The Bear's Lair: The Fiscal Crisis of 2005

By MARTIN HUTCHINSON  |  July 5, 2004 at 1:34 PM
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WASHINGTON, July 5 (UPI) -- Everybody appears to agree that the federal budget deficit is a problem that needs to be dealt with, but not yet an urgent one. After November's election, of course, the urgency of the problem will become fully apparent. It's therefore with asking, with considerable trepidation, what solutions might be found.

With the Federal budget deficit at its present level, apparently of just under $500 billion in fiscal year 2004 (ends September 30) and at least a similar level in fiscal year 2005 (the Congressional Budget office's March forecast was $363 billion, but that's before the Congressional spending pigs got to the trough) it's fairly clear that the ability to finance the Federal budget is not a big concern. At around 4 percent of gross domestic product, the budget deficit is little higher than budget deficits in much of Europe, well within historical parameters, and placing only modest strain on the capital markets. The George W. Bush administration believes that rapid growth in the U.S. economy will tend to narrow the budget deficit over the next few years -- the 2005 Budget presented to Congress in February promised to halve it by 2009 - which would lead to its stress on the financial markets gradually decreasing.

There is however a substantial and growing probability that the Bush administration is wrong in this core belief (if some members of the administration themselves don't believe it, they are unlikely to say so in an election year.) As I have repeatedly discussed in the past, Congress's ability to produce a final budget spending total that is at or below the President's initial proposal disappeared with the replacement of Speaker Newt Gingrich with Dennis Hastert at the end of 1998. Since that time there has each year been a minimum slippage of $25 billion between the initial proposal and the final outcome, and in most years considerably more.

Federal spending appears to have grown only 4.5 percent per annum in fiscal years 2000-2003, but that low figure results from a decline of 13.4 percent per annum in net interest payments. With interest rates headed back up, and the deficits themselves adding substantially each year to Federal debt, that particular holiday from history has come to an end, and the true growth of 7-8 percent per annum in Federal spending will be revealed. Since nominal GDP has grown at only 4.4 percent per annum in the four years to the first quarter of 2004, considerably slower than federal non-interest spending, and Congress shows no sign of acquiring fiscal discipline, it's certainly not obvious that the deficit is about to decline. After all, the Medicare prescription drug benefit kicks in full force in fiscal 2006.

Significantly, the economic statistics over the last couple of months show an economy that is not in an early stage of a long and healthy rebound, but in the latter stages of a short and unstable up-tick, like 1971-73. Inflation is clearly rearing its ugly head again, while Friday's unexpectedly weak jobless data suggests that the economy's recovery may well peter out far below full employment, as the artificial stimulus of ultra-low interest rates is withdrawn. However, as is well known, any weakening in the economy automatically produces a severe effect on the federal finances, causing the budget deficit to yawn ever wider.

The point at which this can no longer be financed without paying "junk bond" interest rates and starving the rest of the economy of capital is unclear. However a deficit of $750 billion, 6 percent of GDP, would almost certainly cause problems, rendered more severe by the fact that interest rates would be on a rising trend, so that buyers of long term government debt would be losing money with every billion they bought, financially hitting themselves rhythmically on the head. Even the dopier Asian central banks might decide at that point that they had something better to do with their money.

This problem will come to a head in the first months of 2005, when a re-elected President Bush or a newly elected President John Kerry faces the unpleasant constitutional necessity of providing Congress and the public with a federal budget for the year to September 2006 whose figures add up. If as I expect by that stage the budget deficit has shown signs of widening further, interest rates have crept up, the economic recovery has faltered somewhat and the bond markets are showing signs of balking at all the new debt, an unpleasant reality will have to be faced: Taxes must go up.

In an ideal world, much of the budget deficit could be closed by eliminating unnecessary or even damaging Federal expenditure (think corporate welfare, farm subsidies, most highway projects, much foreign aid expenditure, export credits) But it's most unlikely that the porkaholic spendthrifts in Congress will make any but the tiniest dent in that direction.

Repealing a high percentage of the Bush tax cuts, or allowing them to expire, is a high probability, but will be nowhere near sufficient to close the gap. Furthermore, the Alternative Minimum Tax, a loosening of which was scheduled to expire in 2005, needs to be addressed as a matter of urgency or tens of millions of Americans will find themselves compelled to complete two tax returns each year. The revenue from allowing the AMT to revert to its pre-2001 level, tightening its grip on the U.S. taxpayer, was included in the President's 2005 Budget; this was one of many features in that document which were simply unrealistic. The real problem with the AMT is that, since it was increased in the Bill Clinton tax raise of 1993, its rate, at 26 to 28 percent, is now far too close to the standard rates of income tax. If the purpose of the tax is to act as an alternative flat tax to catch loophole-exploiters, its rate should be set about 5 points lower than currently, at around 20 percent.

Thus the revenue from repealing or sunsetting the Bush tax cuts, assuming a president Kerry retained most of the lower-income tax cuts as he promises, is at most a few tens of billions of dollars per annum, nowhere near enough.

