Elliott Parker: Budget deficits at the edge of the fiscal cliff
September 1, 2012
Last week’s Republican Convention highlighted the growing federal debt. Yet if Congress does nothing, as its recent track record suggests, taxes will increase and government spending will fall starting Jan. 1. This is projected to cut the annual budget deficit in half, to a rate more consistent with economic growth.
How did we get to the edge of this fiscal cliff, as some call it, and should it occur in order to slow the growth in federal debt?
We have actually been in a similar situation before. After more than a decade of large budget deficits, President Clinton signed the Deficit Reduction Act of 1993 over Republican opposition.
That year, federal spending totaled 22 percent of our Gross Domestic Product, and federal tax receipts totaled 17 percent.
Seven years later, after one of the fastest and longest peacetime expansions in U.S. history, federal spending was down to 18 percent of GDP, while tax receipts rose to 21 percent, with surpluses projected to continue into the distant future.
In 2001, however, the Bush administration passed a 10-year phase-in of dramatic tax cuts, and then expanded these in 2003 in spite of starting two unfunded wars.
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By the fiscal year ending in September 2008, federal spending and receipts switched places: Spending rose to 21 percent of GDP, due mostly to increased military spending, while federal receipts fell to 18 percent.
Between 2000 and 2008, the average federal income tax paid to the IRS by those earning more than $500,000 per year fell from 28 percent to 23 percent of income.
People of more modest means also received income tax cuts. For example, the average income tax rate for those earning $50,000 per year fell from 11 percent to 9 percent, but those in lower tax brackets still paid a much larger income share for payroll taxes and state sales taxes than the wealthy.
The Great Recession of 2008, however, led to a big fall in federal revenues, and big increases in spending.
President Bush’s Economic Stimulus Act of 2008 added $0.2 trillion to the FY 2008 deficit, while his Emergency Economic Stabilization Act added another $0.7 trillion for bank bailouts to the FY 2009 deficit and the Iraqi surge added even more.
Even before the election of 2008, the federal deficit was on target to reach $1.2 trillion. As GDP dropped, spending rose to 25 percent of GDP, and total tax receipts plummeted to 15 percent.
State and local governments also had big falls in revenues, but they didn’t have the option of running deficits. The result would be reductions in spending and employment that continue to this day, and threats of much, much bigger cuts. This would significantly and unexpectedly slow the recovery.
President Obama’s American Recovery and Reinvestment Act of 2009, which passed over Republican opposition, added $0.2 trillion to the FY 2009 budget deficit, plus $0.4 trillion to FY 2010 and $0.2 trillion more to FY 2011.
About a third of this fiscal stimulus went to the states, to help them prevent even bigger cuts to education. Another third went for more tax breaks, and the rest went toward increased infrastructure investment and other things.
The biggest jump in spending, however, went to help states pay for their unemployment and Medicaid benefits, while spending on Social Security and Medicare also increased significantly.
Furthermore, in 2010 President Obama agreed to a two-year extension of President Bush’s tax cuts, and then added a one-year cut to payroll taxes, which was then extended another year.
No matter what anybody claims, this stimulus helped stabilize the economy. The financial crisis made this recession most similar to the Great Depression, but back then the Hoover administration and the Federal Reserve did everything wrong and made a terrible situation worse.
This time, fiscal and monetary intervention made it much less awful. However, the increase in federal government purchases was almost entirely negated by cutbacks at the state and local level, and frankly the President was far more optimistic about the recovery than he should have been.
Federal spending is currently 24 percent of GDP. A quarter of this budget is defense-related, while Social Security, Medicare, and other health care spending together account for 43 percent.
All other spending, including interest on the national debt, only accounts for a third of the total.
Those who advocate for trying to reduce the budget deficit entirely through spending cuts have been intentionally vague about what they would cut, because it is mathematically impossible to accomplish what they propose without either magic, wishful thinking, or huge cuts to defense, Medicare benefits and other popular programs.
Meanwhile, total federal tax receipts are now only 16 percent of GDP, and Americans are paying the lowest income tax share to the federal government since WWII. The deficit has so far come down only slightly since FY 2009.
Through an accident of timing and an inability to get any legislation passed, several things are set to occur in 2013.
First, the Bush tax cuts will finally expire, for all income levels, and the Obama payroll tax cuts will expire with them.
Second, the so-called sequestration cuts will go into effect. These spending cuts, which were only intended to scare Congress into an agreement last year, will impact defense and all other discretionary spending, which in turn will have a huge impact on federal money for states.
Finally, Congressionally-mandated limits to Medicare spending will force a reduction in payments to physicians.
These changes are projected to have a significant impact on reducing the deficit. If the deficit is what matters to you most, you might feel pretty good about that.
The problem with cutting deficits so quickly is that it could backfire by pushing our economy back into recession. Just as increasing spending and cutting taxes in a recession helps the economy, decreasing spending and raising taxes hurts it.
This is not so much of a problem when the economy is running near peak speed, and the private sector is able to take up the slack, but we aren’t there quite yet. Consumers and firms have been dealing with their own excessive debt since 2008, and are not quite ready to begin buying again.
If we are wise, we should phase in some of the tax increases and spending cuts over the next couple of years, so as to avoid returning to recession.
Congress will almost certainly act by early 2013 to address the fiscal cliff. But our experience back in the 1990s should also show us that we can raise taxes and cut spending to balance the federal budget without necessarily jeopardizing economic growth, at least once the private sector is ready to step up to the plate.
• Professor Elliott Parker is chairman of the Department of Economics at the University of Nevada, Reno.