Declining Federal Deficit Appears Manageable: Q3 2005

The U.S. Federal Deficit fell to 15.6% of federal government receipts in Q3 2005. At this level, the deficit was 3.3% of household income, which was about the same ratio to household income as in 1995.

(See Flow of Funds Tables F106 and F100, and the graph, below.)

Since taxation of individuals is the primary source of revenue for the federal government, the relationship between the deficit and before-tax household income is an indication of the manageability of the deficit. This number suggests how much of household income would have to be taxed away to eliminate the current deficit.

The graph shows the size of the U.S. federal deficit, relative to federal and household income, since 1995. The variation over the decade can be explained as follows:

  1. End of the Cold War: Following the end of the Cold War and the collapse of the Soviet Union, the Clinton administration cut back on defense spending and investment in military equipment, declaring a ‘peace dividend’. The readiness of the U.S. armed forces fell significantly.
  2. Increased Taxation: Between 1995 and 2000, the Clinton administration increased taxes on personal income from 12.1% to 14.7%, sending more money to Washington, reducing government debt at the expense of current consumer spending, thereby throwing the country into recession.
  3. Reduced Taxes and War: Between 2001 and 2004, the Bush administration had to deal with two major problems: a new ‘hot war’ — the War on Terror — and the Clinton recession. The Bush administration cut taxes on household income from the level of 14.7% in the last year of the Clinton administration to 10.8% in 2004.
  4. Economic Recovery: By Q3 2005, the U.S. had not only won two conventional land wars in Afghanistan and Iraq, rebuilt and reorganized the defense forces, and continued to fight the War on Terror in liberated Iraq, but also brought the U.S. out of recession, reducing the federal fiscal deficit to levels comparable to 1995 — all with less taxation.

The federal deficit has been largely financed by funds from the trade deficit, as the country benefits from the dollar’s role as the leading international currency. If personal taxes were increased to levels of 1995, and if Congress were to exercise mild restraint in discretionary spending, the deficit could be eliminated in the short run.

Manageable Debt

However, even with taxes at current levels, it appears that the federal deficit is manageable and that it is reasonable that with continued economic growth, the deficit may be further reduced. In any event, as long as the trade deficit continues to grow, the deficit will be easily financed.

Although the deficit appears manageable, this doesn’t mean that this will occur. Because of constant and effective counter-propaganda from the opposition party which controls most of the media, a large segment of the American population has been made to feel uncomfortable with the current administration.

This could lead to the Democratic party regaining power, with a consequent increase in taxation and weakening of the U.S. defense posture. This could result in a new recession and even the loss of the War on Terror.

US Deficit vs. Federal & Household Income
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