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Sunday, May 22, 2011

Three federal fiscal lessons

We're not broke:

So who is the we in the “we’re broke” mantra? The recession has certainly been a rough patch of road for many families, but the output produced by corporations in the private sector has already recovered to pre-recession levels, and these firms’ profits were 21.7% higher overall, driven largely by the 60% jump in pre-tax profits enjoyed by firms in the financial sector.
Why we have a deficit (#1 = Bush tax cuts, #2 = wars, #3 = recession):

Simple deficit reduction arithmetic (cutting spending is harder than it looks, which is why raising taxes also makes sense):

Suppose that the country – let’s call it Austerityland – has a GDP of $100/year, and a budget deficit of $10/yr, or 10% of GDP. And suppose that the government decides it wants to get the deficit down to 5% of GDP. How can it get there? ... 
To keep things simple (and to make it particularly relevant to the three examples mentioned above), let’s focus on the strategy of trying to halve the budget deficit primarily through spending cuts. So the government of Austerityland decides to cut spending by $5/yr. What happens? ...
If G is reduced by $5 in Austerityland, the first thing that happens is that GDP falls by $5. But then a bunch of secondary effects kick in ...[list of effects] 
So, what is the budget deficit in Austerityland after a $5 reduction in government spending? If we assume a relatively modest multiplier of 1.5, and a tax rate of 25%, then we get:
ΔG = -$5ΔY = -$7.5ΔT = -$1.875 
And the new deficit is now $6.875, which is 7.4% of the new level of GDP. Wait, I thought we were trying to get the deficit down to 5% of GDP? What happened?  
What happened is that we’ve missed our target, by quite a bit, due to the ... fall in tax revenues that resulted from the shrinking economy. In fact, just a bit of simple algebra allows us to figure out that government spending in Austerityland will have to be cut by about $9 in order to reach a budget deficit target of 5% of GDP. In other words, the government will have to cut spending by almost twice as much as it initially thought it would in order to reach its deficit target.

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