Saturday, July 15, 2006

Deficit Down, Pessimism Up

Last week, the Sunday New York Times ran an article titled, "Surprising Jump in Tax Revenues is Curbing Deficit." The subheadline, though, countered the good news with a warning that the long term outlook was not any better. The article itself spent a lot of effort detailing the grim outlook for the federal budget.

Now there are a lot of issues with the future, but my own view is not nearly as bleak as those who seem to constantly view the world through a pessimistic lens and, of course, cast as much aspersion as possible on President Bush and the Republicans. Perhaps in another post I will look at the future deficit issue, with some sensitivity analysis on some common sense changes, such as a little increase in retirement age; some means-testing for Social Security and/or Medicare; and some enhanced growth through immigration.

But for now, I just want to point out the obvious reasons for the latest reduction in the deficit, and highlight a major error in the NYT's thinking.

The reduction in the deficit is about $100 billion, with the new deficit forecast for this fiscal year being about $300 billion, down from a forecast of over $400 billion just several months ago. By the way, with GDP running at $13 trillion, this means the deficit is 2.3% of GDP, lower than for France, Germany, Italy, and Japan (Japan is at an amazing 5.8%).

The simple reason for the improvement is that nominal and real GDP have been increasing much faster than expected. Here is some simple math. Let's assume that for a one dollar increase in GDP, federal tax revenues increase by 20 cents (20%). This is a bit above the average Federal tax rate for the US, but it could well be an underestimate of the marginal effect on tax revenues from GDP (see my post below on marginal tax rates). Much of the unexpected GDP increase came from incomes of wealthy individuals, and they face higher tax rates than the average person.

Anyway, now we can do a simple calculation. To get an additional $100 billion in tax revenues, with the marginal tax take at 20%, you need another $500 billion in GDP. With total GDP at $13 trillion, that is a 3.8% increase. So have we seen an unexpected increase in GDP of around 3.8%? If you use nominal GDP, which you should because tax revenues are based on nominal GDP, the answer is yes. The last GDP figures gave a real increase of 5.6% for the first quarter and 8.9% in nominal terms. So the increase in tax revenues is simply coming from faster than expected GDP growth.

Now for the NYT's error in logic. The subheadline and much of the article tries to make us think that the reduction in the deficit does nothing for the long term outlook. It is as if a person found $100 on the road; a nice windfall, but don't let yourself get accustomed to it. But this is not the case with the US economy. Growth was several percentage points higher than expected, and this puts us on a new, permanently higher path -- for both GDP and taxes. From finance theory, we know that stock prices are a random walk, so if the price of a stock goes up, you should assume that is now the new level from which the random walk continues. GDP and taxes are the same. My best estimate at this time is that tax revenues are $100 billion higher than before, permanently, because we had a permanent increase in GDP. This means that the budget deficit is permanently lower by $100 billion.

Another proper analogy is with our own yearly salary increases. A bonus of $100 may be a temporary thing, but when your annual salary goes up by, say, 5% on a base of $100,000, that is $5,000 extra per year that you can take to the bank.

One last calculation. With a nominal interest rate of 6%, the $100 billion per year is worth, in present value, $1.7 trillion. With total US federal debt at $8.4 trillion, I would say that the news is indeed quite good.

Let's drop the pessimism, no?

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