July 13, 2012

The U.S. is racing up toward the "fiscal cliff", a horrible deal agreed to by both houses of Congress that is so terribly unthinkable that the two sides which agreed to it figured no one would ever let the situation proceed to that outcome. Now both sides are playing "chicken", as the deadline zooms toward us. Those who are advocating austerity of federal spending don’t have a genuine understanding of the severity of cuts that would be needed to balance the budget. And those who think that the problem can be solved through higher tax collections are similarly clueless about just how much money can be reasonably brought in.

The chart above helps us to see this point more clearly. The price plot of the SP500 is shifted forward by 12 months to reveal how total federal tax receipts tend to rise and fall as an echo of what the stock market does. The drop in stock prices during the summer of 2011 says that tax receipts should see a similar stumble (on a 12-month basis), and the tepid rebound says that tax receipts on an annual basis are not going to get much higher than what we have been seeing. And if the stock market follows its typical path for the first two years of a new presidential term (2013-2014), then we cannot expect to see the stock market bend the tax collections curve much higher for the next couple of years.

The whole reason why this is so important has to do with the vast spread between receipts and expenditures, as shown in the chart below. Each is expressed as a percentage of GDP, to help us better see the magnitude of both of them.

Over the past 12 months, the federal government has spent money at a rate equivalent to 23.4% of GDP, while it has only taken in money at a rate equal to 15.2% of GDP. Saying it another way, expenditures have been 153% of receipts over the past year. That is clearly not sustainable, with total debt per taxpayer now at $139,297 and rising.

And neither is it something that can be made up by tax increases alone. To equal expenditures, tax collections would have to increase by 53%. The SP500's predictive model says that expecting taxes to ramp up that high is just not supportable. It is not even a supportable idea to think that total annual tax receipts could get up to the April 2008 high of $2.6 trillion, since the SP500 has not been able yet to equal its 2007 high.

The current 12-month rate of tax collections sits at 15.2% of GDP. Every time that this rate has gone above 18%, it has pushed the U.S. economy into a recession. So Congress cannot get us to a balanced budget through tax increases alone, since expenditures are currently at 23.4%, or more than 5 percentage points above that recession threshold level. Politically speaking, spending less is really unpopular. Nobody wants to volunteer to be the marginal recipient of federal expenditures, just as nobody likes to be the marginal consumer of food during a famine.

But the two plots have to somehow be nudged closer together if the U.S. is to survive in the long run. The tax collections plot cannot reasonably be expected to rise above 18% without pushing the U.S. into another recession, the usual response to which is for Congress to cut taxes. In other words, "you can't get there from here" via tax increases alone.

And members of Congress cannot reasonably expect to get themselves reelected if they cut off access to the Federal punch bowl to the degree needed to get these two lines together. Too many special interests are expecting to continue receiving what they have become accustomed to, and they will vote out anyone who yanks away that punchbowl.

It is indeed the thorniest of problems.

Tom McClellan
Editor, The McClellan Market Report