Does the United States have a Revenue problem or a Spending Problem?

There is a debate about the causes of the record deficits in the United States. Republicans argue that we have a "spending problem", by which they mean spending is increasing too fast, while the left argues that we mainly have a "revenue problem", by which they mean taxes are too low.

The outcome of this debate will determine whether the most reasonable solution to the structural deficit will be tax increases or slowing the growth of spending. President Obama and liberals such as Paul Krugman like to give the public the impression that the deficit is entirely or to a large extent caused by Bush tax cuts for the wealthy (which is false, since Obama's proposed tax increase on the rich would only collect 0.3% of GDP). If that were the case, the most fair solution to the deficit would be - as the President put it - to raise "a little bit more" revenue from the rich.

It is easier to motivate tax hikes if you convince the public that the deficit was caused by tax cuts, rather than by an unparalleled expansion in spending.

When Republicans such as Paul Ryan say that the deficit is caused by a spending problem, they mean that once the recession is over, a federal tax revenue target of 19% of GDP (the historical average for the U.S) is sufficient to finance federal spending if spending is also kept at historical levels. Throughout, keep in mind that we are talking about Federal revenue and expenditure, the U.S public sector spends about 40% of national income if states and municipalities are included.

Slate columnist David Weigel attacks the Paul Ryan argument. His evidence is that revenue in 1981 was higher than later years of the Reagan presidency, which according to him proves that the Reagan tax cuts reduced revenue. Weigel is wrong. Revenue is highly volatile, because a lot of it depends on corporate profits, capital gains and other variables determined by the business cycle. Weigel is simply cherry-picking the year, 1981 was one of the highest revenue years in post-war history.

Similarly liberals like to pick the peak of the IT-boom at 2000 as the norm, where 20.6% of GDP was collected as revenue, even though it was the highest year in post-war history, and the second highest in American history overall. The highest year was 1944 during World War II, when Federal revenue briefly reached 20.9% of GDP.

In order to give a better picture, I have plotted the average revenue, deficit and spending as a share of GDP for all presidential terms in the post-war period.


First, this exercise shows us that Weigel is mistaken. Tax revenue during both Reagan terms was virtually identical with the Carter years, even though Reagan cut tax rates dramatically.

Second, revenues during the second Clinton term, the highest of the post-war periods, was 19.9%, only a little higher than the 19.0% level Paul Ryan has suggested (which liberals claim is far too little).

Lastly, President Obama has increased spending to levels never witnessed in American post-war history.

Let's move to President Obama's budget, as calculated by the esteemed Congressional Budget Office.

The President likes to give the impression that the deficit debate is about repealing the tax increases for the wealthy. But let us imagine what would happen if revenue during the coming years would be what is was during President Clinton's second term, long before the Bush tax cuts. During those years revenue was 19.9% of GDP.


The overwhelming majority of Presidents Obama's budgeted deficit would remain even if he collected Clinton-era record revenue. By the end of his term, when the recession is projected to be long over, 80% of the deficit caused by President Obama spending plan would remain even if we assume Clinton-era record revenue.

This is not strange, since during the second Clinton term, federal spending as a share of GDP was 18.8%. President Obama has already increased spending to levels unheard on in peacetime. Federal spending with Obama's budget will be 23.4% in 2016, when the recession is projected to be completely over. These numbers show us that President Obama and his defenders cannot use the recession as an excuse for their expansion of government and the immense deficits it is causing.

Clinton-era record revenue would be nowhere near enough to fund Obama-era record spending.

I want to illustrate a final point. Let's ignore the Obama years, and focus on the long run deficit. The figures for spending are from the Long Term Budget Outlook, again calculated by the Congressional Budget Office. These figures take into account the projected increase of Medicare, Medicaid and Social Security spending. This is primary spending, which means that interests on the debt is not included in spending, the numbers would look even worse if we included these.

Let us also be more generous to the left. Instead of assuming revenue for the highest presidential term, let's assume revenue for the record year. As pointed out previously this was the boom year 2000, where revenue was 20.6% thanks to unusually high capital gains and corporate profits.

This picture illustrates what would happen if Federal revenue as a share of GDP increased to the record high of the post-war period and remained there forever, and we continued at the currently projected levels of Federal expenditure.


Because of ever expanding government, the deficit would explode even when assuming record levels of revenue, with the debt growing to several hundred percent of GDP. Jon Stewart was therefore misleading his trusting and economically unsophisticated viewers when he showed them a graph where the deficit appears to vanish if only the Bush-tax cuts were repealed.

