Economy strong (for now), fiscal deficit not falling (by much)

I have always thought the argument that attributed the widening trade deficit to the absence of growth abroad was a bit deceptive, for the simple reason that in aggregate, growth abroad has been quite strong. Yes, Europe and Japan have lagged, but much of the rest of the world -- including China -- has been growing like gangbusters. The problem there is not the absence of growth, but the composition of the growth -- strongly driven by exports. This global growth has been strong enough, in aggregate, to generate extremely good times for any exporter of natural resources ... when the US trade balance does start to adjust, it is quite possible that the adjustment will take place in a less benign global environment, one with less global growth than we have now.

The same argument holds for the US fiscal deficit.

The US economy continues to grow at a nice clip. A strong economy usually leads tax revenues to grow, and this year is no exception. Revenues, according to the CBO, are up 10.3% y/y.

The big driver of revenue growth? Soaring corporate income tax receipts (Funny, I remember when Paul O’Neill wanted to eliminate the corporate income tax on double taxation grounds). Corporate income tax receipts are up $33 billion in FY 05 (49%).

I guess, soaring corporate profits have offset falls in the effective tax rate. The temporary reduction in the tax rate on corporate profits held abroad also may be helping generate a one-time surge in tax revenues, as previously untaxed profits abroad return to take advantage of the low rate.

Spending, though, is also rising: it is up 6.7% y/y. The CBO estimates the six month fiscal deficit for FY 05 to be $291 billion, $10 billion below the FY 2004 deficit. Remember, we spend more than we collect in taxes, to tax revenues have to increase much more than spending (in percentage terms) to reduce the deficit.

The fine print of the CBO report indicate that the government has yet to really feel the impact of rising interest rates. Interest spending increased by only $6 billion in the first six months of the year (7%). The CBO thinks it will increase more sharply during the remainder of the year, leading to 10% y/y growth.

The latest budget data indicates that the March deficit was $3 billion over the CBO’s initial estimates, bringing the year over year improvement in deficit down to about $7 billion.

Obviously, April is a big month for the government -- so we ought to have a better sense of the overall FY 2005 deficit soon. But it still seems likely that the deficit is not going to fall by much (in nominal terms) this year, despite a relatively benign economic environment. That worries me: this would be a good time to build up a fiscal buffer against future bad news.

Remember, the modest improvement in the overall deficit so far this year has been driven almost exclusively by the surge in corporate income tax revenue. It is not hard to envision scenarioes where that revenue stream falls in the future.

The Bush Administration now likes to talk about its intention to reduce the budget deficit, particularly at international meetings. But I still don’t see any evidence that they are willing to do more than talk about reducing the budget deficit. Expect more rhetorical commitments from the Bush Administration around this weekend’s G-7 meetings, but no greater willingness to act.Update: I just saw an article in the Wall Street Journal (A6) indicating that the Bush Administration is abandoning efforts to cut farm subsidies back in the face of Congressional opposition. I probably have a more nuanced view on farm subsidies than your average Econoblogger: I am from a rural part of the Midwest, and know more than a few farmers personally. But you cannot cut the deficit without cutting something, and this proposal seemed targeted at limiting subsidies to very large farms. The initial call to cut back subsidies got a lot more fanfare than its demise. I suspect the same is true of the Administration’s calls to pare back certain weapon systems that parts of the DOD really want ...