Tuesday, December 18, 2012

Thinking about the fiscal cliff and the government budget.

There is a very good article accompanied by a wonderful short video on the U.S. fiscal cliff in The Economist. The following graph is taken from that article.

First focus on the orange line representing spending by the federal government and the brown line representing government revenue (left hand axis). The graph begins in 1980, the last year of the Democratic Carter administration. (Note that the budget for the year following the end of an administration is determined during that administration.) The spending exceeded income from 1980 to 1996. It was only during a brief period of Clinton administration budgets that revenues exceeded spending. The crash in the latter part of the last decade led to a recession and a fiscal stimulus. The reduction of government revenue was in part due to the downturn in the economy and thus in tax revenues, and in part to tax rate cuts intended to stimulate the economy.

The blue lines represent the federal debt as a percent of GDP. The Reagan years saw a rapid increase in this ratio, and the Clinton administration saw it reduced. The second Bush administration reversed the downward trend, but it increased rapidly since the financial crisis during the Great Recession. The real problem is that it is projected to continue increasing in the future unless federal government policies change.

We want those lines to come closer together in the future, perhaps to touch or even to cross. Thus we might think of government running at say 25% of GDP, with both revenue and spending at that level. In good times we might expect revenue to be larger with respect to spending, and in bad times stimulus might lead to spending exceeding revenues.


Part of the solution should be to grow the economy. As the GDP increases, the ratio of the debt to GDP should tend to decrease. If the nation goes over the fiscal cliff, it is likely to return to recession (probably pulling Mexico and Canada with it, and perhaps the world). Thus many economists recommend that efforts to reduce the deficit not be too draconian.

Government revenues can be increased by increasing the taxes, and most Americans believe that they should be increased for upper income tax payers. That can be accomplished increasing the rates on high incomes. It can also be increased by increasing the contributions of high income tax payers on social security. Alternatively, revenues can be increased by closing tax loopholes and reducing tax exemptions, as was done in the Reagan administration. For example, the maximum deduction for interest might be limited to say $5000 (corresponding to 5% interest on $100,000 debt). It seems to me that reducing deductions would be good policy since the tax breaks on expensive home mortgages helped fuel the housing bubble -- one of the causes of the crash; tax breaks on credit card debt helped to fuel the excessive personal debt created in the last decade.

The following graph is also from the article in The Economist:

The U.S. Defense budget is comparable to that of the next 17 largest national military budgets combined. With the end of the wars in Iraq and Afghanistan, we should be able to reduce defense spending. That will help, but not be a big part of the reduction we hope for.

We can decrease entitlement spending, and certainly decrease the growth in entitlement spending. Some reduction has been included in the Obama health care legislation by making health care more efficient. Some could be accomplished by increasing the age at which social security and medicare kick in.

I would guess that interest rates will go up, and thus net interest on the increasing national debt will also increase.

That leaves the "other" spending on the graph, the so called discretionary spending on things like the national highway system, science and technology and education. Much of this spending contributes importantly to the long term growth of the GDP. Moreover, in total that discretionary spending amounts to less than 5% of the GDP. Not much blood can be squeezed from that stone, but we should try to make some cuts.

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