Dollars and sense: The relationship between Federal spending and the deficit

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    (MINNEAPOLIS) - Last week, we looked at the long term trendof federal spending compared to the economy.  But the so-called Great Recession of 2008 caused significant departures from that trend.  President Obama is regularly blamed for the “trillion dollar deficits” of current years.  But the full picture is more complex.


    The budget during the recession

    The federal budget runs on a fiscal year of October 1 to September 30th.  So the 2008 budget figures describe spending and income from October 1, 2007 through September 30th, 2008.  This actually helps separate out the effects of the recession.  U.S. Gross National Product grew by 1% in the 2nd quarter of 2008, declined by 4% in the third quarter (part of fiscal 2008) and then dropped 9% in the fourth quarter of 2008 and 7% in the first quarter of 2009 (both part of fiscal 2009).  So, to a considerable extent, the fiscal 2008 numbers represent largely normal conditions of a slowing economy and fiscal 2009 represents the first year of the Great Recession.

    The OMB data we used last week shows what happened.  In fiscal 2008 the federal government took in 2.5 trillion dollars, very close to federal revenue of 2007.  In 2008 they spent nearly $3 trillion, up from $2.7 trillion in 2007.  In 2009, as the recession took hold receipts dropped to $2.1 trillion and expenditures climbed to $3.5 trillion producing a $1.4 trillion deficit.

    Federal spending after WWII had hovered close to 20% of the GNP.  In 2009 that went to 25% and only down to 24% in 2010 and 2011.  But why?


    Recessions affect the budget

    Certainly there were changes to federal spending and taxes during the recession, the fabled bail-outs of industry and the much debated stimulus bill come to mind.  But what is lost in the discussion is that an economic recession, in and of itself, causes deficits for the government.  A recession affects both taxes and federal spending, even if there is no change in policy.  These interactions are explained in documents associated with the annual budget.

    A recession lowers taxes paid to the federal government.  Individuals have their income reduced as they get laid off or have to accept pay cuts.  In 2009, individual income tax payments to federal government declined from $1.15 trillion to $915 billion – a reduction of $230 billion.  Corporate taxes are even more sensitive as business post losses.  And they declined by more than half from $304 billion to $138 billion in the same period – a reduction of $166 billion.  Adding in other sources of revenue, the federal government collected $419 billion less in taxes in 2009 then 2008.

    A recession impacts Social Security as well as some are forced into retirement (and start taking Social Security) and fewer pay into the system (due to lowered employment).

    A recession also increases federal spending. Unemployed workers use services instead of contributing taxes to support them.  Medicare and Medicate respond to increases in the cost of health care.  Federal spending went up by $535 billion from 2008 to 2009, but of course, that was not just due to the recession.

    Indeed all the numbers given here are not “pure” effects of the recession because tax policy and spending were changed.  And there are other complicating factors as well as, for example, companies shift the accrual of certain expenses from one year to the next to take advantage of the tax laws.

    One way to isolate what portion of the deficit is due to the recession is with the concept of the structural deficit.  Economists estimate what the deficit would be under the current laws if the economy were functioning at its “normal” level, or near full employment.  When the economy is in recession the structural deficit estimates what portion of that deficit would disappear if the economy recovers.  OMB’s economic analysis argues that in 2008, with the economy moving along, there was essentially no cyclical component to the deficit.  The $485 billion deficit was all structural.  But in 2009, the $1.4 trillion deficit was composed of $1 trillion structural portion and a nearly $400 billion cyclical component.  The recession had added $400 billion to the deficit.

    Another way to look at this issue is to estimate the impact of specific changes in the economy. Those same OMB budget documents include a careful analysis of the impact on future budgets of small changes in economic conditions.  It is estimated that if GDP grows 1% less than predicted that federal receipts will decline by 14 billion and federal spending will increase by 3.6 billion leading to an 18 billion increase in the deficit with no changes in the laws on the books.  These numbers can’t be extrapolated nor are they universally true for all years, they are linked to specific predictions for 2012.  However, they give a good idea of how sensitive federal deficits are to changes in the health of the economy.

    Likewise, inflation and interest rate changes also greatly affect federal deficits.  If inflation and interest rates increase just 1% above baseline predictions for 2012, a predicted increase of 20 billion in revenue will occur, more than offset by a 30 billion increase in expenses (in part because paying the federal debt will get more expensive), leading to an increase in the deficit of 10 billion.


    Who gets the responsibility?

    So it is true that during President Obama’s first year in office, the deficit ballooned from $458 billion to $1.4 trillion.  Or did it?

    Fiscal 2009, with its $1.4 trillion deficit, began in October 2008, one month before the election and several months before Obama took office.  The Congressional Budget Office publishes monthly and quarterly Budget Review bulletins that provide data on how federal government finances are progressing through the fiscal year.  Assembling data from a number of those documents indicates that in the first quarter of fiscal 2009 (Oct – Dec. 2008) the budget deficit was $485 billion, in the second quarter (Jan – March 2009) it was $468 billion in the third quarter $150 billion, and in the forth $300 billion, totally $1.4 trillion for the year.

    Furthermore, the CBO can estimate some of the sources of that increased deficit.  Halfway through the fiscal year (in March 2009) they wrote that the deficit included $284 billion paid out for the Troubled Asses Relief Program (TARP) and another $14 billion in equity given to Freddie Mac.

    So, to sum up, perhaps half of the massive 2009 deficit – and most of the forces that led to it, were already in place before any action by the Obama administration could have any effect.  Of course, it can still be debated if their subsequent actions helped or hurt the economy.


    The bottom line

    A recession leads to increased deficits, even if no policy changes are made.  And likewise, a good fraction of the federal deficit will disappear as the economy recovers.  Indeed, using OMB estimates for 2012, one could expect that the $1.3 trillion deficit would have been $750 billion if the economy had been back to normal.

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