When he announced the record $455 billion federal deficit last week, Office of Management and Budget Director Joshua Bolten reassured Americans that the red ink will evaporate as soon as the economy perks up. In the long term, Bolten insisted, rapid economic growth will generate the federal revenues needed to close the gap.
Bolten's faith in history is charming, but worrisome. His implication is that just as the '90s boom erased the deficit President Clinton inherited, so economic growth will eventually wipe out the deficit President Bush created.
But Bush's own policies make that very unlikely. Even if the economy rebounds, the tax revenue the federal government needs to balance the budget won't return.
Set back the clock to 1993. Marginal income tax rates topped out at 39.6 percent—a result of tax increases by Presidents Bush I and Clinton. Corporate dividends—mostly received by those in the upper income brackets—were taxed at the same rate as ordinary income. Ditto for income created by exercising options. Capital gains were taxed at a 28 percent rate.
Plainly, these taxes didn't inhibit hard work, investment, or capital formation since the '90s brought an orgy of wealth creation. People made millions in options income, capital gains, Wall Street bonuses, corporate profit-sharing, and the like. Because the rewards went disproportionately to those in the higher income—and hence higher tax—brackets, government revenues grew at a rate far faster than overall economic growth. (For data on tax revenue growth in the 1990s, click here.)
Total government receipts nearly doubled from $1.154 trillion in 1993 to $2.025 trillion in 2000. President Clinton's strategy of raising taxes on higher earners and (largely) holding the line on capital gains taxes worked. It boosted revenues without stifling economic growth and turned huge deficits into huge surpluses.
But President Bush has redesigned the tax code in the past few years. And the changes, by design, will make it much harder for the government to grow out of the deficit. In 2001 and 2002, marginal tax rates were lowered. They were lowered again this year, dropping the top marginal rate to 35 percent. Long-term capital gains are now taxed at 15 percent, down from 20 percent before. And now dividend income will be taxed at 15 percent—regardless of your marginal income tax rate.
As they did in the '90s, the wealthy will receive a disproportionate share of the reward when the economy and the markets pick up again. But because of these tweaks to the tax code, the government will harvest much less of the windfall than it did during the Clinton years.
For example, instead of taking compensation in salary, those who can will choose to take income in dividends. (By increasing Citigroup's dividend, as he did last week, outgoing CEO Sandy Weill just granted himself an annual stream of income of $32 million that will be taxed at 15 percent. Under the old regime, had he chosen to take that sum via options or a bonus, he would have paid more than twice as much in taxes.)
We've already seen how the tax cuts are damaging federal revenues. Historically, when the economy grows—even anemically, as it has been—so do government revenues. But federal revenues fell 1.7 percent in 2001 and 7 percent in 2002. So far this year, they're down another 3.5 percent. Federal receipts haven't fallen for three straight years since the early 1920s. (The administration claims that the tax cuts are only responsible for about 23 percent of the fiscal deterioration thus far.)
The current budget predicts massive gains in federal revenues down the road—just as the administration's previous two budgets did. The 2004 budget expects (hopes?) that revenues will grow by about 5 percent in 2004, by an impressive 11 percent in 2005 and then by between 5 percent and 6 percent in each of the three years thereafter.
Don't believe it. The Bush administration has been woefully off-base when it comes to projecting federal revenues and expenditures. Even if economic growth meets its expectations, the recovery in federal revenues won't. They have changed the rules too much.