The Deficit: What My Research Shows



In the past month, I’ve done some research on the US deficit. Originally, I did this for study purposes – as part of my master’s degree I am required to conduct one research project now during the fall, and another one during the summer. However, I found my results to be too interesting to keep to myself – and that is why I’ve written this blog post that you’re currently reading. This study covers the years 1946-2011.

The question I asked myself was: Which factors have determined the size of the US deficit (or, more rarely, surplus) over time? I’m not talking about specific items of expenditure, but more in general. What is it really that makes the US spend more than it takes in? And; what can be done about it?

Some blame the deficit on lack of growth – the phrase “grow away the deficit” is very popular among liberals. That was the whole idea behind the stimulus package after all: Sure, it will create a deficit right now, but it will create growth, growth will produce more tax revenue and hence the deficit will fall back again.

Another favourite claim among liberals is that the deficit is really the Republicans’ fault –  surely we balanced the budget under Clinton, did we not?

Others blame unemployment, or war. Wanna know which excuses actually hold empirically? Keep reading (I’ll start by discussing my conclusions; I describe my methodology later in this post):

Conclusions

- “Growing away the deficit” – an absurd lie. Out of the many findings my research gave me, this one is the most surprising: Growth does not actually reduce the deficit. Here is how it works: Higher growth this year will, as one would expect, reduce the deficit this year – but it will actually raise the deficit the next year. I was shocked myself to find this, and double-checked the data at least a dozen times before accepting that it was correct. Here’s why this happens: If you have high growth one year, then revenue will go up that one year and the deficit will fall. But; once politicians realize that growth for the year has been higher (and the deficit lower) than expected, they will increase spending the following year (the budget for one year is usually set late the year before). Sure as long as growth keeps going up, they figure they’ll be fine. But then, that’s never the case. The net effect (over two years) of high growth is actually negative. 1 % growth will decrease the deficit by roughly $15 billion this year, but increase it by slightly more the following year. Hence, to grow away the deficit is an absurd lie.

- Taxing away the deficit – another liberal daydream. What about raising taxes? Surely that would reduce the deficit? The answer is yes. Don’t get too excited though – a 1 % increase in tax revenue (as a % of GDP) will only reduce the deficit by approx. $32 billion dollars. Given that the deficit is over $1100 billion dollars, the US would have to more than triple its tax revenue (again, as a % GDP share) before the budget (hypothetically!) would be balanced. More precisely, federal tax revenue would have to reach 50.65 % of GDP (compared to 15.4 % in 2011). This would make the US the second highest taxed country in the world (only the small island nation of Kiribati currently has a higher revenue/GDP ratio at 70 % – why can’t liberals just move there?). So why do tax hikes not work as well as one might think? You see, theoretically, a 1 % increase in the revenue/GDP ratio should reduce the deficit by something like $130 billion dollars*. There are two problems: One is that when you raise taxes, you will generally reduce economic activity. There will be fewer companies and workers that you can tax (this is why in extreme cases, a tax hike can actually reduce revenue). However, the major problem again comes down to the politicians: Tax hikes are unpopular. If you want to increase taxes, you’ll most likely have to increase spending as well to make the voters accept it. Also, even if that was not the case, politicians just generally have a hard time keeping their hands off any extra revenue – whether it comes from growth or tax hikes.

- No, inflation won’t solve this either. It is well-known that inflation is good for the borrowers and bad for savers. And since the US as of today most definitely is a borrower, inflation really should help. While there’s no denying there are upsides and downsides with inflation, if you’re hoping that inflation may solve the US deficit crisis all I can say is don’t hold your breath. Inflation does reduce the deficit, but only by about $8 billion for each extra %. Which means that in order to balance the budget, Americans would have to accept an inflation rate around 130 % – again this is very hypothetical assuming each extra % of inflation reduces the deficit by the same amount as the last one. In reality, an inflation rate of 130 % would of course destroy the entire US economy.

- Elections don’t have consequences. Yes, that pretty much sums it up: Democrats and Republicans are equally good at deficit spending. There’s no statistically significant difference, which confirms what you must have suspected after the first two conclusions: The political system is broken. There is a culture in Washington, DC that is permeating the Democrat and the Republican party. This culture – a culture best known for its shortsightedness, lack of care for future generations and disregard for the common man – is the real problem. This is more serious than you might suspect: Because we’re dealing with a “cultural” problem, the problem won’t go away until the culture has changed. Culture rarely changes overnight – changing the culture in Washington, DC may take decades. Meanwhile, the US is quickly running out of time…

- Deficits are addictive. If you’re a regular Caffeinated Thoughts reader, you may recall that I’ve previously argued that governments form habits just like individuals do, and that deficit spending is one of those things that easily becomes a habit. Now, empirical evidence appears to prove me right: A $1 billion increase in the deficit this year, will lead to a $585 million increase in the deficit next year. In short: There is a lag. This means that a deficit isn’t very easy to just shake off from one year to another. That’s not good news, but it’s also no big surprise. Moving on…

- Wars cause deficits. If the previous conclusion was a no-brainer, then this one should be even more so: Wars increase deficits. You may be surprised to find out though that they only increase deficits by about $74 billion (per year). A lot of money, yes – but again the liberal talking point “the budget would be balanced if not for the wars” appears to be wrong. There may have been a time when $74 billion really made the difference between surplus and deficit, but that time is not today. We should also note that sometimes, the alternative to war may have caused a higher deficit: If the US had sat back after 911 and not done anything, that would have allowed for even more terrorist attacks on US soil. I admit I don’t have any empirical data to back this up, but I think in the long run allowing terrorists to hit skyscrapers with airplanes can have an adverse effect on the fiscal well-being of a country.

