from Follow the Money

Well, the 2005 fiscal deficit looks good …

August 16, 2005

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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I'll leave it to others (Brookings, Goldman, CBPP, DeLong with some help from Concord Coalition) to transform the CBO forecast into realistic projections.  Manipulating the CBO long-term budget forecast so that the long-term deficit appears lower than it really is has become something of a Washington DC art form over the past five years.

Suffice to say that the forecasts that show the deficit almost disappearing over time assume that revenues from the personal income tax will increase from 7.6% of GDP in 2005 to 10.3% of GDP in 2015 or so.  Overall revenues increase a bit less; they are forecast to rise from 17.5% of GDP to 19.5% of GDP.  Discretionary spending (including defense) spending will shrink as a share of nominal GDP, falling from 7.8% of GDP to 6.1%.  So called mandatory spending - Social security, Medicare, etc -- is expected to rise from 10.8% of GDP to 11.7% of GDP.  Discretionary spending is expected to increase in line with inflation, not with nominal GDP growth.  See table 1-2.

Assume that revenues stay constant as a share of GDP - no increase in taxes - and discretionary spending stays constant as a share of GDP, and the forecast 0.3% of  GDP deficit in 2015 rises to 4.7% of GDP, even leaving out the higher debt servicing costs associated the higher debt to GDP ratio.

That is why Isabel Sawhill of Brookings says:

"The sun may be shining for now, but there are a lot of dark clouds on the horizon. The long-term budget picture is bad and getting worse."

One thing should be clear: the deficit is falling because of a surge in tax revenues.  The CBO forecasts revenues will rise by almost14% -- over twice as fast as nominal GDP (up 6.2%).   Revenues will jump from 16.3 to 17.5% of GDP.  Personal income taxes increased by 0.6% of GDP; corporate taxes by a similar amount.   The director of the CBO, Dr. Holtz-Eakin thinks ¾ of this surge is temporary.

Spending is rising by 7.9% -- a bit faster than nominal GDP.   Read Max Sawicky.

For 2006, the CBO forecasts that revenue growth will slow, to 6.5% -- a reasonable forecast.  Spending is expected to grow by 4.9%.  

Personally, I expect that spending will surprise on the upside.   Highway bill and all.   The unexpected fall in the deficit kind of takes the pressure off the Congress.   And, as for revenues, who knows ...  the stock market is kind of flat, so that won't generate a surge in capital gains.  But housing prices continue to rise.  If Calculated Risk, Barry Ritholtz of the Big Picture and Stephen Roach are right, and the housing market led consumer driven expansion is on its last legs, though, I would worry about 2007.  I think it is pretty clear that the housing bubble - like the equity bubble - is indirectly supporting federal tax revenues.   A housing/ consumption slowdown that led to an economic slowdown consequently might deliver a mean cyclical shock to the budget.

The CBO's long-term forecast assumes some fall back in corporate tax revenue as a share of GDP.  That is reasonable.   Corporate tax revenues rose $80 b in 2005 (42%), after a similar increase in 2003.   All told, the corporate income tax has doubled as a share of GDP since 2003, to 2.2% of GDP.   And I don't hear the White House complaining that much - at least for now.

Ted Weiseman of Morgan Stanly highlights something that had escaped my notice, namely that a surge in special Treasury bond issuance to state and local governments has reduced the Treasury's market borrowing by even more than the fall in the fiscal deficit would imply.     The timing was almost perfect - state and local governments started buying treasuries just as central banks (particularly the Bank of Japan) eased off their purchases.    Look at the Bond Market Association data.

Weiseman expects the 2006 deficit to be roughly equal to the 2005 deficit - and for market borrowing to be much higher.

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