US tax figures point to sharp fall in deficit

Author: Andrew Balls and Christopher Swann

Published: July 14, 2005

After several years of embarrassing budget figures, the Bush administration yesterday had good news to report.

In the first three-quarters of the fiscal year, which ends in September, the tax take was up by more than Dollars 200bn (Euros 165bn, Pounds 115bn) to about Dollars 1,604bn - a rise of almost 15 per cent compared to the same period of last year.

In its mid-session review, the administration cut its forecast for the budget deficit in the fiscal year ending in September to Dollars 333bn - Pounds 94bn less than the forecast it released in February of Dollars 427bn and a sharp reduction from the Dollars 412bn deficit in the 2004 fiscal year.

The White House's pledge to cut the fiscal deficit in half from its projected 2004 level - excluding the costs of the war in Iraq and various other items - is on track.

And, following the tax cuts of President George W. Bush's first term, some conservatives have hailed the sharp rise in tax revenues this year as a glittering example of the success of supply-side economics - proving that tax cuts can pay for themselves by creating a greater incentive for work that more than offsets the impact of the lower rate.

Others warn that such thinking will prove dangerously complacent, and may only discourage fledgling attempts at spending restraint in Congress. Much of the recent increase in revenues appears to be due to one-off factors, rather than a supply-side revolution.

The heyday of supply-side economics was the early 1980s, when President Ronald Reagan slashed tax rates. In the face of ballooning fiscal deficits, he then approved a series of tax increases starting in 1982.

The Congressional Budget Office has estimated that two-thirds of the swing from the 2001 fiscal surplus to last year's deficit was explained by tax cuts, rather than a cyclical slowdown. Tax revenues will still be lower this year than the level projected in 2001, before the first Bush tax cut.

There are few supply-siders among professional economists. But many conservative thinkers have kept faith. Ben Bernanke, the new chairman of the Council of Economic Advisers, was diplomatic when asked about the supply-side effects of the Bush tax cuts this week. "Certainly the overall strength of the economy was a key element in the (revenue) increases and the tax cuts were essential to that. I am not sure we really have the data at this point to break it down among labour, capital and other sources."

So far during the 2005 fiscal year, individual income tax receipts are up 18 per cent, to Dollars 701bn. Corporate income taxes, however, have risen 40 per cent to Dollars 200bn.

There has not been a surge in withheld taxes, or taxes deducted from payrolls, and employment levels or the length of work weeks have not leapt. "If the supply-side case were true, you would expect to see a large increase in withheld income tax, as Americans decided to work harder," says Bill Gale, a senior fellow at Brookings. "We have not seen this."

The big rise in individual tax revenues has been in non-withheld taxes, such as capital gains taxes, in large part the result of stronger economic growth and stock market gains last year.

Chris Edwards, director of fiscal studies at the Cato Institute, the libertarian think-tank, believes this was partly thanks to the Bush tax cuts. "The lowering of taxes on capital gains and dividends added to optimism in the stock market last year and this helped revenues," he said. "With taxes lower, people were more willing to realise capital gains."

But with the stock market moving sideways for most of 2005, it is unlikely stock options will prove such a bounty this fiscal year.

Edward McKelvey, economist at Goldman Sachs, wrote in a recent research note that while tax cuts might have boosted growth and the stock market, the evidence supports the traditional Keynesian effect of a short-term boost to the economy rather than a supply-side impact on work incentives.

The surge in corporate tax receipts, meanwhile, can be explained in large part by a number of time-limited tax breaks, including the provision that allowed companies to accelerate the depreciation of new investments that expired at the end of in December. "Without an end to this bonus depreciation, revenues from corporate tax would have risen by just 10 per cent rather than 40 per cent, " says Richard Kogan, a senior fellow at the Center on Budget and Policy Priorities, the progressive think-tank.

The CBO warns that the outlook for large deficits after 2008 is unchanged. Social Security and Medicare's future funding shortfalls point to long-term deficits that dwarf those of the past few years.

"Policymakers should bear in mind that we are now just three years away from the retirement of the first wave of baby-boomers," says Mr Edwards at Cato. "If the figures are looking better than expected, the president should be more ambitious. Instead of seeking just to halve the deficit, he should try to eliminate it."