The US Federal Deficit: Choose Your Own Fiscal Adventure

Last week, the Congressional Budget Office (CBO) released its final projection for fiscal year 2014's US federal budget deficit. And it is down again! They estimate the feds ran a $486 billion deficit in 2014.^[i] The direction, even the magnitude of the dip, isn't all that surprising-the deficit has fallen for some time. However, it still managed to attract plenty of debate. Why? The deficit is a frequently kicked around political football, and this time there is something in it for everyone. But we'd suggest ignoring all the noise and taking the figure for what it is-a result of a growing economy!

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This year's reduction isn't a new trend-aside from a teensy uptick in 2011, the deficit has been drifting since 2009's peak-falling steeply in 2012 and 2013. Since 2009, the deficit is down 65.6%. Exhibit 1 shows the deficit's progression over the past decade in dollars. Exhibit 2 shows it as a percent of GDP, down from 9.8% to 2.8%.^[ii] (Exhibit 2)

Exhibit 1: US Federal Deficit, Fiscal Years 2004-2014 (Estimated)

Source: St. Louis Federal Reserve, as of 10/10/2014. The US Fiscal year runs from October 1 through September 30. 2014 figure is the CBO's official estimate published in October 2014.

Exhibit 2: US Federal Deficit as a Percent of GDP, Fiscal Years 2004-2014 (Estimated)

Source: St. Louis Federal Reserve, as of 10/10/2014. 2014 figure is the CBO's official estimate published in October 2014.

Reactions are pretty divided on whether the latest reading is good or bad. Given the political football and the upcoming midterms, some Democrats seem to be celebrating it as a feat of economic management. The 2.8% deficit-to-GDP figure is the lowest since 2007 and below the long-term average (3.2% since 1980). However, many Republicans note the deficit is still high in absolute terms-$486 billion, exceeding every annual deficit before 2009. So each party gets to tell the tale of their choosing.

There are more nuanced "yah buts" too. Like the notion that the reduction has come too fast-that the government cuts have had deep economic consequences for years. Yes, government spending is down somewhat since a 2011 peak, driven by things like the sequester-those automatic budget cuts that kicked in on March 1, 2013 after the US government careened off the fiscal cliff. But the major impact there was slowing the rate of spending growth. However, the thing is, it isn't like we retraced the whole fiscal stimulus pumped into the economy in 2009. Spending rose, then largely flat lined. American austerity doesn't actually mean austere behavior by our elected officials. Spending is only 2.9% lower than 2011's record. It is also up modestly in 2014 (to date). (Exhibit 3) Whatever your view of the government's attempts to stimulate business through deficit spending, the spending part is the supposedly stimulative part-not the deficit. Since that isn't down much, it is hard to see how this is such a big negative.

Exhibit 3: Federal Outlays, Fiscal Years 1985-2014 (Estimated)

Source: St. Louis Federal Reserve, as of 10/10/2014. 2014 figure is the CBO's official estimate published in October 2014.

So if a lack of government spending didn't cause the deficit to fall, then what did? Tax revenues are up big! (Exhibit 4)

Exhibit 4: Federal Outlays and Receipts, Fiscal Years 2007-2014 (Estimated) Indexed to 100 at 10/01/2007

Source: St. Louis Federal Reserve, as of 10/10/2014. 2014 figure is the CBO's official estimate published in October 2014.

Which is another source of ire, for some who grumble that revenue is up only due to tax rate hikes. But tax rate changes appear to be more of a fringe factor. We can see this by looking at revenues after the fiscal cliff deal, which affected a handful of tax measures at the beginning of 2013. For one, the two-year payroll tax holiday expired, increasing tax rates on American workers by two percentage points across the board. Also, some other more targeted taxes were tweaked-such as the one that requires individuals with incomes exceeding $400,000 (couples' incomes exceeding $450,000) to pay 39.6% instead of 35% on income received above that point. But revenues were rising even before tax rates rose in early 2013. The amount of taxable activity-largely comprised of corporate profits and personal income-is what mostly accounts for this change. (Exhibit 5)

Exhibit 5: Nonfinancial Corporate Profits (Pre-Tax) and Gross Personal Income, Fiscal Years Q1 2007-Q3 2014

Source: St. Louis Federal Reserve, as of 10/11/2014. Nonfinancial corporate business profits before tax and without inventory valuations adjustment and capital consumption adjustment. Year indicated is the four quarter period Q4 - Q3 of the following year to match US government fiscal years. Q4 2006 - Q2 2014.

Another common claim is the deficit decline is only temporary-the CBO said so! Which is true! They did! But we wouldn't take that outlook to the bank. The CBO's forecasting track record is sketchy at best, so it really wouldn't be surprising if they were off. After all, in 2003, the CBO thought we'd have a $508 billion surplus in 2013 and a 14.5% debt-to-GDP ratio. Juuuuuuuuuuuust a bit outside. They could just as easily err in the opposite direction.

But the kicker is this recent experience is yet another example of the fact big deficits don't spell death for stocks. This is not new, nor very surprising. We had a big surplus at the end of 1999-and a bear market followed. We had a big deficit in 1982 and 1992-huge bull markets followed. And we had a massive deficit in 2009-since stocks have surged higher. Now, even with the deficit falling, it's still a deficit-it adds to our outstanding debt. However, as long as the US can afford its debt-which it pretty clearly can-then it shouldn't be a pressing risk. (Exhibit 6) Fact is, we've reduced debt held by the public in only 11 years since 1940. None of them were particularly big either-the deficit-financed tanks used to defeat Hitler still cost the government some interest payments now.

Exhibit 6: Federal Interest Payments as a Percent of Tax Revenue

Sources: St. Louis Federal Reserve, as of 10/13/2014. Bureau of the Fiscal Service Monthly Treasury Statement, as of 08/31/2014. 1940-2014. The 2014 figure only accounts for October 1-August 31 (11-month period)-and it is likely overstated since the government usually runs a surplus in September.

The budget deficit is falling-but for the most part it isn't because of crazy tax hikes or government austerity. Revenues are rising because the economy is chugging along. But that many people look askance at this sign-of-the-economic times speaks to sentiment-skepticism still remains, which is one signal the bull has more room to run.

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^[i]The figure isn't set in stone. One month ago the CBO projected a $506 billion deficit this year-four percentage points above the current level, a fairly big skew in only 30 days.

^[ii] Finally! The US can join the EU club since it now complies with the Maastricht Treaty, which mandates all EU nations' deficits remain below 3% of GDP.