Economic & Print Market

Flash Report

Special Economic Report on Government

Spending, Taxes and Debt: Charting the Numbers
Dr. Ronnie H. Davis, Vice President and Chief Economist

Over a year ago when the economy was falling fast and the “stimulus” was enacted,
expectations were flamed for a quick economic turnaround. The recession has continued,
“Economic & and although economic growth has returned, consumer and business confidence remain
Print Market low and labor markets are dismal.
Flash Report” is
published by Why hasn’t the economy improved at a faster, more traditional pace? A big reason, of
course, is the fact that the current “Great Recession” is an unusual hybrid mix of a typical
Printing recession with a financial crisis. Additionally, the current direction of overall economic
Industries of policy is biased toward the public sector and against the private sector even though the
America’s private sector generates around 80 percent of the nation’s income and almost 85 percent of
Economic and jobs. The resulting uncertainty in consumers and the business community is dragging
Market Research down investment and job creation. There is a long list of other more specific negatives
Department and hanging over the economy:
• Concern about growing government spending and the resulting deficit.
is available only
• Uncertainty over tax policies such as the expiration of the last round of tax cuts and
to members of the temporary expiration of the estate tax.
Printing • Questions about health care reform and what it may mean for employer mandates
Industries of and taxes on jobs.
America. • Doubts concerning energy policy, particularly “cap-and-trade” which would create
an entirely new tax burden on production.
• Recent increases in the minimum wage which reduces the level of demand for
entry-level employment.
• A step-up in antitrust investigations and enforcement from the U.S. justice
department which has crimped merger and acquisitions which have the potential
of creating increased wealth, income, and jobs.
• A lack of focus on exports and trade negotiations.
• Concern over pending new financial regulations that may worsen the banking and
credit environment.

Lastly, Americans appear to be experiencing a heightened anxiety concerning federal

spending, deficits, and the growing debt. Consumers and businesses have been reducing
their debt to de-leverage over the course of the recession. In contrast, governments at all
Printing Industries of 1
America
levels—local, state and national—have added massive amounts of debt.
200 Deer Run Road
Sewickley, PA 15143.
www.gain.net
Government spending, government taxes, and government borrowing mix in a dynamic and
simultaneous manner to influence the level, rate, and direction of change in economic activity (GDP). At
the same time, these last three variables influence government spending, taxes, and borrowing.

The Simultaneous Relationship: Taxes, Spending and Deficits

“Æ” And “Å” = Affects

GDPÆÅGovernment Taxes/SpendingÆÅGovernment Surplus/DeficitÆÅGDPÆÅGovernment

Taxes/SpendingÆÅGovernment Surplus/DeficitÆÆÆ
At the same time:
Tax Rates (+ or -) ÆTax Revenues (+ or -)ÆÅ GDPÆÅGovernment
Taxes/SpendingÆÅGovernment Surplus/DeficitÆÅGDPÆÅGovernment
Taxes/SpendingÆÅGovernment Surplus/DeficitÆÆÆ
What are the trends in these variables? In this Flash, we chart recent trends in federal tax receipts,
spending, deficits, and the national debt and examine how these trends impact economic performance.

What’s the Trend in Tax and Spend?

One way to provide a perspective on federal spending is to examine trends in per-capita spending
adjusted for inflation over the past few decades. From 1950 to 2010, inflation-adjusted federal spending
per capita increased from $2,627 to $10,708, a ratio of 4.1. By comparison, inflation-adjusted economic
output (gross domestic product) rose by a ratio of 3.4.

The rise of inflation-adjusted federal spending per capita increased every decade except the 90s. The
unusual set of circumstances in the 90s—healthy economic growth, tax gains, windfalls from capital
gains, political cooperation on spending, and to a smaller extent, the so called “peace dividend” from
the end of the Cold War—held it in check.

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 Per Capita Federal Spending
Adjusted for Inflation 1950-2010
Thousands
12

10

0
1950 1960 1970 1980 1990 2000 2010
Per Capita Federal Spending (2005$) 2.627 3.481 4.792 6.023 7.343 7.251 10.708

Per Capita Federal Spending (2005$)

Historically, at least from 1950 through the past decade, federal government spending ranged from
around 16 to 20 percent of total economic output (GDP or gross domestic product). On the tax side, over
the same period, federal government taxes as a percent of GDP were similar—ranging from about 15 to
21 percent.

However, as a result of the recent surge in federal spending (particularly the “stimulus” package), in
2010 federal spending will likely comprise more than 26 percent of GDP. In contrast, since federal
revenues are relatively elastic in a negative direction, as a result of the “Great Recession,” federal taxes
will likely take only about 16 percent of GDP.

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 Tax and Spend
Percent of GDP 1950-2010
30

25

20

15

10

0
1950 1960 1970 1980 1990 2000 2010
Federal spending as % of GDP 16.3 16.4 19 20.7 21.6 18.9 26.3
Federal Tax Receipts as a % of GDP 14.9 17.8 18.7 19 18.5 20.8 16.4

Tracking GDP, Government Spending, and Debt

A focus on the trends in GDP, federal spending, and total federal debt shows that Government debt per
capita has risen much faster than government spending and GDP per capita over the past six decades.

