if you raise their tax rate. "In the long run", we're supposed to make up for the gaping deficits with explosive economic growth.

But look what happened between 1993 and 2000. Clinton raised income taxes just for the top 2% of earners in 1993. Every year between 1993 and 2000, tax revenues grew. At the same time, federal spending grew more slowly than the economy. We went from record budget deficits and projections that deficits would stay near that record level as far out as projections went, to a balanced budget.

Meanwhile, economic growth during Clinton's two terms in office was the highest since the 1960s. The labor force participation rate hit a peak, and if some conservatives were sulking through it all, it was certainly made up for by exuberance from somewhere else that defied conservatives' predictions.

Unemployment fell consistently below five percent, again for the first time since the 1960s.

There isn't any empirical data that suggests marginal income tax rates around the level set by Bill Clinton in 1993 significantly constrain economic growth. On the contrary, there are "facts on the ground" that the sort of fiscal discipline the Clinton administration engaged in helps the economy more in the long run than borrowing money to finance tax cuts and spending beyond our means.

There's no good reason for the federal government to habitually bring in a lot less revenue than congress chooses to spend. Right now, the federal government is bringing in a whole lot less revenue than it is spending, and as the chart shows, the biggest gap is on the revenue side - we just aren't bringing in as much income tax revenue as we've brought in for the past sixty years.


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