- Reducing unemployment only goes so far. Here’s some good news: If we could only reduce unemployment back to normal levels (about 5 %), the deficit would be approx. $150 billion lower than it currently is ($50 billion for each %). The bad news of course is that there’s still almost $1 trillion deficit left. And the really bad news of course is that the current jobs policies pursued by the Obama administration won’t create any jobs in the private sector. While the public sector is an important part of society, jobs in that sector don’t really do much to reduce the deficit – the government has to pay the salaries, so those jobs actually represent an expenditure. I trust that most CT readers already know this – I’m just explaining it in case there are any politicians reading this. They are the only ones who don’t seem to get it.

spending

What is the solution? 

What I’ve written so far has been very depressing. Trust me when I tell you that conducting this research was even more depressing for me than reading the results were for you. I truly want the US to succeed. I am one of few Europeans who openly support the US superpower and who wants the 21st century to be an American century. I’m not gloating at your misfortune.

When I began working on my research project, I had a pretty good idea about what I would find. I knew it would be mostly bad news – though I could never have imagined how bad.

The bottom line is: The US  cannot grow, tax nor inflate its way out of its current deficit. As you’ve probably guessed, this leaves only one option: Cutting spending.

This is something that we need everyone to understand: The only thing we should be discussing right now are which budgets to cut and by how much. The sooner we understand that austerity is the only way to go, the faster we will get out of this mess. As long as politicians and pundits are fooling themselves into thinking we may somehow solve this with a bit of growth and maybe a tax hike, the problems will only get worse.

The other suggested “solutions” to the deficit remind me a lot of fad diets promising to help you lose weight effortlessly – it’s only once you realize that there is in fact no easy way, and that you have to make major changes to your lifestyle that you can begin to shed pounds. And the same thing goes with the deficit: As long as we believe in solutions promising balanced budgets without effort, nothing will ever get done and we’ll only get fatter until the inevitable heart attack happens. We can still do something. The US is not yet doomed, but we can only be saved if every conservatives leads by example and accepts spending cuts, even if it will hurt them personally (for example a conservative with a mortgage should support eliminating the mortgage deduction). You are going to have to cut about 40 % of your budget – there is no way this can be done if everyone insists the budget cuts be designed in a way so that everyone gets hurt except themselves. I am frankly quite pessimistic; I don’t know whether Americans will accept these hard truths before its too late. But it’s not too late now, so it’s still possible.

Basically, the only good news I can bring you is that there is still time.

 

Methodology

For those of you interested in the technical details of my research, here’s a summary of my methodology: I constructed a model with the surplus/deficit as the Y-variable, and the following X-variables: GDP, GDP last year, Surplus last year, War, Inflation, unemployment, tax revenue. War is a dummy variable taking the value 1 if there was a war, and 0 otherwise. I also tested for (more) lags of each variable, but they came back insignificant. I also tested whether which party possessed the white house/congress/both had any impact on the deficit, but as I state above these variables were insignificant. The model’s adjusted r-square is 92 %. I didn’t find any heteroscedasticity nor serial correlation (for p=2). Unit roots were identified in inflation, GDP and surplus data, but the Engle-Granger tests that I made showed no cointegration. My research covers the years 1946-2011, ie the entire post-war period. *I have adjusted the data for inflation using 2005 as my base year. The average GDP during this time was about 6.4 trillion, meaning a tax hike only yields about half on average of what it should theoretically yield.

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Comments

  1. says

    Gus-

    My only quibble with your post is the way you framed your remarks on growth: “Growing away the deficit” – an absurd lie. If someone doesn’t read what you wrote carefully they’ll assume that you are maintaining that growth cannot under ANY circumstances wipe out a deficit, which, as you know, it most certainly can. Indeed, any REAL plan to balance the budget must take into consideration a robust economy that is growing and thus sending lots of cash into the federal treasury. Your problem isn’t with the growth-cuts-deficit concept, it’s what idiot politicians do with the increased revenue that growth brings in: They spend it (and then some)!

    Great piece, however.

    All the best,
    Brian

    • says

      You’re right about this Brian – growth could theoretically wipe out the deficit. But then as I’m sure you know, empirical studies don’t look at what COULD happen, but what have happened. Growth, historically, just hasn’t managed to wipe out any US deficits even though it should be theoretically possible.

      Thanks for your comment.

  2. says

    I would posture that spending cuts alone won’t be sufficient to address our current fiscal crisis. It would help to address the deficit, but like some of the other suggestions, it won’t be a dollar for dollar reduction. When you cut spending there is also a negative impact on GDP of $1-3 dollars for each $1 in spending cuts. That reduction in GDP results in reduced tax revenues as well. So, if you balance the budget and cut spending by $1 trillion, you’ll be reducing tax revenues by $1-3 trillion, albeit temporarily. Tax increases likewise have a negative impact on GDP. So, we’re faced with a “lesser of two evils” scenario in which neither tax increases nor spending cuts will fix our fiscal woes. Unfortunately, Congress has kicked the can so far down the road that options have narrowed to the point that it will likely require spending cuts and tax increases to address the deficit and the debt. It took 112 twelve years to get into this bad of shape and it’s not going to be fixed overnight. By increasing the tax base and including all but the very poor contributing to income taxes along with major cuts in spending will we even begin to return to a balanced budget and meaningful reduction in our national debt. Once the pain the the medicine has been dealt with we can begin to see a return to meaningful growth and reduction in unemployment, increasing further the base of taxpayers. Once the budget is balanced and debt has been returned to a manageble and sustainable level, discussions can begin again about tax cuts that will further stimulate the economy (as long as spending is restrained). But I’m thinking that conversation won’t happen until my grandchildren are elected to Congress.