If the administration really wants to close the budget gap, and produce a massive engine of further government expansion, the most efficient mechanism is through a value added tax, by which traders, manufacturers, retailers and providers of services are charged at a flat percentage rate on the value added by them. To the final consumer, this has much the same effect as a sales tax, but it is more efficient to collect, being imposed at each level of production and distribution, and can therefore be imposed at a considerably higher rate than the 6 to 9 percent at which U.S. state sales taxes are levied.

The revenue potential from a VAT is immense. Britain, for example, imposes a VAT at 17.5 percent, but with many exemptions, including most notably food, real estate transactions, books and children's clothing, so that little more than half consumer expenditure is captured. In the fiscal year 2002-2003, VAT yielded 63.5 billion pounds, 6.0 percent of Britain's GDP in that year. A tax that yielded 6.0 percent of US GDP annually would produce revenue of $750 billion per annum, enough to close almost any budget gap, with potential under either of the current candidates on offer to fund yet another considerable further expansion in social programs.

The most difficult political problem with a VAT is that it attacks the sales tax, the revenue base of most state governments. However, this is easy to get around; you simply have the Federal government impose VAT at a flat rate of 10 percent (by all means with an exemption for food, but preferably not for real estate) to which state governments would be free to add whatever additional percentage they wish -- thus a jurisdiction with an 8 percent sales tax would in principle levy an 18 percent combined Federal and state VAT.

There would be a certain amount of transfer irregularities, with jurisdictions dominated by retailing losing out to jurisdictions dominated by manufacturing, but on balance this would remove a number of anomalies in the current system, in particular the excessively favorable tax base of the wealthy suburbs compared to that of manufacturing areas. VAT is a regressive tax, but not excessively so, particularly if basic foodstuffs are exempt.

With the same exemptions as Britain, a 10 percent Federal VAT could be expected to yield 3.4 percent of GDP, or $430 billion per annum on a $12.5 trillion GDP, enough to solve the budget problem although not to produce a further revenue bonanza.

Another revenue possibility would be to impose a much higher fuel tax. Using British statistics again, the fuel tax in 2002-2003 produced revenue of 22.1 billion pounds, 2.1 percent of GDP. In the U.S., fuel is already subject to some tax, so the additional revenue that could be raised by elevating gas prices to European levels would be perhaps 1.5 percent of GDP, or $188 billion per annum -- a big help in solving the deficit problem, though not a complete solution. There would however be the additional benefits of greater energy self-sufficiency and lower carbon emissions -- maybe the bureaucracy that regulates the Corporate Average Fuel Economy standards could be abolished, saving more money, since the price mechanism would now do its work for it.

Corporate income taxes have slipped as a revenue source -- from $140.4 billion (2.0 percent of GDP) in fiscal 1994 to an estimated 1.4 percent of GDP ($161 billion) in fiscal 2004 -- both early years of recovery from recession, which factor is important as corporate tax yields are very cyclical. Restoring corporate taxes to their 1994 level would yield about $75 billion per annum, about as much as repeal of all those portions of the Bush tax cuts that Kerry wants to repeal.

This can be done easily and fairly, because the relative decline in corporate tax revenues since 1994 is largely the result of a scam. Corporations, which find themselves quite unable to value executive stock options in their reports to shareholders, have no difficulty in providing a value, and a very generous one, for those options in their tax filings, and deducting the result. Consequently, all the inflated earnings of companies that grant large amounts of stock options disappear in their tax books, and the federal budget receives no benefit from tax on them. The solution to this is quite simple: corporations should not be permitted to deduct any stock option costs from their taxable income that they do not also deduct from their net income reported to shareholders.

Companies like Microsoft, that (now) report stock option grants fairly, would not be affected by this; companies like the great majority of the bloated tech sector, that play stock option games with their earnings, would be forced to pay tax on their illusory profits, and penalized thereby. This would provide at least some additional push towards the fair reporting of stock option costs, on which, appallingly, the Financial Accounting Standards Board appears likely to wimp out, announcing last week that it is considering delaying implementation of proper stock option accounting until 2006 -- giving the tech sector an additional non-election year of 2005 to bring political pressure to bear to perpetuate the fraud. At least we can make sure the federal budget is not cheated by these people.

Of course, introducing the necessary tax increases in 2005-06 will throw the U.S. economy into deep recession, just as President Herbert Hoover's tax and tariff increases did in 1930-32. But that's what you get, after the political system perpetuates an entire decade of economic bubble and flim-flam.

Grossed out by these appalling possibilities for higher taxes, and their necessity? Well perhaps your ancestors should have been more careful before they rebelled against King George III -- colonial America was among the most lightly taxed jurisdictions in the history of mankind.

Happy July 4th!

(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

Martin Hutchinson is the author of "Great Conservatives" (Academica Press, June 2004) -- details can be found on the Web site

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