Tuesday, January 22, 2013

How the Deficit Became Cyclical


Recent federal budget deficits have been mainly cyclical, with only a small structural component. Three-fourths of last year's deficit, for instance, can be explained by the weak economy. But the federal budget balance -- that is, the difference between government revenues and expenditures -- hasn't always responded significantly to the upswings and downturns of the economy.

Until the 1990s, in fact, the budget balance showed only slight cyclical behavior. By the end of President Bill Clinton's second term, however, it had become so sensitive to economic performance that, for every 1 percentage point change in the output gap, the budget balance could be expected to also change by more than 1 percentage point. (The output gap is a measure of where the economy is relative to its potential.)

The federal budget balance, in the more formal economic terminology, went from an output-gap elasticity of approximately 0.4 to an elasticity of over 1.0.

Why did the federal budget balance become so cyclically sensitive in the 1990s? And why has it remained so?

Most of the shift can be attributed to the changing behavior of income tax revenues from individuals, I found in analysis of data from the Office of Management and Budget and the Congressional Budget Office.

Revenues from the individual tax were effectively acyclical until the 1990s. Whether the economy was booming or in recession, the individual income tax raised roughly 8 percent of gross domestic product. That changed rapidly when Clinton was president. By 2000, for every dollar the output gap increased, revenues from the individual income tax could be expected to rise by 40 cents.

What explains, then, the sudden appearance of cyclical elasticity in individual income tax receipts? Three potential causes stand out: rising income inequality, rising income-tax progressivity, and the rising share of capital gains in income.

It's well known that income inequality has increased since the 1970s, with gains particularly skewed towards the extreme high end of the income distribution over the last two decades. Rising income inequality has caused individual income tax receipts to become more cyclical, as high incomes tend to be volatile incomes as well. Such earners take more of their income from capital gains and pass-through business income, both of which have been historically more volatile than labor income. Income inequality has contributed to the volatility of income tax receipts and thereby to the cyclical swings of the budget balance.

Income inequality, though, may not fully explain the changes. Over the last three decades, the individual income tax has become substantially more progressive, with effective income tax rates diverging between the rich and poor. The most rigorous way to see the increasing progressivity of the individual income tax, however, is through the "progressivity index" developed by Michael Stroup of the National Center for Policy Analysis. Stroup's measure takes the difference in area between what economists call "Lorenz curves," graphical measures of inequality, for the income and tax distributions. Stroup finds that federal tax progressivity has increased by more than 30 percent since 1990. This rise in progressivity has made revenues from the individual income tax even more dependent on the "volatile top" than it would have otherwise been.

The third source of the changing behavior of the income tax and budget balance comes from capital gains, which have increased sharply as a share of total individual income. From the end of the Great Depression until the 1990s, capital gains rarely comprised more than 3 percent of income. Then it surpassed 9 percent of income in the last two economic expansions, swinging violently upward and downward with each business cycle. Capital-income volatility has therefore become a major source of cyclical movements in the budget balance.

Although the individual income tax is the "lead actor" in the story of how the deficit became more cyclical, spending has played a supporting role -- and an increasingly important one at that. Spending on federal income-support programs has become more responsive to economic conditions over the last decade, as has spending on Social Security and health programs -- in particular, Medicaid. This seems to have much do to with policy changes which make these programs more generous and widely available in bad economic times.

Cyclical swings in the federal budget balance aren't anything to worry about from a policy standpoint. In fact, it would be unwise to try to offset them with structural changes in spending and taxation. The recent increase in cyclical elasticity, however, means that policy makers are mostly unused to alternating between large cyclical budget surpluses and deficits. They will have to learn to avoid using surpluses as an excuse for tax cuts and new spending, or deficits as a rationale for tax hikes or spending cuts.

3 comments:

  1. Wow, Evan. What LeBron James is to basketball, you are to economic punditry. I just hope you can stay healthy.

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    1. Thanks! If you have any questions about deficits, I'd love to know.

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  2. Evan,

    Your point on the increasing capital gains % of income stuck me as needing further explanation. While annual capital gains should be expected to be volatile, in general, I would expect economy-wide capital gains to be much more similar across decades as they really represent the non-income return to holding capital assets. Rates of return on capital have varied over decades but without a strong pattern of increasing over time. So it seems like its a mix change question. Are share buybacks converting cash flows into capital gains, perhaps? Or is it a question of allocation of gains to individual taxable income rather than other non-taxed pools (pension funds, IRAs, endowments, etc.). That one would be hard to believe.

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