Greg Ip

Articles by The Economist’s U.S. Economics Editor

As Bigger Piece of Economic Pie Shifts to Wealthiest, U.S. Deficit Heads Downward

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By Greg Ip and Deborah Solomon

979 words

17 July 2006

The Wall Street Journal



(Copyright (c) 2006, Dow Jones & Company, Inc.)

IN ANNOUNCING a big drop in its estimate of this year’s federal budget deficit, the Bush administration was quick to credit itself.

“Tax cuts worked to generate economic growth, and economic growth is now working to raise revenues,” White House budget director Rob Portman said last week during an online discussion with the public.

But this explanation falls short. While tax revenue is growing far faster than the Bush administration forecast in its budget projections in February, the nation’s economy isn’t.

What has changed isn’t the size of the economy, but how the economic pie is divided. The share of national income going to corporations and the wealthiest individuals, already large, has expanded, while the share going to typical wage earners has shrunk. Because corporations and the wealthy generally pay income tax at higher rates than does the typical wage earner, that shift benefits the federal Treasury.

U.S. tax revenue for fiscal 2006, which ends Sept. 30, is expected to be 5% — or $115 billion — higher, than the administration projected in February. Largely as a result, the budget deficit is expected to be $296 billion this year, instead of $423 billion.

But total economic output is expected to be just 1% larger, before adjusting for inflation, than the White House predicted. After adjusting for inflation, it is projected to be just 0.1% larger. While the unemployment rate is lower than the administration had expected, payroll growth has been slower.

MR. PORTMAN acknowledged in an interview last week with The Wall Street Journal that the economy hasn’t expanded much more than anticipated. However, he said, the administration “didn’t necessarily understand as much in February about how that growth would affect revenue. Income tax is coming in more from higher-income earners,” he said. Precisely what happened won’t be clear until detailed tax data is available, which could be years from now. Coming revisions to government estimates of economic output, profits and wages could also affect explanations for the surge.

Robert Carroll, Treasury’s deputy assistant secretary for tax policy, said it isn’t yet clear whether individual income-tax liability is being boosted by capital gains, wages, equity-based compensation or some other factor.

The administration has raised its estimate of corporate profits this year by 11%, but trimmed its estimate of wage and salary income by 1%. As a result, expected corporate tax collections have been revised up 20% from February. Individual income taxes were revised up 7%, with the increase primarily from wealthier taxpayers. Payroll taxes — for Social Security, levied only on the first $94,200 of wage income, and Medicare — are expected to total 1% less than expected.

So, the tax windfall is another piece of evidence that income inequality in the U.S. continues to grow, which in turn may explain why the average American still gives President Bush low marks on the economy despite its overall strength.

ON THE OTHER HAND, it also may be evidence that Mr. Bush’s tax cuts are working as advertised. Lower tax rates were meant to encourage people to work more, and because their taxes were cut the most, relative to income, the wealthiest may have the biggest incentive to work and earn more.

In addition, cuts in taxes on capital gains and dividends were meant to reduce the cost of capital and encourage companies to invest more, which should lead to higher profits. This is called the supply-side effect, because it means workers and businesses are encouraged to supply more goods and services.

“I think there must be something to that,” says Douglas Holtz-Eakin, a former director of the Congressional Budget Office now with the Council on Foreign Relations. “Good tax policy matters.”

Rudolph Penner, a senior fellow at the Urban Institute, a Washington think tank, and a CBO director picked by Republicans in the 1980s, says a supply-side effect “doesn’t come close to explaining the revenue surge.” If it did, “you would have forecast a much bigger rise” in gross domestic product, or the total value of all goods and services produced in the country. And, he says, it should have led to more income than expected for all wage earners, not just those at the top, since the majority of wage earners got a tax cut.

He notes the administration itself puts the tax cuts’ maximum supply-side boost at just 0.7% of GDP, stretched over many years.

Mr. Penner says the revenue surge reflects not a supply-side effect but a replay of the late 1990s, when the 1% of richest taxpayers prospered most and “paid a huge amount of taxes,” eventually driving the budget into surplus. Indeed, the CBO and the White House repeatedly raised revenue forecasts then, much as they have now. But the recession and the stock-market bust in 2001 caused revenue to fall far more rapidly than budgeted.

That experience suggests the current revenue surge could also be transient. The administration says it’s being conservative in projecting future revenue growth at just 2.4% next year. But how much revenues actually increase depends not only on how the economy fares, but on whether income inequality remains as wide as it is now.

Even if the wealthy and corporations maintain their larger share of national income, budgeting could become more treacherous. That’s because corporate profits and the performance-based pay that makes up so much of the affluent’s income are inherently more volatile than wages, as they are more dependent on fluctuations in business and stock-market conditions. Thus, the difficulty of projecting the Treasury’s tax take could be long-lasting.


Written by gregip

July 17, 2006 at 11:04 pm

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