April 2004
By ROBERT PEGG
The combination of a sharp economic slowdown, tax cuts and higher spending has transformed the U.S. budget. Just a few short years ago the fiscal surplus, brought about by the booming economy, was 2.4 percent of the Gross Domestic Product (GDP), among the highest of industrialized countries. By fiscal 2003, however, the federal budget deficit had reached 3.5 percent of the GDP. By next fiscal year, budget watchers expect it to rise to 4.3 percent of the GDP.
To some observers, the shift is unfortunate though it appears not to be a cause for great worry. Over the last three years, the U.S. was hit by an unprecedented combination of an economic slowdown, terrorist attacks and stock market weakness. Now, however, boosted by tax cuts, buoyant economic growth, coupled with disciplined spending, the flow of red ink may soon be halted. The strong economic and productivity growth that the nation is enjoying appears to underscore that view.
Nonetheless, there are many disbelievers. In a recent poll, members of the National Association of Business Economists described the federal deficit as the biggest problem facing the U.S. economy. A bipartisan coalition of three economic think tanks Ð the Committee for Economic Development, the Concord Coalition and the Center on Budgetary and Policy PrioritiesÑrecently declared that the next 10 years might be the most fiscally irresponsible in the nation's history.
In the short run, the fiscal shift to budget deficits has been significant but not dangerous. Growing deficits usually flow from an economic slowdown, as tax revenues fall off and spending rises. Part of the nation's fiscal troubles over the last three years has come from a slower economy. Tax revenues fell further than expected after the stock market bubble burst. Spending increases and tax cuts reinforced the trend, but the tax cuts also have helped the economy. Few economists disagree that the aggressive use of fiscal stimulus, combined with low interest rates, helped stave off a sharper domestic and global economic downturn. Moreover, with plenty of slack still in the economy, today's budget deficit is unlikely to squeeze out private investment for some time.
However, even if the economy turns out to be better than expected, budget forecasters still must deal with four main issues over the next 10 years that will place considerable pressure on the budget. The first is extending the tax cuts. Many of the tax cuts expire over the next 10 years. Extending them may worsen the 10-year budget outlook by $1.7 trillion. The second is reforming the Alternative Minimum Tax (AMT). More and more taxpayers are being affected by this provision, which is not indexed to inflation and claims a greater and greater share of personal income taxes. Reforming that, however, adds $690 billion to the deficit over 10 years. Then, there is controlling Congressional spending. If spending patterns of the last five years are included, the budget deficit soars by $3.3 trillion. Current forecasts assume unrealistically low spending levels by the federal government and Congress. Finally, there is the Medicare question. Costs of drug benefits could cost at least $400 billion over the next decade.
Add all these factors together and the U.S. deficit appears far worse than the official forecasts suggest. Among Washington's independent budget experts, the consensus opinion is that the official figures underestimate the cumulative deficit by $5 trillion. As a result, the U.S. is likely to see deficits that average at least three percent of the GDP over the next decade.
All of these projections assume a healthy average growth of real GDP at three percent a year. Faster growth would improve the outlook. The economic consequences of such large deficits are negative. Big budget deficits reduce savings rates and could eventually crowd out private investment and reduce long-term economic growth. They can cause volatility in global capital markets and raise the risk of financial collapse.
Moreover, a turnaround in fiscal matters will be difficult. There is no "end of the Cold War" peace dividend and pressure on military spending may continue to increase depending on world events. The U.S. is also not likely to see another stock market bubble that would drive up tax revenues. With baby boomers retiring, placing pressure on entitlement spending, the path to a balanced and sustainable fiscal policy may be very difficult.
About the author: Mr. Pegg is managing director of Tocqueville Asset Management LP, the New York City-based investment advisory firm which serves businesses, institutions and private individuals.