In a surprising twist of economic events, the federal budget deficit has more than doubled in the first 10 months of the fiscal year compared to the same period last year, without a corresponding increase in inflation. Typically, such a significant fiscal gap would be expected to stimulate growth and concurrently, inflation. However, this year’s anomaly serves as a potent reminder that wider deficits do not necessarily lead to higher inflation rates, a crucial lesson as the chasm between government spending and revenue continues to expand.
The key to understanding this unusual economic dynamic lies in the factors driving the deficits. In many cases, a widening fiscal gap is a result of Congress approving large spending packages or implementing tax cuts. For instance, during the peak of the Covid-19 pandemic in 2020 and 2021, the government issued stimulus checks and tax credits to Americans, causing inflation to spike to a record 9.1% in June last year. However, this year, the growing deficit is attributed to a significant drop in nonwithheld tax revenue, alongside an increase in government spending on interest on old debt. This shift in fiscal dynamics is reshaping our understanding of the traditional relationship between deficits, economic growth, and inflation.
Fiscal Deficits and Inflation: An Unexpected Disconnect in 2022
In an unexpected turn of events, the Federal deficit in the United States has more than doubled in the first ten months of the fiscal year in comparison to the same period last year. This surge, in usual circumstances, would stimulate growth and subsequently inflation. However, inflation has instead steadily dropped, presenting a puzzling mismatch and suggesting that wider deficits do not necessarily result in higher inflation.
Deficit Drivers and Economic Stimulation
The underlying factors driving these deficits are critical in understanding this anomaly. Generally, a widening gap is a result of Congress approving large spending packages or tax cuts. During the height of the Covid-19 pandemic in 2020 and 2021, the government provided Americans with stimulus checks and tax credits. This type of direct support stimulates the economy, pushing inflation to its peak of 9.1% in June last year.
However, this year, the growing deficit is significantly attributed to a steep drop in tax revenues paid quarterly or through annual tax returns, rather than employer-withheld taxes. Revenue from nonwithheld taxes is down by $278 billion, or 26%, so far this year.
Capital Gains and Debt Interest
In 2021, record-breaking tax hauls were recorded after financial markets soared, with U.S. taxpayers reporting net capital gains of roughly $2 trillion, a 67% increase. However, this year has seen a decline in revenue from capital-gains taxes as markets sagged.
Simultaneously, the government’s spending on interest on old debt has increased by $136 billion, or 23%, due to higher interest rates. These factors, along with reduced Federal Reserve earnings resulting from higher interest rates, do not directly feed back into the economy in the short term, contributing to the rising deficit.
The Impact on Economic Growth
A model by the Brookings Institution indicates that despite higher spending and lower tax revenue, fiscal policy has slowed economic growth this year. The second quarter saw GDP growth 0.8 percentage point lower due to the absence of Covid-19 fiscal stimulus.
According to Louise Sheiner, Policy Director at Brookings’s Hutchins Center on Fiscal and Monetary Policy, the factors increasing the deficit are not contributing to GDP growth, implying the government isn’t stimulating the economy.
Future Projections and Potential Outcomes
Looking forward, the Congressional Budget Office (CBO) anticipates deficits to continue growing, reaching 7.3% of GDP in 2033, up from 5.5% last year. The inflation rate is projected to stabilize at the Fed’s 2% target in 2033. However, a wild card is the spending triggered by the Inflation Reduction Act, which subsidizes clean-energy projects across the country. This could add to the deficit if the uptake of subsidies outpaces the CBO’s expectations, leading to increased short-term economic growth as per a Goldman Sachs analysis.
The strange disconnect between the fiscal deficit and inflation this year offers valuable lessons about public finance and fiscal policy. However, economists warn that rising deficits can still pose economic problems such as increased borrowing costs and crowding out private investment. Therefore, it is crucial for fiscal policy to strike a balance and promote long-term growth while taking steps to reduce the deficit.