The End Of Declining Deficits

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by: Calafia Beach Pundit

On a rolling 12-month basis, the federal budget deficit hit a peak of almost $1.5 trillion in February 2010. From that dizzying height of just over 10% of GDP, it fell steadily for six years, hitting a low of $402 billion last February, a mere 2.3% of GDP. It's unlikely to get any lower than that, unfortunately, unless and until we see stronger economic growth and/or significant reform to entitlement programs. For the foreseeable future, the budget deficit is likely to get bigger; it's already jumped to just over $500 billion as of last month. There are several culprits: weaker economic growth, weaker tax collections, and a pickup in spending.

The chart above shows the nominal level of federal spending and revenues on a rolling 12-month basis. Note that spending was flat from mid-2009 through last year, but is now on a clear uptrend. At the same time, it appears that the strong uptrend in tax revenues, from early 2010 through early last year, is fizzling out. Two virtuous trends have reversed.

The chart above shows the level of federal spending and revenues as a percent of GDP. Note how both have been trendless over long periods.

It's time for policymakers to revisit Hauser's Law: there is a limit to how much tax revenue can be extracted from the private sector, and we are now approaching that limit. Tax rates have risen in the past year or so, but tax collections have weakened. Raising taxes - as both Clinton and Sanders are proposing - will almost surely fail to close our current and projected budget gap, because higher rates will discourage work and investment, while encouraging more tax evasion.

As the chart above shows, the weakness in tax collections is concentrated in individual and corporate income tax collections - both of which are driven by weaker profits - while payroll tax collections are rising at a 4% rate that is commensurate with the ongoing rise in payrolls and wages.

The first of the two charts above shows the nominal level of federal budget surpluses and deficits, while the second shows the level as a % of GDP. There's nothing necessarily scary here, since it will be a while before the deficit rises meaningfully relative to GDP. The larger message is that the budget deficit is going to be returning to the headlines before too long, and politicians who fail to understand Hauser's Law will mistakenly call for a fix in the form of higher tax rates. The correct fix, of course, would be to reduce tax rates, simplify the tax code, and reform entitlement programs in order to keep spending under control.