Tag: Federal income tax

What Explains the Surprising Surge in the Federal Budget Deficit?

Figure from CBO’s monthly budget report.

During 2023, GDP and employment have continued to expand. Between the second quarter of 2022 and the second quarter of 2023, nominal GDP increased by 6.1 percent. From July 2022 to July 2023, total employment increased by 3.3 million as measured by the establishment (or payroll) survey and by 3.0 as measured by the household survey. (In this post, we discuss the differences between the employment measures in the two surveys.)

We would expect that with an expanding economy, federal tax revenues would rise and federal expenditures on unemployment insurance and other transfer programs would decline, reducing the federal budget deficit. (We discuss the effects of the business cycle on the federal budget deficit in Macroeconomics, Chapter 16, Section 16.6, Economics, Chapter 26, Section 26.6, and Essentials of Economics, Chapter 18, Section 18.6.) In fact, though, as the figure from the Congressional Budget Office (CBO) at the top of this post shows, the federal budget deficit actually increased substantially during 2023 in comparison with 2022. The federal budget deficit from the beginning of government’s fiscal year on October 1, 2022 through July 2023 was $1,617 billion, more than double the $726 billion deficit during the same period in fiscal 2022.

The following figure from an article in the Washington Post uses data from the Committee for a Responsible Federal Budget to illustrate changes in the federal budget deficit in recent years. The figure shows the sharp decline in the federal budget deficit in 2022 as the economic recovery from the Covid–19 pandemic increased federal tax receipts and reduced federal expenditures as emergency spending programs ended. Given the continuing economic recovery, the surge in the deficit during 2023 was unexpected.

As the following figure shows, using CBO data, federal receipts—mainly taxes—are 10 percent lower this year than last year, and federal outlays—including transfer payments—are 11 percent higher. For receipts to fall and outlays to increase during an economic expansion is very unusual. As an article in the Wall Street Journal put it: “Something strange is happening with the federal budget this year.”

Note: The values on the vertical axis are in billions of dollars.

The following figure shows a breakdown of the decline in federal receipts. While corporate taxes and payroll taxes (primarily used to fund the Social Security and Medicare systems) increased, personal income tax receipts fell by 20 percent, and “other receipts” fell by 37 percent. The decline in other receipts is largely the result of a decline in payments from the Federal Reserve to the U.S. Treasury from $99 billion in 2022 to $1 billion in 2023. As we discuss in Macroeconomics, Chapter 17, Section 17.4 (Economics, Chapter 27, Section 27.4), Congress intended the Federal Reserve to be independent of the rest of the government. Unlike other federal agencies and departments, the Fed is self-financing rather than being financed by Congressional appropriations. Typically, the Fed makes a profit because the interest it earns on its holdings of Treasury securities is more than the interest it pays banks on their reserve deposits. After paying its operating costs, the Fed pays the rest of its profit to the Treasury. But as the Fed increased its target for the federal funds rate beginning in March 2022, it also increased the interest rate it pays banks on their reserve deposits. Because most of the securities it holds pay low interest rates, the Fed has begun running a deficit, reducing the payments it makes to the Treasury.

Note: The values on the vertical axis are in billions of dollars.

The reasons for the sharp decline in individual income taxes are less clear. The decline was in the “nonwithheld category” of individual income taxes; federal income taxes withheld from worker paychecks increased. People who are self-employed or who receive substantial income from sources such as capital gains from selling stocks, make quarterly estimated income tax payments. It’s these types of personal income taxes that have been unexpectedly low. Accordingly, smaller capital gains may be one explanation for the shortfall in federal revenues, but a more complete explanation won’t be possible until more data become available later in the year.

The following figure shows the categories of federal outlays that have increased the most from 2022 to 2023. The largest increase is in spending on Social Security, Medicare, and Medicaid, with spending on Social Security alone increasing by $111 billion. This increase is due partly to an increase in the number of retired workers receiving benefits and partly to the sharp rise in inflation, because Social Security is indexed to changes in the consumer price index (CPI). Spending on Medicare increased by $66 billion or a surprisingly large 18 percent. Interest payments on the public debt (also called the federal government debt or the national debt) increased by $146 billion or 34 percent because interest rates on newly issued Treasury securities rose as nominal interest rates adjusted to the increase in inflation and because the public debt had increased significantly as a result of the large budget deficits of 2020 and 2021. The increase in spending by the Department of Education reflects the effects of the changes the Biden administration made to student loans eligible for the income-driven repayment plan. (We discuss the income-driven repayment plan for student loans in this blog post.)

Note: The values on the vertical axis are in billions of dollars.

The surge in federal government outlays occurred despite a $120 billion decline in refundable tax credits, largely due to the expiration of the expansion of the child tax credit Congress enacted during the pandemic, a $98 billion decline in Treasury payments to state and local governments to help offset the financial effects of the pandemic, and $59 billion decline in federal payments to hospitals and other medical facilities to offset increased costs due to the pandemic.

