There’s a catch-22 with increasing the deficit through unabated government spending and then expecting to pay for such outlays with tax increases. Government tax revenue is proportional to the gross domestic product (GDP), and unless the GDP increases, tax revenues will decline. The catch is that sustained GDP growth depends on a number of factors, including private sector investment and innovation, as well as personal consumption (consumer spending) and net exports. In turn, government spending, tax and regulatory policies affect these factors. The goal of this short study is to discuss these dynamics with available macroeconomic data.

The relationship between the U.S. GDP and government tax revenues was discovered by economist Kurt Hauser [1]. Hauser’s 1993 analysis of federal revenue data showed that total federal revenue since WWII had remained at ~19.5% of GDP – i.e., that tax receipts are independent of marginal tax rates. This result is striking given the fluctuation of marginal rates from 1952 to 2009 – individual federal top marginal rates have declined from ~91% to ~35% and corporate federal top marginal rates have declined from ~52% to ~35%.

In an effort to reproduce Hauser’s conclusion, I looked at GDP and federal government revenue data readily available from the U.S. Bureau of Economic Analysis (BEA) [2]. Figure 1 shows total federal government revenue as a percentage of GDP, plus major contributors to that total. All data is expressed in current U.S. dollars, is quarterly data seasonally adjusted at annual rates, and is part of the latest release from the BEA (June 25, 2009). The long-term average of total federal revenue is ~18.1% as of the latest data, and is indeed remarkably level, particularly when compared to the government revenue vs. GDP signatures of other countries. Note the more than doubling of government social insurance tax revenue vs. GDP over the period – the greatest increase among contributors.

Next in Figure 2, I look at the current (nominal) and chained (‘real’) GDP over the same 1947-2009 period, with markings for business cycle recessions as called and defined by NBER [3]. What is striking is the sharp decline of GDP in the current recession, even in the nominal GDP. Other recessions, even the ’81-’82 recession, appear to have had less effect on the GDP, which recovered remarkably well after a flat period and resumed a respectable growth path upward.

Figure 3 shows a compelling story, one I have yet to see elsewhere. It is the % change in real GDP of quarterly seasonally adjusted data, at an annual rate, with the major contributors. The GDP has four major contributors: personal consumption (which includes consumer spending), private domestic investment, net exports, and government expenditures. In Q1 2009 these contributors were ~72%/12%/-3%/19% of the real GDP respectively. Almost without fail, major declines in the GDP were preceded by large declines in private investment. On the face of it, this seems obvious: if private investors stop funneling money into the economy, business growth contracts, jobs contract and eventually even personal consumption (consumer spending) contracts – the data in Fig. 3 shows that real private domestic investment has had a negative annualized change in 9 of the last 12 quarters, and 2 of the last 3 quarters have seen relatively large declines of personal consumption. The last time we had such pernicious declines in private investment and personal consumption was the ’73-’75 recession. The data is clear that private investment is a leading indicator, and that the GDP is highly correlated to it. And so I ask the question: why is it then that government policy makers don’t recognize this basic fact, and set fiscal (tax-regulate) policies to promote private investment when declines are nigh? Stay with me here, there’s more to the story.

Figure 4 shows federal government expenditures as a percentage of GDP, plus contributors. Note the recent major tick up in both current social transfer payments and capital transfer payments (= the infamous $700M TARP

), and an increase in the deficit (net borrowing). Quarterly numbers don’t yet reflect the massive $787B stimulus passed in February ’09. Social transfer payments have nearly tripled from 1947-2009, and do not reflect off-balance-sheet liabilities to Social Security and Medicare entitlements. To complete the picture, I also looked at state-local government revenue (Fig. 5) and expenditure (Fig. 6) data from the BEA. Total state-local receipts include tax receipts and social program transfer payments from the federal government. Note that state-local tax receipts have been remarkably constant as a percentage of GDP since the early ‘70s. When added to total federal receipts in Fig. 1, federal-state-local revenue totals ~ 27-28% GDP.

[caption id="attachment_145" align="alignnone" width="150" caption="Figure 6-US State-Local Expenditures vs. GDP"] [/caption]

