$3.8 Trillion…..Really???

I promise to get to tax reform soon, but in the meantime, I just had to comment about the President’s Budget plan released last week. As always with government budgets, I pay a great deal less attention to numbers in the long-term (e.g. 5-10  years from now) than the short run (next 1-2 years) because of the peculiarities of how the CBO, Congress and the Administration make such projections. (i.e. there are many “built-in” inaccuracies such as ignoring behavioral changes which I will get to later).

But the eye-popping, “you got to be kidding me” number is that this Administration is proposing a budget of $3.8 trillion for Fiscal Year 2013 (i.e. Sept 30, 2012 to Sept 30,2013) that is HIGHER than what we spent in FY 2011 (i.e. $3.6 trillion) NOT LOWER.  In other words, with justifiable concern about a long-term collapse of the US economy, downgrades to US debt occurring in 2011 and a recognition on the part of most Americans that we ABSOLUTELY do need to do something about the deficit and in particular government spending, this current administration is doing NOTHING! ….REALLY ???

The answer in the short-term is apparently not EXCEPT that the budget also includes very significant tax increases relative to todays levels. (Remember the Bush income tax rates, dividend and capital gains treatment all expire at the end of 2012). In fact, the budget assumes that federal tax revenues would rise from “actual” levels during FY 2011 of $2.3 trillion to $2.9 trillion in FY2013 or almost 30% in two years. This more than accounts for the budget assumption that the deficit would fall to $0.9 trillion from todays $1.4 trillion, while still allowing spending to grow further.

In other words the budget as currently proposed relies entirely on TAX increases and not at all on “real” budget reductions. (Note that the “mandatory” budget cuts from the deficit deal are from “projected” future spending which of course absent these cuts is continuing to rise rapidly. So there aren’t any REAL cuts that have been enacted yet). And though most Americans are for “some” tax increases to help solve the debt crisis, I suspect that very few “if asked” would be for tax increases so that the budget can keep growing.

On top of this, the estimated increase in tax revenues must have been developed by accountants who just visited Fantasyland. For one, the estimates assume very robust GDP growth at the same time as the tax increases are occurring in spite of the strong evidence over the past 100 years that tax increases typically provide a significant drag on economic growth and that tax cuts help stimulate growth. In other words, I would happily take the “under” on a bet on whether the actual tax revenues will be $2.9 trillion in FY 2013 assuming the current tax system reverts back to the pre-Bush years as it is now scheduled to do absent any Congressional action. 

In addition, even federal tax revenues measured as % of GDP are projected to increase substantially from 15% today to 18% by FY2013. The last time we were at 18% was 2007 and it was the peak of the last expansion (and the economy under any objective measure was far stronger than it is today). There are lots of reasons to suspect that this assumption will prove overly optimistic. However, the most basic reason is that not only does a higher tax burden lower GDP growth but it also changes behavior in terms of  the amount of income earned, reported and deferred. With higher marginal tax rates for income, capital gains and dividends, individuals will tend to defer income til later when they can,  and avoid realizing capital gains (or take gains today but NOT in the future) or avoid investing as much in dividend earning stocks. (I have actually done this myself as I have shifted out of stocks and taken capital gains over the past year so I would not have to do it in 2013 when the rates go up).  In addition for the wealthiest top 1% earners, income and capital tend to be pretty mobile and higher rates will certainly spur income flight to friendlier tax havens overseas.

So bottom line, tax revenue increases are going to be needed in order to help ultimately balance the federal budget, BUT one needs to be much smarter about this than raising marginal tax rates. In other words, tax reform with elimination of all or at least most deductions is far more effective in increasing tax revenues and will be less damaging to the economy overall. However, that is a topic for another day.