GDP, Government Spending and

Debt $ Thousands
50

40

30

20

10

0
1950 1960 1970 1980 1990 2000 2010
GDP per capita 12.34 18.07 20.62 25.47 31.88 39.26 42.57
Gov t. spending per capita 1.925 2.74 3.98 5.525 6.97 7.15 9.65
Gov t. debt per capita 11.6 8.6 7.8 8.5 17.8 22.5 40.1

GDP per capita Govt. spending per capita Govt. debt per capita
Per capita adjusted for inflation
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In terms of percentage change from 1950 to 2010, inflation-adjusted GDP per capita rose by 245 percent
while inflation-adjusted federal government debt per capita rose by an almost equal amount, 246
percent. However, inflation-adjusted federal government spending per capital exploded by 412 percent
over the same period. Much of the rise in inflation-adjusted federal spending is from the recent
“stimulus.” Since the issuance of debt follows spending, this means that government debt per capita will
be rising rapidly in the near term.

Focusing on trends since 1970, the ratio of GDP to total national debt has grown considerably. In 1970
total national debt was considerably less than GDP—less than 40 percent of GDP. At the current time
there is an almost 1-to-1 relationship.

Government Debt and GDP

1970-2010
$Trillions
16
14
12
10
8
6
4
2
0
1970 1980 1990 2000 2010
Total Federal Debt 0.3809 0.909 3.2063 5.6287 13.7866
GDP 1.0127 2.7242 5.7345 9.821 14.6239

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 The Debt Burden
Debt as a % of GDP 1970-2012
120

100

80

60

40

20

0
1970 1980 1990 2000 2010 2012
Debt as a Percent of GDP

The growing debt means that the U.S. government has an increasing dependence on the purchasers of
their bonds. In the past most of these bonds were purchased by domestic buyers—banks, financial
institutions, other companies, the Federal Reserve System, and the Social Security System. In 2010 the
Social Security System shifted to a net seller of bonds, and now foreign buyers, particularly China and
Japan, are the major purchasers. Foreign bond purchases are the way that the current account deficit
(trade balance) is re-circulated back to the U.S. to purchase more foreign goods and services.
As long as this treadmill keeps going, we can maintain our standard of living, but it may not last forever.
The recent example of Greece is a case in point as the treadmill stopped when Greece could no longer
find buyers of their bonds resulting in a serious downshift in Greek standards of living (higher taxes,
lower spending and reduced wages, salaries, and pensions).

Impacts on Economic Performance

Since 1970 federal spending has increased at a significantly higher rate than U.S. population and
household income. While inflation-adjusted federal spending has increased by more than 220 percent,
population has increased only by 50 percent and household income by 32 percent.

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 The Growing Spending Gap
Relative Change 1970-2008
350
300
250
200
150
100
50
0
1970 2008
Federal Spending 100 321
Population 100 149.6
Household Income 100 132

Federal Spending Population Household Income

Federal spending and household income adjusted for inflation

How might these trends impact economic performance? From a longer run perspective, there is an
inverse relationship between economic performance (growth of inflation-adjusted GDP) and inflation-
adjusted government spending per capita. Looking at trends in these two series since the 1970s shows
that per capita federal spending more than doubled even as economic growth has been halved.

Federal Per Capita Spending and

Economic Performance 10

0
1970 2010
Federal Per Capita Spending ($1000) 4.28 9.172
RGDP Growth by Decade 3.3 1.7

Federal Per Capita Spending ($1000) RGDP Growth by Decade

RDGP change of -.3 % per $1,000 increase in per capita federal spending

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Looking deeper and further back in history, an examination of the “trend line” or average rates of Real
GDP over the past few decades shows the U.S. economy has slowed down.

Average annual rate—real GDP

Decade Average annual change

50s 4.1%
60s 4.2%
70s 3.3%
80s 3.1%
90s 3.1%
00s 2.0%

An alternative view, using different periods, demonstrates a similar conclusion:

Average annual rate—real GDP

Period Average annual change

Last 20 years (87–07) 3.1%

10 year trend (88–97) 2.9%
Last 10 years (99–08 2.5%

At the same time the economy has been slowing, it has also become more stable. Over the past six
decades, the growth rates achieved in the highest growth quarters have generally declined while the rates
of decline in the worst quarters have generally been milder. The pattern is one of both milder growth
spurts and milder recessions.

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 The Economy
Slowing Down
30

25

20

15

10

0
50s 60s 70s 80s 90s 00s
Annual growth 4.1 4.2 3.3 3.1 3.1 2
Instability index 27.8 15.3 21.4 16.2 10.3 8.9

Annual growth Instability index

Why slowing/more stable? What’s behind this pattern of a slowing and more stable, less cyclical
economy? There are a number of factors:
• A maturing economy
• A more service and less manufacturing-oriented economy
• The growth of information technologies
• The global economy
• Government policy and regulation
• The growth of government

A maturing economy: As the U.S. economy has matured and grown, it has become a $14 trillion
behemoth producing approximately one-fourth of world output. As such, it could be expected that a
natural increase in stability occurs.

