Aftermath. Thomas E. Hall

2.4 makes these adjustments by plotting federal outlays as a proportion of annual U.S. gross domestic product (GDP), which is the standard measure of the nation’s economic output. In 1929, federal spending was 2.7 percent of GDP, of which 1.6 percentage points were transfer payments. The 1930s’ New Deal programs caused these values to rise, and then during World War II, the government soared in size, peaking at almost 50 percent of economic output in 1944 and 1945. Transfer payments began diverging from the other outlays after the Korean War. Since then, federal spending excluding transfer payments has declined relative to economic output; in fact, the series is now roughly where it was in the late 1940s. Meanwhile, transfer payments rose to nearly 12 percent of GDP by the mid-2000s.

Figure 2.4 FEDERAL GOVERNMENT OUTLAYS INCLUDING AND EXCLUDING TRANSFER PAYMENTS, AS PERCENT OF GROSS DOMESTIC PRODUCT, 1929–2009

      SOURCE: Federal Reserve Bank of St. Louis, FRED data set.

      Table 2.2 shows various components of federal receipts and outlays during two recent years. In 2007, federal receipts were 19.4 percent of GDP, with the individual income tax accounting for 8.8 percentage points and the Social Security and Medicare taxes comprising 6.6 percentage points. That same year federal outlays for transfer payments—Medicare, Social Security, income security, and net interest—were 11.8 percent of GDP. The 2007–2009 recession caused tax receipts to decline relative to income, to 16.2 percent of GDP by 2010. Meanwhile, a federal spending binge caused outlays to expand to 25.8 percent of GDP, of which 14.8 percentage points were transfer payments. Since receipts were 16.2 percent of GDP while outlays were 25.8 percent, the government borrowed the difference (9.6 percentage points of GDP).

Table 2.2 FEDERAL RECEIPTS AND OUTLAYS AS PERCENT OF GROSS DOMESTIC PRODUCT, 2007 & 2010

Receipts
Year	Total Receipts (%)	Individual Income Tax (%)	Corporate Income Tax (%)	Social Security & Medicare Tax (%)	Other*
2007	19.4	8.8	2.8	6.6	1.2
2010	16.2	6.7	1.4	6.5	1.6
*Other receipts include gift and estate taxes, excise taxes, customs duties, and Federal Reserve deposits.
Outlays
Year	Total Outlays (%)	Defense (%)	Medicare (%)	Social Security (%)	Income Security (%)	Net Interest (%)	Other**
2007	20.6	4.2	2.8	4.4	2.8	1.8	4.7
2010	25.8	5.2	3.4	5.3	4.6	1.5	5.8
**Other outlays include international affairs, health, and post office.
Federal Deficit
Year
2007	1.2
2010	9.6

      SOURCE: Federal Reserve Bank of St. Louis, FRED data set.

      In other words, in 2010 the federal government collected about 16 cents of every dollar of income produced in the United States, and spent 25 cents (of which 15 cents were transfer payments). This shortfall required federal borrowing of almost 10 percent of GDP produced that year. The federal government has evolved into a monolith that taxes “Peter” (those with jobs or earning high incomes, or both) to pay “Paul” (primarily senior citizens receiving Social Security and Medicare benefits). In effect, this is an intergenerational transfer scheme that taxes workers and pays older retirees. Retirees, of course, feel entitled to these benefits because they have paid taxes into this system while they worked, and the current workers accept the arrangement so long as they believe benefits will be available when they retire.

      The huge expansion of transfer payments has required higher tax rates to help fund them. Recall that in 1937, the original Social Security payroll tax rate for OASDI (old-age, survivors, and disability insurance) was 2 percent. Figure 2.5 shows the payroll tax rates for OASDI and Medicare hospitalization insurance.¹⁸ The Social Security tax has risen more than sixfold (from 2.0 percent to 12.4 percent), whereas the Medicare tax went from 0.7 percent when first instituted in 1966 to the current rate of 2.9 percent. Another difference between the two levies is that the Social Security tax has an annual income limit beyond which the wage earner pays no further taxes (in 2010, the amount was $106,800), whereas the Medicare tax has no income limit.

Figure 2.5 SOCIAL SECURITY AND MEDICARE TAX RATES, 1937–2010

      SOURCE: www.ssa.gov/OACT/ProgData/taxRates.html.

       Our Modern Federal Tax System

      In 2010, the U.S. federal tax system collected about 90 percent of its revenue from taxes assessed on various types of income. Of that amount, 41 percentage points came from the personal income tax, another 40 percentage points from Social Security and Medicare taxes, and 9 percentage points from the corporate income tax. The remainder of the federal government’s revenue that year (the 10 percent of total revenue that did not come from taxing income) was primarily from taxes on gifts, estates, excise taxes, and customs duties. Therefore, at the federal level, by far the most important item being taxed is income. Since wage income is the major component of household income, work is the predominant economic activity being taxed.

      Most of the revenue from federal taxes