Unsustainable Deficits and Growth

Just how much contraction can we expect to get the Federal budget deficit back under 3% of GDP on a trend basis if the private sector doesn't pick back up? Is the multiplier greater when cutting the deficit?  NorthGG

To answer this question, I start with the budget assumptions released by the CBO.  (In my last point, I used the much less realistic numbers published by the OMB.)  Under the CBO’s assumptions, the deficit dips under 3 percent in 2014 before unfavorable demographics push it back over 3 percent by 2020. 

We can’t adjust the deficit for growth assumptions until we pin down the relationship between revenue growth and GDP growth.  I copied the picture below from the CBOs website—ignore the scary outlays line, I only want to talk about revenues.  Between 1950 and 2007, revenues remained around 18 percent of GDP.  This implies that on average revenue growth has been the same as nominal GDP growth.  In the CBO projection (remember they are constrained by law), revenues are growing consistently faster than nominal GDP. 

So, first things first.  I adjust the CBO’s revenue line so that it matches its historical growth pattern.  This scenario, shown by the solid red line below, yields a deficit that stabilizes around 8 percent of GDP before trending negative in 2018.  If GDP growth stays low as NorthGG suggests, the deficit trends negative from 2012 forward, reaching almost 11 percent of GDP by 2020. 

Neither of these scenarios is sustainable.  Under the first scenario to reach a 3 percent deficit by 2020, total nominal spending growth can increase no more than 1 percent per year from 2012 forward.  To achieve the same goal by 2015, requires total nominal spending to fall by 2.3 percent per year beginning in 2011.  Under the slow-growth scenario, these numbers fall to zero and negative 4.5 percent.

Is the multiplier greater when cutting the deficit?

Good news.  In my view, government spending is for the most part a drag on growth.  The spending can be good or bad but it harms growth.  So, reducing the deficit by slowing the growth of outlays is positive for growth. 

Unfortunately, politicians love large government.  (Yes, this statement is true across ideologies.)  The deficit is much more likely to be attacked from the tax side rather than the spending side.  Higher taxes are the likely outcome.  This route is unambiguously bad for growth—both from distortionary taxes and distortionary spending. 

In my view, the budget doesn’t have to be balanced but spending has to be brought under control.  I don’t think it will happen, though.  At least not until, the pain of adjustment is far more difficult than mere 1 percent nominal growth of spending.