Krugman Wrong About Cause of Growing Deficits

Paul Krugman asks why deficits have grown. He gives the impression that the explosion in the deficit is due to tax revenue being too low, rather than spending being too high.

I have re-created the graph on his homepage using BEA data. From 2008 we observe tax revenue plummet, whereas spending just seems to continue its “natural” historical trend.


Looks pretty convincing, right? But we hopefully have the dear-bought wisdom at this point not to trust data from this particular source.

In fact, lower tax revenue - because of the recession, not because tax rates are lower - explain only one third of the increase in the deficit. Two thirds of the increase in the deficit is due to more spending. I will try to convince you of that in a moment.

First, let’s understand how Krugman's trick works.

Most importantly, notice that the graph is in nominal dollars. Krugman neglects to adjust for the overall size of the economy.

Here is the same exact graph, in terms of % of GDP, not cutoff to make small changes look bigger, and starting at the year 2000 rather than 2005 (which obscures longer trends).


Notice that the “natural” increase in spending isn’t there anymore. Between 2000 and the period of the crisis in late 2007, spending is essentially flat, while revenue decreases (thanks to the IT-bubble bursting and the Bush tax cuts). Between late 2007 and now however, spending rises sharply as a share of GDP.

This brings us to the most subtle trick Krugman uses. Go back to the original picture. Notice that during the crisis, tax revenue in nominal dollars drop, whereas spending just continued its path.

But wait a second. During the crisis, the American economy was shrinking rapidly. This helps explains why tax revenue dropped. Yet, government spending continued to increase at the same rate it did before the crisis! This political choice to continue expanding the government despite a shrinking economic base is what explains the lion share of the increase in the deficit.

Now it’s one thing to agree with this policy. I certainly believe the government should spend more during recessions. It is something quite different to – once you discover that the deficit spending policy you were the main cheerleader for was not popular – trying to trick people into believing it just never happened.

Here is the exact same graph Krugman used, with the same period, and the only difference that I plot Revenue and Spending as a share of GDP, rather than in nominal dollars.

I have plotted what would happen if the U.S. would be spending at late 2007 rates, as a share of GDP. The difference constitutes the share of the deficit due to increase in spending (red) and due to less revenue (blue). Remember that there was a deficit already there in 2007, which is not counted as an increase.


It is hopefully clear from the picture that Krugman is trying to hide why the U.S has such a big deficit: Mostly due to more spending. Particularly compare the size of the red and the blue line I added at the end.

Let me also give you the figures so you don’t have to trust a picture.

In the third quarter of 2007, according to the Bureau of Economic Analysis seasonally adjusted figures as a share of GDP spending was 31.4%, Revenue 29.6%, and the deficit 2.2%.

In the second quarter of 2010, the latest they report data for, spending was 36.1%, Revenue 27.0%, and the deficit 9.2%.

So the deficit grew by 7.0%, out of 4.7% was increase in spending and 2.7% a decline in Revenue.

So simple arithmetic tells us that 67% of the increase in the deficit as share of GDP between late 2007 and mid 2010 was due to spending going up.