All Budget Deficits Are Surely Not Created Equal

Tax reform is a hot political issue, and therefore, so are federal budget deficits. A big question about what the Trump administration and Congress might hammer out on taxes is: Will tax reform be revenue neutral or will it expand the budget deficit?

But it’s important to keep in mind that all budget deficits are not created equal.

In simple terms, there are three main causes for an increase in the federal government’s budget deficit. First, the size of government increases, with the acceleration in government spending outrunning any increase in federal revenue. Second, a slowdown in the economy or a recession results in a decline in federal revenues. Third, tax cuts translate into less revenue being taken in by the government. Of course, these three causes can, and often do, occur in combination.

For example, the most recent jump in the federal deficit occurred from 2008 to 2011. The budget deficit went from $160.7 billion in 2007 to $1.413 trillion in 2009, and remained at lofty levels in 2010 ($1.294 trillion) and 2011 ($1.3 trillion). As a share of GDP, the deficit went from 1.1 percent in 2007 to 9.8 percent in 2011, and persisting at 8.5 percent in 2011. That period, of course, included a brutal recession, and the start of a dismal economic recovery. It followed that federal revenues dropped off dramatically – dropping from $2.568 trillion (17.9 percent of GDP) in 2007 to $2.105 trillion (14.6 percent) in 2009, and inching up to $2.163 trillion (14.6 percent) in 2010 and $2.304 trillion (15.0 percent) in 2011. In misguided Keynesian fashion, Congress and the White House responded with a massive increase in federal spending – with federal outlays moving from $2.729 trillion (19.1 percent of GDP) in 2007 to $3.518 trillion (24.4 percent) in 2009 and $3.603 trillion (23.4 percent) in 2011.

Here’s a historic increase in the federal budget deficit resulting from a dismal economy and a major expansion of federal government spending. While Keynesians have long argued for government spending to respond to an economic downturn in this manner, their theory always has been faulty – after all, draining more resources from the private sector, whether via taxes or debt is a recipe for additional economic troubles, not a path to recovery. And that, of course, is exactly what has happened, with our economy still suffering from poor growth today.

Indeed, it’s worth highlighting what occurred when the books were closed at the end of September of the 2016 budget year. The federal budget deficit increased from $438.4 billion in 2015 to $587.4 billion in 2016. Why? Well, economic growth in 2016 slowed dramatically, from an uninspiring 2.6 percent in 2015 to a meager 1.6 percent in 2016. As a result, federal revenues barely budged, growing by a mere 0.5 percent, while federal outlays jumped by 4.5 percent.

These budget deficits are and signal bad news for the economy.

But what about a budget deficit resulting from substantive tax relief? That’s a very different story. First, if tax relief is designed in a productive manner so that incentives for working, saving, investing and entrepreneurship are enhanced, that’s good news for boosting economic growth. Second, faster economic growth means revenue feedback in federal coffers, and fewer demands on federal unemployment and poverty-related programs.

That’s what happened, in part, with the tax cuts of the 1980s, coupled with noteworthy regulatory relief. Economic growth picked up, and expected revenue losses were far less than what government bean-counters projected. Consider that once the 1981 Reagan tax cut was fully implemented by 1983, federal revenues dropped in that year, but then along with strong economic growth, federal revenue growth resumed quickly and rather robustly. Federal spending continued to expand. Over this period, the budget deficit jumped from $128 billion in 1982 to $208 billion in 1983, lingered in the $185 billion to $221 billion range to 1986, and then dropped markedly to a range of $150 billion to $155 billion for the rest of the decade.

The Reagan experience was a classic example of a short-term deficit resulting from pro-growth tax relief resulting in a temporary revenue loss to government. The same basic scenario played out with the Harding-Coolidge tax cuts of the 1920s, the Kennedy tax cut in the early 1960s, and the George W. Bush tax cut of 2003.

So, as the Trump administration and Congress wrestle with tax reform and relief in coming months, it’s critical to understand that, in fact, all budget deficits are not created equal. If a temporary increased deficit results due to pro-growth tax policy, that’s nothing to be worried about – rather it will be good news for our economy and for fiscal responsibility going forward. And imagine the additional good news if pro-growth tax relief gets combined with reduced government spending.