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Tax-Cut Vote Likely
Markets assume a high probability that the 2008 expiration date will be extended.


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David Malpass

The visibility of budget issues is rising in Washington. Federal Reserve chairman Alan Greenspan has increased the urgency of his warnings on the deficit situation, and the confusion stalling Social Security reform has focused more attention on the growing outlays for Medicare, Medicaid, and Social Security.

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In his March 10 remarks to the New York Council on Foreign Relations, Greenspan said “We are moving to a real serious budget debate . . . which must halt the path which essentially becomes a significant fiscal problem in 2015 and beyond.” In his prepared text that day, Greenspan said that “According to the Congressional Budget Office, [the fiscal deficit] will rise significantly as the baby boomers start to retire in 2008. Our fiscal prospects are, in my judgment, a significant obstacle to long-term stability because the budget deficit is not readily subject to correction by market forces that stabilize other imbalances.”

I don’t think the budget numbers point to a financial or economic crisis, but they do show a severe problem in how Washington allocates spending. Social Security expenditures are expected to be 4.4 percent of GDP in 2015 and grow to 5.5 percent of GDP by 2025. Combined Medicare and Medicaid spending is expected to be 5.6 percent of GDP in 2015 and grow to 7.4 percent of GDP by 2025. This will squeeze other federal programs and provide endless debating points for those wanting to raise taxes.

In a good turn of events, however, the recently passed House and Senate budget resolutions include reconciliation instructions requesting tax-cut legislation in 2005. In votes beginning this week, the full Senate will likely pass a budget resolution that includes a reconciliation instruction with enough funding to extend the current tax rates on capital gains and dividends to 2010 from 2008. This would take roughly $25 billion of the $70 billion now in the Senate Budget Committee’s resolution, leaving the possibility that some of the funding for tax cuts could be voted out and still allow the two key cost-of-capital provisions to be extended by the Finance Committee later in 2005 — if the House and Senate agree on a joint budget.

Indeed, a joint House and Senate budget that includes tax-cut funding would be a positive development for both the economy and the stock market. It would avoid the uncertainty that would have built if the tax-cut issue had been delayed into 2006, and would also show that there is a Senate voting process for extending the 2003 tax cuts with 51 votes (a procedure available under the reconciliation process). On the other hand, an explicit vote to drop all or most of the tax cuts from the Senate’s budget would be a negative surprise, although this is unlikely.

I think financial markets are assuming a high probability that the 2008 expiration date will be extended. Tax rates are a critical factor in the valuation of equities, due to their direct effect on the after-tax value of earnings and capital gains as well as the effect of changes in the cost of capital on economic growth. Equities surged in the May-June 2003 period after the Bush tax cuts were passed (see “A Tax Cut at Work“), and would probably decline substantially if those tax cuts were not extended.

The debate over the budget deficit is coming at a time when the growth in tax receipts is the fastest since April 2001. Receipts are up 8.7 percent year-over-year in February. As a result, the budget deficit has fallen to $407 billion (roughly 3.4 percent of GDP) in the twelve months through February from a twelve-month peak of $459 billion (roughly 4.1 percent of GDP) in April 2004. The deficit per GDP will likely remain well below 2004 levels until at least the next recession.

Looking farther out, federal budget outlays are projected to grow much faster than the economy sometime around 2015, causing outlays as a percentage of GDP to expand rapidly. Total federal outlays are projected to be 20 percent of GDP in 2015, rising to 23 percent — a level that exceeds the previous peaks — by 2025. This is the focus of Greenspan’s concern. But I note that the U.S. debt-to-GDP ratio, a key measure when it comes to the federal budget, will likely remain relatively low by historical standards.

Of course, it would be welcome news if the Bush administration succeeds in slowing the growth of entitlement spending — and perhaps even makes entitlement savings an annual event. But right now the more realistic prospect is for a joint-resolution to extend the Bush tax cuts of 2003. Such a resolution would be a big positive for both equities and the economy.

– David Malpass is the chief economist for Bear, Stearns.



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