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Strong tax-revenue growth is narrowing the federal budget deficit -- again.


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James C. Capretta

Many Americans would be surprised to learn that the federal budget outlook has improved considerably over the last three years. The gap between federal revenue and spending continues to narrow, with the full-year deficit for 2007 likely to come in near 1.1 percent of GDP (or lower) — which would make 2007 one of the best budget years of the last four decades.

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The public’s surprise at the improving budget picture would be understandable since a shrinking deficit runs directly counter to the media’s portrayal of a hopeless U.S. fiscal situation caused by the Bush tax cuts. The remarkable, three-year revenue surge simply does not fit with that storyline.

But facts are facts: The revenue surge that began in 2005 continues into 2007.  The Treasury Department reported last week that federal revenue is up more than 11 percent in the first seven months of this fiscal year compared with the same period last year. This increase comes on the heels of a 12 percent revenue increase in 2006 and a 15 percent increase in 2005. This strong growth in tax collections has reduced the federal budget deficit substantially. In 2004, the deficit was 3.6 percent of GDP; by 2006, the deficit was just 1.9 percent of GDP, well below the recent historical average of about 2.4 percent of GDP.

And all signs indicate that the deficit in 2007 again will fall substantially. Through April, the budget deficit for this fiscal year totaled just $81 billion, down more than $100 billion compared to the same seven-month period in 2006.

The lesson here is simple: For deficit reduction, there is no substitute for strong economic growth.

The large budget deficits that emerged during Bush’s first term were unavoidable because the economy was weak. The bursting of the tech stock bubble in 2000, the 9/11 terrorist attacks, and the revelations in 2002 of several high-profile corporate scandals all contributed to a prolonged period of high unemployment and poor income and earnings growth. With the economy in the tank, federal revenues fell in nominal terms in three consecutive years — 2001 to 2003 — for the first time in four decades. No amount of fiscal discipline would have kept the budget surpluses of the late 1990’s from turning into deficits in the early Bush years.

Yet just as the budget deficits of 2003 and 2004 were largely the predictable result of outside events and a stagnant economy, today’s more favorable fiscal outlook is due almost entirely to the remarkable economic performance that has taken place since the 2003 tax cuts were signed into law. It is worth remembering that President Bush proposed and championed the 2003 tax changes — which included a tax cut for dividends and the acceleration of rate relief — in the face of fierce criticism from opponents still smarting from the passage of the 2001 tax law. And it is now clear that 2003 marked a real turning point in the performance of the economy.

The unemployment rate has fallen from 6.3 percent in June 2003 to 4.5 percent in April of this year, with more than 7.8 million new jobs having been created since August 2003.  U.S. businesses have booked record profits and U.S. households have prospered, with wealth accumulation up nearly 40 percent since 2002. The Dow Jones, meanwhile, now stands at over 13,200, up nearly 50 percent since mid-2003.

Predictably, federal tax receipts also have soared, with strong growth in both individual and corporate tax payments.

Official deficit and revenue estimates, as usual, have been slow to catch up to the trend.  Both Bush administration and Congressional Budget Office (CBO) estimates of the full-year 2007 deficit are thus likely to again be too high since their revenue estimates are too low. The administration predicted in February that the full-year 2007 deficit would be $244 billion. But with seven months in the books, the deficit in the last five months of the year would have to be nearly $100 billion above the level recorded during the last five months of fiscal year 2006.

The CBO predicted in March that the 2007 deficit would be just over $200 billion, assuming enactment of the war supplemental. (The CBO estimated the deficit at $177 billion under current law, with the president’s war request adding another $27 billion in spending this year.) The CBO’s deficit estimate, however, assumed revenues would increase just 5.6 percent in 2007 compared with 2006. For this to happen, tax receipts in the last five months of this fiscal year would have to be nearly 2 percent below tax receipts for the same period a year ago.

The CBO has noted that some tax payments recorded in April were booked earlier this year than in past years, which could suppress tax collections in the fiscal year’s final months. But even if revenue growth tails off to a 3 percent rate, revenue for the full fiscal year would still be nearly $50 billion higher than the CBO’s March estimate. A 2007 federal budget deficit in the range of $150 billion, or just 1.1 percent of GDP, is entirely possible.

The improving short-term budget outlook should strengthen Bush’s leverage in coming budget confrontations. If the current expansion continues, even at a more moderate pace, it is entirely possible that the budget could balance in the next few years without the tax increases that Democrats argue are necessary.

Somewhat counter-intuitively, the improving budget situation also should help Bush enforce spending discipline. With balance much more within reach, there will be a stronger political impulse to do what it takes to finish the job. And, having put his own, detailed balanced-budget plan on the table, the president now has the credibility to oppose new spending that would make the goal less attainable.

In the end, though, the most important factor for continued progress on the budget deficit is the performance of the U.S. economy. If the economy weakens, no realistic budget plan could close the resulting budget deficits, nor should policymakers try. And it is worth noting that strong tax collections tell us more about the strength of the economy in the recent past than what we can expect in the future. Nonetheless, it is clear that we have been in the midst of a very strong expansion. If it continues, all that will be needed to attain a balanced budget is a modicum of spending discipline.

James C. Capretta, a fellow at the Ethics and Public Policy Center, was an associate director at the Office of Management and Budget from 2001 to 2004.



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