As we live in a global economy, it is highly instructive to compare equivalents of Figs. 1-6 to those of other countries. Figure 7 shows real GDP growth, as annualized % change, of 30 OECD countries [4]. The countries are ranked on the right according to the highest projected real GDP growth for 2010. Numbers to 2008 are actual. Major economic crises are certainly reflected for South Korea (1997 Asian currency crisis) and Iceland (recent government default). All countries are expected to endure significant declines in 2009, but regardless of the global crisis, 9 countries are projected to maintain positive growth. Figure 8 highlights total government tax revenue of OECD countries as a percentage of current (nominal) GDP. For the U.S., this is the addition of the data in Figs. 1 & 5, subtracting federal social transfer payments to the states from Fig. 5. The U.S. appears to be the only OECD economy where total government revenue (dominated for the most part by tax revenue) is relatively constant since WWII! This signature (and it is a signature, as other economies are different) ought to be used to set policy. The rank of countries on the right side denote highest-to-lowest %GDP of tax revenue. Next, I looked at two important metrics, private domestic investment (Fig. 9) and gross government debt (Fig. 10). The rankings on the right side are highest-to-lowest of the annualized change in investment outlays and to gross debt as % GDP, as projected for 2010 by OECD. Note that many of the same countries that are seeing positive and increasing GDP growth (Fig. 7), even through the latest global slowdown, also show growth in private domestic investment. Additionally evident is that those same countries have relatively low gross government debt as a %GDP. On the other end of the spectrum is Japan: a slow grower with a high public debt load and anemic private investment growth – and with the highest marginal tax rates on corporate income. The U.S. is not far behind.

[caption id="attachment_147" align="alignnone" width="150" caption="Figure 8-OECD Tax Revenue vs. GDP"] [/caption][caption id="attachment_149" align="alignnone" width="150" caption="Figure 10-OECD Gross Govt Debt vs. GDP"] [/caption]

Not to be excluded from this discussion are the “BRIC” countries, Brazil-Russia-China-India. I also include a few others, such as South Africa. For that data, I turned to the IMF database [5]. In Fig. 11a, I show the current (nominal) GDP in US$ for the BRIC, SA, and a selection of OECD countries, as well as a few other up-and-coming economies, such as Singapore, Taiwan, Latvia, Argentina, Israel and Egypt. The ranking on the right side is highest-to-lowest GDP projections by the IMF for 2014. Figs. 11b-c are blow-ups of Fig. 11a so as to show the GDP data for the smaller economies. Clearly there are several standouts: (1) the sheer size of the U.S. GDP (economic output) compared to all others; (2) the rapid increase in output of China’s economy, which is projected to overtake Japan this year; (3) the flat growth of the Japanese economy since the implosion of its stock and real estate markets in the early 90s; (4) the projected rising stars of Russia, India, Brazil and Canada.

[caption id="attachment_151" align="alignnone" width="150" caption="Figure 11b-BRIC and OECD Current GDP, Expanded"] [/caption]

I then gathered private domestic investment rates as a percentage of GDP from both OECD (on BRIC, SA, and a few OECD countries) and IMF, in Figure 12. The IMF data is actual to 2008 but makes projections to 2010. The rankings on the right are highest-to-lowest as of 2007. The countries with the highest % (China, India, Korea) are not surprisingly those with above-average GDP growth. The countries with the lowest % (the U.S., Germany, U.K.) have slower or projected slower growth – which will in turn affect tax revenues and deficits. Two standouts again: (1) Japan, with declining investment but still a respectable level as of 2008, has not been able to translate that level into significant GDP growth – likely because of its very high public debt load and business-unfriendly tax policies, as well as a low ranking of foreign direct investment (FDI); (2) the U.S., which is projected by IMF to have significantly declining private investment levels, and which likely accounts for their forecast of flat U.S. GDP growth into 2010/11 – yet provides us with a suspension of belief after that – the resumption of high growth from 2011-2014 in Fig. 11a simply cannot happen without the participation of private investment.

So we come back to where we started – that catch-22. We can’t have a resumption of GDP growth without private investment participation, and we can’t increase government revenue without a resumption of GDP growth, and we can’t balance our public books without a decrease in the rate of growth of government spending.

What fiscal policies would support a healthy growth cycle, given the dynamics shown here? Let’s start with cutting corporate and investment tax rates. When you tax less of something you get more of it – tax corporations and investors at lower marginal rates and we’ll see a pickup in private investment. That in turn will increase GDP growth and government revenue. Next in line are regulations (like carbon emission cap-and-trade, or state mandates on health care) that act as a tax on businesses and consumers – stop or remove them wherever possible and the growth effects described will be even greater.

“We need true tax reform that will at least make a start toward restoring for our children the American Dream that wealth is denied to no one, that each individual has the right to fly as high as his strength and ability will take him…But we cannot have such reform while our tax policy is engineered by people who view the tax as a means of achieving changes in our social structure.” –Ronald Reagan

References and Endnotes:

[1] “You Can’t Soak the Rich,” David Ranson, Wall Street Journal, May 20, 2008.

[2] “National Economic Accounts,” Bureau of Economic Analysis, U.S. Dept. of Commerce.

Site contains extensive data on the GDP, federal and state revenue and expenditures, as well as other metrics.

[3] “Business Cycle Expansions and Contractions,” National Bureau of Economic Research (NBER).

[4] “OECD Index of Statistical Variables,” Organization for Economic and Cooperation Development (OECD).

See also the OECD and BRIC country statistical profile database here .

[5] “IMF World Economic Outlook Database,” International Monetary Fund (IMF).