Why Is The Federal Deficit Really Falling?

By Daniel R Amerman CFA

There are two ways a nation can use economic growth to reduce budget deficits. The first method is to participate in economic growth, with a growing economy increasing tax collections. A second method is to raise taxes so drastically that they consume all economic growth.

The United States government recently announced it has some great news – a fast moving economic recovery is slashing the size of the deficit.

“Thanks to the tenacity of the American people and the determination of the private sector we are moving in the right direction,” Treasury Secretary Jacob J. Lew said in the report. “The United States has recovered faster than any other advanced economy, and our deficit today is less than half of what it was when President Obama first took office.”

New York Times

In this analysis, using numbers directly from the White House Office of Management and Budget, we’ll take an independent look at these assertions and see if they are supported by the data.

1) We will examine whether the source of the shrinking deficit is indeed rebounding economic growth, or whether the actual source is higher federal government taxes taking a greater share of the economy.

2) We will look at how much economic growth is left for the private sector after adjusting for the substantially higher tax take from the federal government.

3) We will adjust economic growth for inflation, and examine the surprisingly powerful impact of inflation and rising taxes working in combination when it comes to reducing non-governmental economic growth.

4) We will examine whether this is an anomaly, or is instead the result of fundamental factors that are likely to persist in the future in the United States and in other nations in similar situations.

5) We will consider the implications if the true rate of inflation were to be even slightly higher than the official rate of inflation.

6) We will explore the broad range of implications for investors.

Economic Growth vs. Growth In Federal Taxation

According to official US government figures, the federal deficit, after being fairly stable at just under a $1.3 trillion annual deficit in fiscal years 2010 and 2011, fell to a level of approximately $1.1 trillion for fiscal year 2012, and then dropped all the way down to $679 billion for fiscal year 2013. This is getting close to a 50% reduction in the federal deficit in the two years between fiscal years 2011 and 2013.

During this time in nominal dollar terms (not adjusted for inflation) the reported gross domestic product (GDP) of the United States rose from approximately $14.8 trillion to approximately $16.6 trillion.

In those same years, federal tax receipts rose from a little under $2.2 trillion in fiscal year 2010 up to almost $2.8 trillion in fiscal year 2013.

Now just eyeballing those two figures, it would appear that the federal tax receipts are jumping up faster on a percentage basis than the growth in the economy. Is that indeed the case, and how great is the differential?

(click here to see the supporting calculations)

As shown in the blue bars in the graph as well as the percentages in the table, the United States economy grew 4% between 2010 and 2011, it cumulatively grew 8.8% by 2012, and grew a total of 12.4% by 2013.

Now what is fascinating is when we look at the red bars, which are the cumulative percentage growth in federal tax receipts.

Per the government’s figures, the economy grew by 4% in 2011 – but federal taxes grew by 6.5%.

In over two years between 2010 and 2012, the economy grew by 8.8% – but federal taxes grew by 13.3%.

And most remarkably, taking into account the sharp increase in taxes that took place at the end of the 2012 calendar year, while the US economy cumulatively grew by 12.4% between 2010 and 2013 – federal tax receipts grew by 28.3%.

The graph – and the underlying numbers – are unmistakable.

Federal tax receipts are growing at a much faster rate than the economy itself.

So to understand exactly why it is that the deficit has been falling so sharply – it is because the government is taking significantly more of the economy than it previously was.

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