Are federal tax revenues on the brink of collapse?

Commentary about business and finance.
April 12 2007 6:18 PM

The Coming Tax Crash

Are federal tax revenues on the brink of collapse?

One of the outstanding features of the economy in recent years has been the huge and unexpected surge of federal tax revenues—up nearly 13 percent in 2005 and up nearly 12 percent in 2006. It has made politicians look like heroes, enabling them to spend liberally while appearing to shrink deficits, and has provided long-awaited vindication for supply-siders. Their conclusion: Tax cuts have stimulated an economy that is now reliably throwing off large volumes of corporate and personal income taxes.

But there's a more alarming explanation for the surge in tax revenues. It could be that the orgy of speculation in recent years—in housing, stocks, investment instruments—has generated an unexpected gusher of the types of tax revenues derived from flipping assets and trading securities. And that suggests that with the housing boom over and the stock market moving sideways, tax-revenue growth could be slowing down, and soon.

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Wall Street analyst Kenneth Safian directs our attention to the Monthly Treasury Statement. Each month, the statements chart how much revenue comes from payroll and income taxes, from corporate profits, and from a category called "other income not-withheld." This last category contains taxes paid on things like dividends, capital gains, and income from self-employed traders and condo-flippers. Not all of those revenues derive from speculation (there are armies of self-employed people out there, including Moneybox). But a lot of them do.

And these figures have shot up rapidly in recent years, both in real terms and as a percentage of total taxes paid by individuals. In 2004, the category accounted for about $243 billion, or nearly a quarter of all taxes paid by individuals. In 2006, it was $387 billion, or 31 percent of the total paid by individuals. It rose 60 percent in just two years!

Safian also believes rising corporate income taxes can be ascribed in part to speculation. Corporate income taxes have grown rapidly in recent years, from $131.8 billion in fiscal 2003 to $354 billion in fiscal 2006. Sure, the massive profits generated by the likes of ExxonMobil have pushed the totals higher. But so have the massive profits generated by the likes of Goldman Sachs and other investment banks and hedge funds. (Today, the financial sector accounts for about 21 percent of the value of the S&P 500.)

So, what's not to like about the surging other category? It can't last, that's what. The taxation regime that lives by speculation and asset-flipping also dies by speculation and asset-flipping. When investments decline in value, owners reduce tax payments. As Abby Goodnough reported in the New York Times last week,states such as Florida are already seeing sharp declines in revenues from things like real-estate transfer taxes. And as I noted ($) last month in the New York Times, state tax revenues, which are more dependent on sales taxes, have already seen their growth start to decline.

The good news? The federal government is already assuming that the cooling economy will lead to slower revenue growth. The current budget calls for revenues to rise by about 5 percent annually in the next few years rather than at the double-digit rates it has seen in recent years. The bad news: These reduced expectations may not be low enough. Taxes paid on capital gains and other speculative profits inevitably lag—you pay only after you cash out. When assets start to decline, the process works in reverse. After investors recognize losses, and thus earn credits against taxes owed, revenues start to decline. You can't conclude too much from one month's figures. But the March Treasury Monthly statement, released this week, notes that overall federal revenues rose by only 1.2 percent from March 2006.

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