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Federal budget outlook still deeply troubling

Although in the past few months there has been some improvement on the margin in the state of the federal government's budget, the overall picture is still deeply troubling. The improvement comes mostly from a decline in outlays (measured on a rolling 12-month basis), which in turn is a function of the running-off of the crisis-mode spending that occurred in the early months of last year. In addition, in the past few months there has been a slight firming in revenues, which is not surprising given the improvement in the economy since last summer.

But unless big changes are made to the government's spending plans, we are likely to see spending rise back up to 25% or more of GDP in the years to come, especially if healthcare reform is implemented. In an optimistic scenario in which the economy continues to post growth of 3-4% per year, revenues could move back up to 18% of GDP, but that would still leave a deficit of 7-10% of GDP. The deficit over the past 12 months is just under $1.4 trillion, and even "optimistic" numbers such as these would yield annual deficits of $1.1 to $1.7 trillion two years from now.

Thus, our debt to GDP ratio is on track for 100% within the foreseeable future, with the lion's share of the deterioration coming from government spending fueled mainly by transfer payments and entitlement programs. We will be passing on a huge debt to future generations with nothing much to show for it save a growing and cancerous culture of dependency. In a best-case scenario, this will mean a substantially slower trend rate of growth in the future, and lower living standards for most of us than would otherwise have been possible.

The prospect of trillion-dollar deficits is already driving calls for higher taxes on the rich, but that has limited potential to solve the problem since the rich are already paying most of the income taxes these days. The only way to generate a significant increase in revenue is with a VAT tax, such as is being proposed by Paul Volcker, that would land squarely on the shoulders of the middle class.

In the meantime, the prospect of higher income taxes next year is probably helping to drive the improvement in the economy and in the budget situation this year. That's because people have a powerful incentive to accelerate the recognition of income and capital gains to take advantage of today's lower rates. This positive dynamic has its cost, of course, and that will be seen next year in the form of slower income growth and reduced capital gains realizations. (This reminds me that the capital gains tax is the only tax you can legally avoid, simply by not selling whatever you hold at a gain.)

We have seen this dynamic happen several times in the past, as the above chart shows. Prior to the scheduled increase in capital gains taxes in 1987, capital gains realizations surged in 1986, only to collapse once the higher rates kicked in. Conversely, the reduction in the capital gains tax rate in the late 1990s produced a surge in capital gains realizations in subsequent years. Yet despite the abundant evidence that changes in tax rates have profound effects on people's tax strategies and their incentive to work and invest, OMB routinely projects (and politicians happily agree) that higher tax rates will always produce higher tax revenues, and vice versa. Unfortunately it just ain't so: higher tax rates next year could well lead to an even worse budget situation.

Where does this leave us? It's my hope and expectation that this budget picture is ugly enough to grab the electorate's attention. That attention will become laser-focused by the emerging discussion of the need to close an enormous budget gap with hugely higher taxes. With a little luck the electorate will decide we are on an unsustainable path (i.e., too much spending) and vote for change of the positive variety (i.e., less spending). So even though the outlook is deeply troubling, there is still plenty of reason to be optimistic about the future.

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