More Great Budget News Points To A Supply Side Revival

by: Calafia Beach Pundit

Arguably, the most under-appreciated statistic today is the unprecedented and ongoing decline in federal government spending. In the 12 months ended January 2014, spending was 4.4% below the level of January 2013. Annual spending has not increased at all since mid-2009. We've lived through over four and a half years of zero net change in spending, and almost three years of steadily declining spending (spending peaked in Q1/11), and the sky has not fallen. Not only is this excellent news, but it is news that has proven to be the exact opposite of what was expected to happen. Spending was supposed to continue to rise for as far as the eye can see, by at least 4-5% per year.

The still-prevailing Keynesian wisdom (will it ever be vanquished?) holds that a decline in spending relative to budgeted baselines of such magnitude would prove devastating to economic growth. But our new (new in the sense that classical economic thinking is making a dramatic comeback) understanding of how the economy works tells us that less government spending - especially when it comes from a very high level - is very good for the health of the economy. The chart above makes that point: the unemployment rate invariably declines as the level of government spending falls relative to GDP. Regardless of how the money is spent (most of it goes not for infrastructure but rather for transfer payments), the federal government cannot spend money as efficiently or as productively as the private sector. And regardless of how federal spending is financed (by borrowing or taxing), spending always requires taking money from the private sector. At current levels, the bulk of government spending is still a deadweight loss to the economy.

The chart above shows that spending has not increased since mid-2009, whereas revenues have increased a lot. The vast bulk of the increase in revenues has been organic: the result of an expanding tax base (more people working, higher incomes, higher corporate profits), and not the result of higher tax rates.

Today Congress decided to suspend the debt ceiling until March 2015. Is that a big deal? No, because we no longer have a budget crisis. The federal budget deficit has fallen to a mere 3.3% of GDP, and that's not scary at all. If recent trends continue, the budget deficit could be less than $400 billion by the end of this year, and that would probably be only 2.5% of GDP.

The challenge going forward, at least for the next year or two, will NOT be to rein in spending in order to keep the deficit and the debt from exploding. It will be to reform our tax code, which has become Byzantine in its complexity and suffocating in its progressivity. We have applied so-called "austerity" to spending, and we have succeeded. Now we need to apply policies that represent genuine stimulus, and that means lower and flatter marginal tax rates with fewer deductions and subsidies. Reduced regulatory burdens would also be a huge help (hint: repeal or redesign Obamacare so that market forces are brought to bear on the problem instead of trying to solve things by government fiat).

The biggest problem we face today is that the economy is operating at only 90% of its capacity (see above chart). We need policies that grow the economy, and the best way to do that is to create incentives for the private sector to work harder and invest more. What better way than to slash corporate tax rates and marginal tax rates on incomes (which in many cases are approaching 50-60%)? It's almost a no-brainer, but hardly anyone gives tax reform a chance these days.

As I pointed out the other day, the prospects for tax reform have improved greatly with the CBO's new-found respect for the dynamic effects of changes in marginal tax rates. Tax reform that flattens the tax code by eliminating subsidies and deductions and lowers top marginal rates shouldn't be difficult at all to justify, since it could dramatically boost future economic growth.

Thanks to a huge decline in the burden of government spending and the CBO's introduction of dynamic scoring, supply-side economics is about to experience a long-overdue comeback. We'll probably have to wait for the November elections to see exactly how powerful and imminent this new dynamic is, but a new and healthier direction for policy should be evident even before then, and markets are excellent at discounting that sort of thing.