Meet the Author

Daniel Carroll |

Research Economist

Daniel Carroll

Daniel Carroll is a research economist in the Research Department of the Federal Reserve Bank of Cleveland. His primary research interests are macroeconomics, public finance, and political economy. Currently, he is studying the implications of progressive income taxation for the distributions of wealth and income.

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Meet the Author

Brent Meyer |

Economist

Brent Meyer

Brent Meyer is a former economist of the Federal Reserve Bank of Cleveland.

10.06.11

Economic Trends

Government Support for Households Amplifies Tradeoff

Daniel Carroll and Brent Meyer

The Great Recession and the subsequent weak recovery have prompted the U.S. government to take a larger role in the economy. This increased involvement has been delivered through two channels, one passive and one active.

The passive channel, commonly known among economists and budget geeks as “automatic stabilizers,” works through the interaction between existing programs and the business cycle. For example, as average income declines during recessions, income tax revenue naturally falls while social insurance payments rise to cover more low-income and unemployed people. The active channel occurs directly from policy changes. Payroll taxes have been reduced, temporary tax credits have been enacted, and unemployment benefits have been extended in response to the downturn. This increase in government activity in the economy has resulted in a tradeoff between increased available income now and larger obligations in the future.

The first half of this tradeoff is made evident by comparing two measures of income from the national income and product account (NIPA): market income and disposable income. Market income is all pretax income less any transfers from the government. Basically, it’s what people earn from private market activities. We construct this from the NIPA by taking personal income and subtracting out net transfers (that is, transfer payments minus contributions to social insurance—largely, Medicare, Medicaid, social security, unemployment insurance, and veterans benefits). Disposable income is income after government interaction and represents what is available to households for consumption and saving. It is calculated by removing personal current taxes from personal income.

Normally, market income exceeds disposable income, although during and shortly after recessions the gap narrows. However, since the second quarter of 2009, and for the first time in the NIPA’s near 70-year history, the relationship has been reversed: disposable income is greater than market income. This suggests that through a combination of transfers and tax changes, the government has provided an unprecedented amount of support for disposable income (and, thus, consumption spending). In fact, for disposable income to be larger than market income, transfer payments must be so large that they exceed personal income taxes and payroll taxes combined.

Turning to the other half of the tradeoff, we can see that the effect on deficits of this “propping up” of income by examining the government budget. First we combine the budgets of federal, state, and local governments because federal, state, and local income taxes enter into the calculation of disposable income and because debt from all levels of government is ultimately financed by households. By dividing the government budget into the net income tax (here defined as personal income taxes plus payroll taxes less transfers) and all other activity (composed almost entirely of sales, property, and corporate income taxes less government consumption and interest service on the debt), several trends become apparent.

First, the deficit over most of the past half century can be characterized as a change in the net income tax pulling against a long-term downward trend in the remainder of the budget. Traditionally, the net income tax has been a large surplus in the government budget, helping to offset the deficit between other spending and taxes. Although the net income tax declines during recessions and rebounds afterward because of automatic stabilizers, the magnitude of the decline has been extremely large over the last two cycles. Second, there has been a strong downward trajectory in the net income tax since 2001, while the trajectory of the rest of the budget has remained more or less the same. This has created an extraordinary acceleration in the deficit.

The relatively large decline in market income points to what would have been an equally sizable drop in disposable income without the combination of automatic stabilizers and active government support. That larger decline in disposable income would have likely led to an even greater contraction in consumption (and GDP) than we experienced, had the government not intervened. On the other hand, the government’s intercession did exacerbate an already troublesome debt situation. It is unclear whether the short-run benefits of this tradeoff will outweigh the longer-run costs.