Why Is the Federal Deficit Falling and Will It Continue to Fall?

July 12, 2007

Yesterday, the White House’s Office of Management and Budget released its revised forecast for the fiscal year 2007 deficit. Originally projected to be $244 billion, the revised figure put the amount at $205 billion. And for fiscal year 2008, which begins in October, the projected deficit is now $258 billion. While the deficits remain relatively high in dollar figures, especially compared to the surplus the federal government ran in 2000, the deficit as a percentage of GDP is still relatively small.

Below are some points that you may not hear from administration sources or administration foes.

(1) The deficit projections are based upon current law, meaning that any AMT patch that is passed for this year will increase the deficit for both fiscal years 2007 and 2008. Also, education tax credits may be expanded for both fiscal years, and for fiscal year 2008, it is likely that the itemized deduction for sales taxes paid will be extended. Furthermore, for fiscal year 2008, the expiration of S-CHIP may cause differences between reality and what the White House projects.

(2) The main driver of the declining deficit is the surging revenues that the federal government is collecting. As many critics of the administration have conceded, corporate profits have been skyrocketing, going from 1.2 percent of GDP in 2003 to 2.7 percent of GDP in 2006. One consequence of this will be surging corporate tax revenues at both the state and federal level. Furthermore, individual income tax collections have risen dramatically this year, as well, as a result of a healthy stock market, increased profits for businesses that file under the individual income tax, and moderately growing wages. Unfortunately, a growing problem is that employer-provided health insurance is an ever-increasing part of employee compensation, and it is tax-free, which in the end merely forces individual tax rates up.

(3) Some have argued that not all Americans are sharing in the growing economy, citing statistics that corporate profits are at all-time highs and income inequality is rising. When this occurs, however, federal revenues will grow faster than normal, for two reasons. First, corporate income is often subject to taxation at two stages – first in the form of the corporate income tax and second in the form of dividends and capital gains income on the individual income tax side. Second, because the federal income tax code is highly progressive, if more income is being earned by those at the top of the income scales, there will be higher tax collections than if that money were earned by those at the bottom. (This is why tax collections can fall as a result of minimum wage increases as they are merely off-budget forms of income redistribution.)

(4) Finally, some have suggested that the higher revenues are the result of the tax cuts passed in 2001 and 2003. While there is obviously some feedback from tax cuts in the form of higher economic growth, most economists will agree that this feedback is not substantial enough to actually increase revenues. In fact, the child tax credit component of the President’s tax bill will not only decrease revenues on the first-order magnitude, it will also likely decrease labor supply due to the income effect on labor, meaning the revenue loss is even greater than static estimates would suggest. On the other hand, because the income tax system now contains a large amount of business income and investment income, lower tax rates on these sources of income, which are typically more tax-sensitive than labor supply, can have a significant feedback effect. However, this feedback effect still will likely not be strong enough to offset the costs of the tax cuts in the long run. (In the short run, if Keynesian policies of business cycle control like tax rebate checks are actually effective, then revenues may increase as a result of a tax cut or government spending increase.) But throughout this whole debate over the Laffer Curve, one needs to ask the question: should tax revenue maximization even be the goal of a government in a free society?

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