Federal finances continue to improve

Federal tax receipts are growing strongly while spending is stagnant, thanks to a deadlocked Congress, a growing tax base, and higher tax rates. The federal deficit as a % of GDP has fallen almost by half in the past 3 1/2 years. This dramatic improvement is likely under-appreciated and almost totally unexpected. At the very least this removes a good deal of uncertainty about the future, at the same time as it removes the need for further tax hikes and increases the odds that tax rates might be lowered in the future.

Federal spending has changed very little in the past four years. In the 12 months ended May 2013, spending actually declined 1.1%. 

Federal tax revenues have been rising steadily for the past several years, and have surged at a 17% annual rate in the six months ended May 2013. Several factors were responsible: jobs and incomes are growing, the payroll tax holiday expired at the end of last year, income was shifted forward at the end of last year as people attempted to avoid an anticipated increase in tax rates, tax rates on top income earners increased, and a stronger stock market generated more capital gains. Federal revenues over the past 12 months reached a new all-time high of $2.7 trillion.

The federal deficit in the past six months was $870 billion, down from a high of $1.47 trillion in CY 2009. Relative to GDP, the federal deficit has dropped almost by half, from a high of 10.5% to now only 5.5%. Almost all of the nominal reduction in the deficit has come from increased revenues (since spending has been flat), which in turn is mostly due to ongoing economic growth, and partly due to higher tax rates. Relative to GDP, 3 percentage points of the 5 percentage point reduction in the deficit have come from the decline in the relative size of government spending, while 2 percentage points have come from the rise in tax revenues.

If current trends continue, the budget could end up balanced within 5-6 years.


UPDATE:

Note to Keynesians: The massive increase in the deficit that occurred from late 2008 through 2009 was supposed to "jolt" the economy back to life, but instead we got the weakest recovery in history. If anything helped get the recovery started, it was the Fed's first Quantitative Easing program, which supplied the cash and cash equivalents that were so desperately needed in a world that had become suddenly very risk-averse. Similarly, the huge decline in the deficit that began in 2010 would have choked most Keynesian models, leading to a painful contraction of economic activity that never occurred. Massive fiscal stimulus was followed by excruciating fiscal contraction, yet the economy grew at a fairly steady and unimpressive pace of about 2% throughout—with surprisingly little variation, as the chart above shows.

This recovery has been a perfect laboratory test of the predictive powers of Keynesian economic models, and they have failed utterly. It's time to throw Keynesian economics into the dustbin of history.