In this blog post from February, we discussed the challenges posed to Congress and the president by the CBO’s forecasts of rising federal budget deficits and corresponding increases in the federal government’s debt. The unexpected expansion in the size of the federal budget deficit for the current fiscal year significantly adds to the task of putting the federal government’s finances on a sound basis.

How Did the United States Reduce the Debt-to-GDP Ratio after World War II?

Main Gun Mount Assembly Plant, Northern Pump Co. Plant, Fridley, Minnesota, 1942. (Photo from the Franklin D. Roosevelt Presidential Library & Museum.)

To fight World War II, the federal government had to dramatically increase spending. As the following figure shows, total federal spending rose from $6.8 billion in 1940 to a peak of $100.1 billion in 1944. National defense spending made up most of the increase, rising from $2.8 billion in 1940 to $97.3 billion in 1944.

Part of the increased spending was paid for by increases in taxes. Total federal tax receipts rose from $6.2 billion in 1940 to $35.8 billion in 1945. Individual income taxes rose from $1.0 billion in 1940 to 18.6 billion in 1945. Tax rates were raised and the minimum income at which people had to pay tax on their income was reduced. From the introduction of the federal individual income tax in 1913 until 1940, only people who had at least upper middle class incomes paid any federal income taxes. Following the passage by Congress of the Revenue Act of 1942, most workers had to pay federal income taxes. In 1940, 7.4 million people had to pay federal individual income taxes. In 1945, 42.7 million people had to. For the first time, the federal government withheld taxes from workers paychecks. Previously, all taxes were due on March 15th of the year following the year being taxed. Milton Friedman, who in the 1970s won the Nobel Prize in Economics, was part of the team at the U.S. Treasury that designed and implemented the system of withholding income taxes. Withholding of individual income taxes has continued to the present day.

Although large, the increases in federal taxes were insufficient to fund the massive military spending required to win the war. As a result, the U.S. Treasury had to greatly increase its sales of Treasury bonds. Recall from Macroeconomics, Chapter 16, Section 16.6 (Economics, Chapter 26, Section 26.6 and Essentials of Economics, Chapter 18, Section 18.6) that the total value of outstanding Treasury bonds is called the federal government debt, sometimes called the national debt. The part of federal government debt held by the public rather than by government agencies, such as the Social Security Trust Funds, is call the public debt. In order to gauge the effects of the debt on the economy, economists typically look at the size of the public debt relative to GDP. The following figure shows the public debt as a percentage of GDP for the years from 1929 to 2022.

The figure shows that the ratio of debt to GDP increased sharply from 1929 to the mid-1930s, reflecting the federal budget deficits resulting from the Great Depression, and then soared beginning in 1940. Debt peaked at 113 percent of GDP in 1945 and then began a long decline that lasted until 1974, when debt had fallen to 23 percent of GDP. The ratio of debt to GDP then fluctuated until the Great Recession of 2007-2009 when it began a steady increase that turned into a surge during and after the Covid-19 pandemic. (We discuss the causes of the recent surge in debt in this blog post.)

What caused the long decline in the ratio of debt to GDP that began in 1946 and continued until 1974? The usual explanation is that the decline was not primarily due to the federal government paying off a signficiant portion of the debt. The public debt did decline from a peak of $241.9 billion in 1946 to $214.3 billion in 1949 but there were no significant declines in the level of the public debt after 1949. Instead the ratio of debt to GDP declined because GDP grew faster than did the debt.

Recently in a National Bureau of Economic Research Working Paper, “Did the U.S. Really Grow Out of Its World War II Debt?” Julien Acalin and Laurence M. Ball of Johns Hopkins University have analyzed the issue more closely. They conclude that economic growth played a smaller role in reducing the debt-to-GDP ratio than has previously been thought. In particular, they highlight the fact that for significant periods through the 1970s, the Treasury was able to pay a real interest rate on the debt that was lower than market rates. Lower real interest rates reduced the amount by which the debt might otherwise have grown.

As we discuss in Money, Banking, and the Financial System, Chapter 13, Section 13.2, in April 1942, to support the war effort, the Federal Reserve announced that it would fix interest rates on Treasury securities at low levels: 0.375 percent on Treasury bills and 2.5 percent on Tresaury bonds. This policy continued after the end of the war in 1945 until the Fed was allowed to abandon the policy of pegging the interest rates on Treasury securities following the March 1951 Treasury-Federal Reserve Accord. Acalin and Ball also note that even after the Accord, there were periods in which actual inflation was well above expected inflation, causing the real interest rate the Treasury was paying on debt to be below the expected real interest rate. In other words, part of the falling debt-to-GDP ratio was financed by investors receiving lower returns on their purchases of Treasury securities than they had expected to.

Acalin and Ball conclude that if the Treasury had not done the relatively small amount of debt repayment mentioned earlier and if it had had to pay market real interest rates on the debt, debt would have declined to only 74 percent of GDP in 1974, rather than to 23 percent.

Sources: The debt and GDP data are from the Congressional Budget Office, which can be found here, and from the Office of Management and the Budget, which can be found here.