Monday, January 07, 2013

Thoughts on the Budget Deficit

by Bill McBride on 1/07/2013 01:57:00 PM

Note: The US government is on a fiscal year that runs from October 1st through September 30th of the following year. Fiscal year 2012 ended on September 30th of 2012, and fiscal year 2013 started on October 1, 2012.  The graphs below use fiscal year GDP.

A few points on "short term" vs. "long term" issues, and cyclical vs. structural deficits. None of this should be controversial (or political).

1. The "fiscal cliff" was about reducing the deficit too quickly in the short term. This was concerning because a rapid reduction in the deficit (aka "austerity") would probably have taken the economy back into recession. The fiscal agreement reduces the deficit this year compared to fiscal 2012 - the payroll tax hike alone adds almost $120 billion in revenue this year. Those saying "nothing was accomplished" are possibly confusing the short term with the long term.

2. There is a long term budget problem mostly related to spending for health care.  I'll have more on this in a future post, but I think it helps to focus on the short term right now.

3. There is a significant difference between a "structural" budget deficit, and a "cyclical" deficit. A cyclical deficit happens when the economy goes into recession because tax revenues decline, and spending on safety net programs like unemployment insurance and food stamps increases. A cyclical deficit is expected during recessions, and the Federal government is (and should be) counter-cyclical. (this should not be controversial).

4. A structural deficit is a mismatch between tax revenue and outlays even during good times. A structural deficit is much worse for the economy than a cyclical deficit since a cyclical deficit will decline as the economy recovers, but a structural deficit is ongoing.

Here are a couple of graphs.

US Federal Government Revenue Outlays Click on graph for larger image.

The first graph shows revenue and outlays as a percent of GDP. Clearly, in fiscal 2012, the government had BOTH a revenue and spending problem. Both revenue and spending have been impacted by the great recession, and are slowly recovering.

There was also a structural deficit starting in fiscal 2002, and even during the housing boom, revenue was below outlays.  So the recent low level revenue was due to both cyclical and structural reasons.

In fiscal 2013, revenue will increase due to the payroll tax increase, an increase in the tax rate on high income earners, and an improving economy. Spending will probably decrease as a percent of GDP due to some defense spending cuts and an improving economy.

Here are the data sources for these graphs. CBO: Historical Budget Data and An Update to the Budget and Economic Outlook: Fiscal Years 2012 to 2022, BEA: GDP Tables

US Federal Government Budget Surplus DeficitThe second graph shows the budget deficit each year as a percent of GDP. As David Wessel at the WSJ recently noted: Putting the Brakes on Cutting the Deficit

In the depths of the most recent recession, the fiscal year that ended Sept. 30, 2009, the deficit was 10.1% of gross domestic product, the value of all the goods and services produced. Since then, the deficit has declined to 9% of GDP in 2010, 8.7% in 2011 and 7.0% in fiscal 2012. Private analysts predict the deficit will be between 5.5% and 6.0% of GDP in fiscal 2013 ...
My guess is the deficit will decline to around 5.5% of GDP this year. If there is no change in policy, I expect the deficit to continue to decline over the next few years.

However, later this decade, the deficit will probably start to increase again, mostly due to rising health care expenditures. This is the long term issue, and health care spending needs to be addressed to put the debt on a sustainable path long term.

The key points are: the cyclical deficit will slowly decline, and there is a long term issue, mostly related to health care costs that we need to start to address in the next few years.

We'd be in better shape without the structural deficit and if we had avoided the great recession (I did my best to alert policymakers in 2005).   But that is water over the dam.  The bottom line is this is all very solvable.

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