What’s The Problem, Revenue Or Spending?

I got into it a bit over at Drum’s place, where commenters are arguing that the S&P is a bunch of GOP plants because of the negative outlook report. Given that I spent some time analyzing historical revenue & spending tables with a calculator to generate one of my comments, I wanted to expand on it here.

The CBO expects GDP to grow from $14.9T in 2011 to $22.5T in 2020, an annual growth rate of over 4%, and expects deficits as a percentage of GDP to return to more sustainable levels slightly north 3%. This, of course, assumes the Medicare “Doc Fix” actually goes into effect, and all the temporary stimulus and the extension of Bush tax rates expire at the end of 2011 and 2012, respectively. I suspect it’s unlikely all three events occur. In addition, they assume that rates of growth in discretionary spending programs track inflation, while discretionary spending growth has averaged well above this (7.5%) over the last decade. (Note — it’s unclear in this data set whether the overall spending numbers, i.e. overall GDP, are inflation-adjusted. I assume so if they are calculating a 4% growth rate, unless they are projecting inflation less than 1.5% per year over the course of the decade.)

The S&P says the US debt outlook is ugly and not expected to improve. The S&P considers 4% growth to be their optimistic scenario, and doesn’t see long-term deficits even optimistically to drop below 4%:

In our baseline macroeconomic scenario of near 3% annual real growth, we expect the general government deficit to decline gradually but remain slightly higher than 6% of GDP in 2013. As a result, net general government debt would reach 84% of GDP by 2013. In our macroeconomic forecast’s optimistic scenario (assuming near 4% annual real growth), the fiscal deficit would fall to 4.6% of GDP by 2013, but the U.S.’s net general government debt would still rise to almost 80% of GDP by 2013. In our pessimistic scenario (a mild, one-year double-dip recession in 2012), the deficit would be 9.1%, while net debt would surpass 90% by 2013. Even in our optimistic scenario, we believe the U.S.’s fiscal profile would be less robust than those of other ‘AAA’ rated sovereigns by 2013.

As an example, I ran some numbers on Real US GDP values from 1969->2010, and calculated a compound annual growth rate for the general economy of around 2.79% (Note — I’m not 100% sure of the validity of my data set there, so if someone in the comments wants to check my work, feel free). I think a baseline of 4% GDP growth is wildly optimistic at this point, unless we experience a technology-based productivity shift on par with that we experienced in the 1990’s. I can’t say I see where that change would come from, but then again if I could see where that change may happen, I’d be spending my time investing in it rather than blogging!

Even with those assumptions, where does spending fall historically? Even at these rosy projections, it never falls under 22% of GDP (on par with the highest spending the country has seen since WWII), and those rosy projections came in January 2010. A year later, in January 2011, the CBO outlook got worse. It now shows spending never falling under 23% of GDP during the decade 2011-2020. Historically, spending has not exceeded 23% of GDP for a single year between 1946 and 2008.

For comparison, the stretch of 1996 to 2007 — a subset in those years being the only period of my lifetime where the US gov’t had run a surplus — government spending never exceeded 20% of GDP. We certainly had a negative GDP shock in 2009, and some stimulus programs to go with it, but that doesn’t explain why government should jump by more than 3% of GDP for the decade following.

Where has revenue been over the last few decades? Well, for the years 1991-2000, during which time we suffered one mild recession followed by the tech bubble, total government revenue averaged 18.75% of GDP. For the years 2001-2010, where we dealt with the tech bubble collapse followed by the subprime bubble and then crash, total government revenue averaged 17.07% of GDP. A sizeable drop, to be sure (the worst spots being 2009 & 2010, where the financial crash slammed revenue below 15% of GDP). But fundamentally not that far out of line with historical precedent.

The CBO projections for revenue — assuming the expiration of all the temporary tax stimulus programs at the end of 2011 and the expiration of Bush tax rates at the end of 2012, have revenue exceeding 20% of GDP for the latter half of the decade — which has only occurred since WWII in the years 1952 and 2000. Their projections show tax revenues sustaining well above historical norms as a percentage of GDP, and assuming Real GDP even somewhat approximates their projections, revenues that will be at inflation-adjusted levels well higher than the nation has ever seen.

So where is the problem, on the revenue side or on the spending side? Well, revenue in both percentage of GDP and in inflation-adjusted dollar amounts will be well above historical norms, assuming “optimistic” revenue numbers for the government (expiration of Bush tax rates). Yet spending will still outclass revenue by over 3% of GDP per year with no end in sight. Even if we rescind the Bush tax cuts, pushing revenue to a level this nation has NEVER seen outside of WWII, we’re still unable to pay for the government our Congress demands, because those demands reach sustained levels never seen in the nation’s history with the exception of WWII.

The S&P is right. We have no plan to get our fiscal house in order, and given that we’re adding onto debt levels (public debt held as a percent of GDP) that are well beyond those of other sovereign AAA-rated bonds, one wonders how they can continue to justify our rating. This is a nightmare scenario unlike this country has probably ever seen, and if it doesn’t get addressed, we may be seeing the end of America as we know it.

Revenue is NOT the problem. We need to fix the spending.