The only reasonable conclusion that the United States primarily has a spending problem, not a revenue problem. It is the expansion of the government - some already carried out by Obama, some projected to occur - that is causing the long term structural deficit to grow beyond control, not a reduction of revenue caused by lowering the taxes on the rich.

If liberals want to argue that government spending is too low, and that we should increase it for reasons of social policy and raise taxes to pay for it, they should feel free to do so. But please do not claim that the long term deficit is primarily caused by taxes being too low relative to historical levels, because that is simply not true.

David Brooks and Malcolm Gadwall wrong about I.Q, Income and Wealth

In his book "The Social Animal", reviewed here, David brooks writes:

"Once you get past some pretty obvious correlations (smart people make better mathematicians), there is a very loose relationship between IQ and life outcomes."

Brooks further cites a study claiming that there is "no correlation between accumulating large wealth and high IQ."

Both claims are wrong. The result Brooks cites is after "controlling" for education and income. But education and income are themselves functions of I.Q, so you shouldn't control for them if the question you want to answer is how I.Q effects life outcomes.

I have not seen this graphed online, so let's visualize the relationship between an estimate of I.Q and income and wealth so you can see for yourself. The source is NLYS79, a dataset which tracks a representative sample of the U.S population. Intelligence is approximated by the military when the individuals in the sample were mostly teenagers, while income and wealth data is for the same guys in their 40s. The sample is restricted to non-Hispanic white men.

For this group the lowest decile is people with I.Q below 84, and the highest decile above 116, which is not a very high cutoff. So keep in mind that we are not talking about only super-geniuses, in which case the results would be even stronger. Also remember that the middle of the distribution have very similar I.Q scores, the 5th decile is around 101-104, and the 6th decile around 104-108.

As you can see Americans men lucky enough to be born either with genes or a home environment that facilitates high I.Q earn more and accumulate more wealth.




The strong link between I.Q and earnings is well known by labor economists, but perhaps not by the affluent and high-I.Q readers of the New York Times. Obviously most of it goes through education. As technological development makes I.Q more valuable and unskilled labor less valuable, this disparity is increasing.

Another common claim of Brooks and of Malcolm Gladwell is that I.Q may matter, but only until around 130, after which it becomes meaningless. This is also wrong. Many previous samples have had too few observations to make reliable inference about the effect of I.Q above 130. Of course not having sufficient data hardly justifies Gladwell confidently claiming that I.Q above 130 is irrelevant even for scientists in technical fields (which I and others who are not smart enough to handle advanced mathematics could have told you from personal experience was a bizarre theory). After all, 130 is not that high, around the mean for a Harvard or SSE student.

This recent paper by Heckman, Gensowski and Savelyev studies the life outcomes of the Terman sample, which entirely consists of American men and women with I.Q above 135 (in some cases far above 135). They find that I.Q has a significant effects on earnings and educational outcomes, also for those above the 135 I.Q threshold. Another Malcolm Gladwell myth busted.


There are some policy implications from this realization. One is that smart and successful people shouldn't congratulate themselves so much. They didn't so much "earn" their talent than were lucky in the gene/environment lottery. If you are born healthy, with high I.Q genes and with educated parents and a good home environment you are expected to earn more than a more disadvantaged child who exerts the exact amount of effort through life.

Unlike libertarians, Conservatives believe that those who were the recipients of good fortunate have a moral obligations towards the rest of society, in particular to the people who do their best but just have less marketable skills.

Another is that the left is wrong about the market allocating income mainly based on chance, connections or "power". In fact, earnings are strongly linked to intelligence, which indicates that they are linked to productivity, just as economic theory predicts. Poor people are on average less productive than rich people, a claim which may sound obvious (almost tautological) to an economist but which outrages a lot of people on the left.

Denying the link between productivity and earnings is very important for the modern left, as their entire source of outrage is based on the view that the capitalist system "exploits" the poor. More likely, because of the modern welfare state and because of the growing importance of human capital, more resources are transferred from the productive rich to the poor than vice-versa. There is so little demand in the labor market for unskilled people that the poor in industrialized countries increasingly don't even work full time.

The fact that the rich don't exploit the poor doesn't mean the rich shouldn't help the poor. But it's one thing to claim you are rich because you are stealing from poor people, and another to believe you have an obligation to help all members of society due to randomly having being granted more valued skills. Fairness perceptions are not only a function of the type of distribution we desire, but to an even greater extent a function of the process we believe creates inequality.

I suppose David Brooks and Gladwell give an inaccurate impression about I.Q and income/wealth in order to make their readers feel warm and fuzzy. But that is not an accurate depiction of the world we live in, we live in a much harsher and more unfair reality.