There isn’t a lot of good economic news to go around these days.

In the final year of President George W. Bush’s second term and in the first two years of President Barack Obama’s first term, the U.S. government spent at least $1.3 trillion more each year than it collected in taxes. By 2010, things looked quite bleak, and it appeared as though Washington lacked the will to take the issue seriously.

At the time, I suggested a series of hard choices facing lawmakers that could have a meaningful impact.#-ad_banner-#

Sure enough, despite the lack of a broad formal agreement (known as the “grand bargain”) between Republicans and Democrats to cut spending and boost tax revenue, progress has been made anyway.

According to the U.S. Treasury Department, total federal outlays (on a rolling 12-month basis) are actually lower than they were two years ago. That’s the first time the U.S. has actually reduced spending since the late 1940s.

In light of this progress, investors should be quite pleased. After all, the national debt still stands as one of the greatest long-term threats to our economy. Falling deficits (and hopefully eventually falling debt levels) reduce the risk of an economic calamity, and lower risk means that stocks can afford to trade at higher valuations. Indeed, the recent rally in U.S. markets may already reflect reduced debt concerns.

That doesn’t mean it’s time to celebrate. Total debt is still rising. Perhaps of greater concern, smaller deficits means reduced government spending and higher tax receipts, both of which can create a drag on economic growth. So it’s crucial the U.S. economy grows at a pace much greater than the fiscal drag that deficit reduction entails.

Thanks to a combination of spending cuts and tax hikes, the deficit fell to $1.1 trillion in fiscal year 2012, and while many expected that figure to dip slightly below $1 trillion this year, we’re doing a lot better than that.

It now looks as if the budget deficit will be under $800 billion this year. According to Goldman Sachs, it could shrink to $600 billion next year and $475 billion in fiscal 2015.

 
Source: Goldman Sachs. Note: Fiscal year ends in September.

‘”This slowdown has occurred with essentially no effect from sequestration, which is expected to reduce spending by $42 billion in fiscal year 2013 but probably had very little effect on outlays through March,” note Goldman’s economists.

The forced spending cuts from the so-called budget sequester are expected to trim the deficit by $89 billion on a full-year basis in fiscal 2014. The 2.4% drop in spending in the first six months of fiscal 2013 is the result of shrinking government payrolls and a wind-down of the wars in Iraq and Afghanistan.

For much of the past year, monthly employment reports have been characterized by robust private sector job gains, offset by government job losses. That means our nation’s employment picture would have been even better by now were it not for the government employment shrinkage. And it’s a hopeful indicator that we’ll see the national unemployment rate move lower when the government’s employment levels stabilize.

Yet the real credit for the shrinking deficit goes to the revenue side of the ledger. In the first six months of fiscal 2013, government revenues are up 12.4% due to changes in the tax code and more robust economic activity, which fuels greater tax receipts.

The trend appears intact into April, with personal and corporate tax payments trending 34% higher than a year ago. “The last time April tax-filing season payments gained this much over the prior year was in 2005 and 2006,” Goldman’s economists said.

As further hikes in tax rates appear politically impossible (and perhaps unwise), look for lawmakers to focus on closing loopholes. In October, I outlined several ways that could reduce the deficit to zero.

Frankly, our nation’s lawmakers have no choice but to take further steps. As I noted in my December 2010 column, we’re still “sitting on a whopping pile of unpaid bills that has been run up for the past decade.” According to the U.S. Treasury, our total national debt is $16.8 trillion and still rising.

Some economists suggest that we can sustain moderate budget deficits in perpetuity, as we have done for many decades. But that’s foolhardy: The interest expense on our total debt will eventually become unmanageable when interest rates start to rise.

As I noted in December, our annual interest expense on the debt seems manageable now in the $350 billion to $400 billion range. However, that expense would rise to nearly $700 billion a year if interest rates were to return to 2005 levels.

In effect, we’re hoping that interest rates stay low for a very long time to come. Ideally, the government would be selling only 20- or 30-year bonds now, and paying off the short-term debt obligations, to buy more time to fix the problem. But the U.S. remains vulnerable to a rise in interest rates, and that would force the government to slash cherished programs — or we would see our deficit swell anew.

Risks to Consider: Forecasts of further drops in the deficit are based on moderate economic growth expectations. But if the economy slumps, so will tax receipts, and the deficit will start to rise again.

Action to Take –> The shrinking deficit is clearly good news and may help partially explain why stocks have fared quite well in recent quarters. Washington deserves some credit, but this is no time to step off the gas pedal. The U.S. economy appears to be taking the tax and spending changes in stride, and as the economy gets stronger, policymakers should be emboldened to seek out further steps to close the budget gap.

These further steps won’t be easy, but we have a pretty clear sense on how they’ll play out. Higher tax rates appear unlikely, but both political parties appear willing to close tax loopholes to raise revenue. Areas such as credits for research and development, mortgage interest deductions, charitable deductions and other sacred cows may come on the chopping block.

On the spending side of the equation, there is also more pain ahead. The Department of Defense is coming under pressure to do more with less, which means it’s risky to invest in defense stocks right now. This is a good time to determine the amount of exposure to government spending for each stock in your portfolio. Long-held federal contracts are coming under greater scrutiny and can’t be counted on in the future.

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