No one ever quite figured out why the strong economy of the 1990s generated so much more tax revenue than anticipated, wiping out the US' federal budget deficit and creating substantial surpluses.
So it should not be surprising that no one has a good handle on what the slumping economy today may do to the fiscal outlook.
The issue is front and center again because both Democrats and Republicans have already allocated much of the projected surplus to a variety of uses. Should it be smaller than expected, something would have to give among three main policy goals: cutting taxes; increasing spending on education, health care and the military; and paying off the national debt. It would also leave little money to strengthen Social Security over the long run. So far, there is little evidence that the nation is falling back into a fiscal abyss. Even if the surplus is smaller than anticipated, the two parties seem intent on living up to their pledge to use excess Social Security revenue to pay off the US$3 trillion in government debt.
But the economic slowdown this year has forced a re-examination of the presumption that the projected surpluses were as good as money in the bank. One of the most detailed, and sobering, studies of the interplay between economic trends and the fiscal outlook comes from Goldman Sachs.
Two trends have provided the foundation for a rosier budget outlook, said William Dudley, the firm's chief domestic economist. One is a surge in tax revenue, greater than expected even at a time of strong economic growth. The other is an improvement in the nation's long-term economic potential. Both now seem to be going into reverse, he said.
One big source of additional tax revenue in recent years has been strong corporate profits, which are taxed at higher rates than individual incomes, and have been making up a growing share of the total tax base. But in the last several months, corporate profits -- and revenue from taxation of them -- have plummeted.
The pretax profit share of GDP will fall to 8.4 percent this year from 9.5 percent last year, Dudley projected, implying a substantial drop in corporate income tax revenue.
Moreover, individual income tax receipts could also be under pressure because of the end of the bull market on Wall Street, Dudley said.
Dudley pointed to the experience of California. The nation's most populous state estimated recently that the exercise of stock options had contributed more than US$80 billion to personal income in the state last year, up from US$50 billion in 1999. Now the state is assuming that income from options will fall back at least to its 1999 level.
Extrapolating from the experience in California, Dudley calculated that the drop in options income nationwide could shave as much as US$40 billion off federal income tax receipts next year.
Capital gains revenue is also likely to tail off, he said. The stock market is now down more than 20 percent from its peak last year, he said, yet the Congressional Budget Office is only estimating a falloff in capital gains revenue of 3 percent next year, to about US$125 billion. A more realistic estimate, Dudley said, is US$98 billion, the level of capital gains receipts in 1999, when the market was roughly where it is now.
Over all, Dudley estimated that tax receipts could fall short of projections next year by US$50 billion to US$75 billion -- enough to put a crimp in the plans of both parties for more spending.
Such a shortfall could set off a political storm -- Democrats are already building a case that the tax cut US President George W. Bush signed into law last month will lead to renewed budget deficits -- but the real question is what happens over the next decade or so.
Dudley said predictions that productivity gains would remain high, and therefore that growth would return to historically robust levels once this cyclical downturn ended, might be overly optimistic.
The analysis by Goldman suggests that the economy is capable of a long-term noninflationary growth rate of about 3 percent a year, 0.3 of a percentage point lower than the growth rate assumed by the budget office in developing its 10-year surplus projections. If Goldman's figures are correct, Dudley said, the projected surplus would come in US$750 billion lower than the budget office's projection.
After accounting for Bush's tax cut and the bipartisan agreement to put the Social Security portion of the surplus off limits, there is no more than US$1 trillion of the 10-year surplus projection of US$5.6 trillion still available. If Dudley's calculations are right, then the surplus will have all but disappeared.
Easy come, easy go.
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