A more service-and less manufacturing-oriented economy: Over the past few decades, the U.S. economy
(and other modern industrialized economies) has become more service intensive and less manufacturing
intensive. Because there are no inventories for the production of services, this leads to more stability.

The growth of information technologies: Computers and information technology have reduced the
“inventory cycle” within manufacturing sectors, further adding to economic stability.

The global economy: The increased integration of global economies has decreased economic cycles
because of the tendency of some economies to be up and some down at any particular point in time.

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Government policy and regulation: To a degree government tax and regulatory policies are
countercyclical, resulting in increased stability. However, at the same time that they put a floor on
declines, they also, unfortunately, place a ceiling on growth.

The growth of government: The growth of governmental spending as a proportion of the economy also
increases stability since government purchases are much less influenced by economic cycles. Again this
is good and bad in that it tends to decrease the down cycles but also decreases the upward potential
because of the “tax drag” from the increased taxes. In particular, the recent surge in spending and
borrowing as a result of the “stimulus” package and the planned increases in government spending over
the next few years will most likely continue to reduce economic growth.

These factors appear to have created a “trampoline” effect. The same factors that reduce the downside
reductions also reduce the upside cycles resulting in a lower average rise—similar to placing a platform
under a trampoline. The impact of slower growth will be higher levels of unemployment.

The Stimulus Tradeoff

From a more current perspective, the recent escalation of “stimulus” spending has perhaps lifted GDP
over the past few quarters. However, as shown in the chart below, the increased recent and projected
government spending from the “stimulus” and other factors has been offset by reduced private spending
with the likely net negative impact on economic output (GDP).

The Stimulus Tradeoff

2009-2013
800
600
400
200
Government Spending ($B)
0
Private Spending ($B)
-200
Net Impact on GDP ($B)
-400
-600
-800
-1000
2009-2013
Gov ernment Spending ($B) 600
Priv ate Spending ($B) -900
Net Impact on GDP ($B) -300

Based on anlysis by Robert Barro of Harvard University

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The Trend in Unfunded Liabilities

A major problem going forward is the growing burden of unfunded U.S. government liabilities from
Social Security and Medicare—$43 billion and $36 billion respectively in 2010. The national “debt to
income” ratio of about 5.5 to one is somewhat equivalent to a $100,000 income household holding a
$550,000 mortgage—a high debt burden. Indeed, on an average basis, the unfunded liability burden per
household works out to almost $380,000 for Social Security and more than $335,000 for Medicare.

Unfunded Liabilities and GDP

$ Billions in 2010

GDP
Medicare
Social Security

GDP 14.6
Medicare 38
Social Security 43

Per household: medicare $335,350, social security $379,475

Recently, The Economist magazine ranked the U.S. number 8 out of 22 developed countries in terms of
“debt sustainability,” an index combining three separate metrics of national debt burden. The three
metrics were:
• Total government debt.
• Economic growth less the cost to finance government debt.
• Average years to maturity of government debt.

This ranking demonstrates the increasingly precarious financial position of the U.S. economy.

Summing Up

As demonstrated above the interrelations between U.S. federal government spending, taxes, debt, and
the economy are dynamic and complex. It is an unmistakable trend that federal government spending
and debt are increasing relative to economic output and population growth. Are there bottom-line
conclusions that we can draw from these trends? There are a few:

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 • The level of federal spending and borrowing has far outpaced the growth of the economy,
population, and household income.
• The troubling trends in federal spending, borrowing, total debt, economic growth, population,
and household incomes will likely continue for the foreseeable future.
• The U.S. economy’s capacity to carry the increased debt is becoming uncertain with the decline
in economic growth.
• At this point in time, the problems are extremely serious but solvable by polices that promote
economic growth and reign in federal spending, borrowing, and debt.
• Over the next few years, politicians and policymakers need to address these issues before the
more viable solutions are no longer available.
• It appears that the U.S. economy is becoming more and more “Europeanized” with political
advantage being substituted for competitive advantage, slower economic growth, and higher
unemployment levels.
• The possibility of a Greek like debt default and resulting downsizing of economic activity and
standards of living is, unfortunately, increasing.

In closing it appears that if the current economic policy trajectory is not changed dramatically sometime
in the next few years, the U.S. economy may indeed reach a tipping point where it loses its prominence
as the world’s premier economy. However, there is still time to make the necessary course corrections.

At the core there are only five possible ways to reduce the debt burden:
• Reduce government spending—specifically entitlement spending since this is the segment
growing fastest.
• Increase government revenues—either through tax rate increases or tax rate decreases
depending on the specific elasticity of the variable being taxed (just as with prices in the
private sector a tax increase can either increase tax revenues or decrease tax revenues).
• Increase economic growth since government revenues are elastic with respect to economic
output.
• Deliberately increase inflation which in reality is a hidden tax increase.
• Default on the debt.

The last two options are obviously not viable choices. The first option is necessary since spending must
ultimately be brought under control. The second option also should be accomplished but it would be best
achieved through tax rate changes that take advantage of elastic tax responses and also recognize the
global nature of the current economy. Finally, option three is by far the best choice since it involves the
least pain and most potential gain.

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