Fiscal policy has been a significant drag on growth for most of the current recovery—not because of a declining deficit, but because of excessive spending. Spending is taxation, as Milton Friedman taught us, because spending must eventually be paid for by higher taxes. Spending is also bad because government doesn't spend money with the same efficiency as the private sector; you surely spend your own money much more carefully and frugally than you would if you got to spend someone else's money.
The good news is that even though the federal government arguably is still spending way more money than it should (federal spending is running about $3.5 trillion per year), federal spending as a % of GDP has been declining steadily for the past five years, so the drag of fiscal policy today is much less than it was just a few years ago. It's also good because the big decline in the federal budget deficit has all but eliminated the need for higher tax rates. As the public sector shrinks relative to the private sector, the private sector has more room to grow, and it's the private sector that delivers prosperity.
The following charts illustrate some of the points made above:
Federal spending has been effectively flat for the past five years, thanks mainly to congressional gridlock and an improving economy, which in turn has reduced the need for social safety net spending. Federal revenues have been rising steadily, thanks mainly to more jobs, rising incomes, capital gains, and rising profits, and only partly thanks to higher tax rates imposed beginning last year. In retrospect, we would have been much better off not raising tax rates on anybody.
Federal spending relative to the size of the economy has declined by almost one-fifth, from just under 25% of GDP to just over 20% of GDP. This has reduced expected future tax burdens enormously, and on the margin it has helped to boost the economy's overall efficiency. Revenues are now about 17.2% of GDP, which is only slightly less than the 17.4% they have averaged since 1968.
The result of flat spending and rising revenues has been a two-thirds reduction in the federal budget deficit (from $1.5 trillion to $0.5 trillion). Relative to GDP, the deficit has collapsed from a high of 10.2% to now only 3%.
The decline in the unemployment rate has correlated very closely to the decline in government spending relative to GDP. A significant decline in government spending relative to the economy did not in anyway harm the economy by this measure. As the graph above suggests, further declines in spending relative to GDP are very likely to coincide with a healthier labor market.
All in all, lots of good news here, even though there is plenty of room for further improvement. Things could be a lot better, of course, but at least they are getting better.
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