Red states won - now the red ink

President Bush appeared quite cheery at his press conference last week. But that glow will be tested in the months ahead as he faces the task of putting America's fiscal house in order after four years of massive tax cuts and rampant overspending.

Everywhere he turns, pools of red ink lurk: a huge federal budget deficit, a record deficit in the current account (that is, a growing imbalance in the nation's international payments), a record shortfall in national saving, record household indebtedness, and the lowest level ever of personal savings. Some of these issues lie beyond the president's direct influence. But not the budget deficit. How Bush handles it will determine to a large extent the economic success of his second term.

"The next four years are going to be unusually challenging from the standpoint of America's economic stewardship," warns Stephen Roach, chief economist of Morgan Stanley, an investment firm. "Never before has the United States pushed the envelope to this degree.... The US economy is an accident waiting to happen."

There's one bright spot. The budget deficit, which reached $413 billion last fiscal year, may have peaked. One of the Bush tax cuts, a bonus depreciation for business, expires this year. That will add about $38 billion to revenues in fiscal 2005. The economic recovery could boost revenues another $38 billion, says the Congressional Budget Office.

That should help the president get a little closer to his goal of cutting the budget deficit in half (as a proportion of gross domestic product). But various budget experts doubt he can do it in five years, as he has promised.

The reason is that other expenses, such as Iraq, Medicare, and Medicaid, keep crowding in, and that the president has other priorities that will swell the deficit. For example, the first budget items on the Bush agenda probably will be the complete repeal of the estate tax, and then the extension of any other expiring provisions of the 2001 and 2003 tax cuts.

With a bigger Republican majority in the Senate, he will probably get them, says Charles Schultze, chief economic adviser to President Carter.

Repeal of the estate tax is favored by some Democratic senators. So it may easily gain a filibuster-proof 60 votes.

Thus, this fiscal year's deficit will hover around $350 billion, figures Richard Kogan, an expert at the Center on Budget and Policy Priorities in Washington. Beyond that point, annual deficits will run at least $300 billion for years, he calculates, adding to the national debt and its interest-rate burden.

The war in Iraq is another budget burden. It has so far cost $147 billion, of which $21 billion is for reconstruction and related aid, calculates Steven Kosiak of the Center for Strategic and Budgetary Assessments, another Washington think tank. Every month of occupation costs another $4 billion to $5 billion, he adds, which would mean another $40 billion for fiscal 2005. Other Washington reports say the president will request an extra $70 billion from Congress for Iraq.

On the plus side, from a budget perspective, is the possibility that Bush will find it politically easier to withdraw from Iraq than a President Kerry would have.

Also important could be a revival in spending restraint. In February, the president's new budget will probably call for sizable cuts in almost every program except defense and homeland security.

"Then will begin a long fight ... that will not just cause tremendous discomfort to Democrats but will rend the Republican Party," says Robert Reischauer, president of the Urban Institute in Washington. On one side will be Republicans concerned for the future of their party if such cuts disenchant voters. On the other side will be supply-side members of Congress, mostly in safe seats, arguing that trimming the size of government is more important.

The administration has not done a good job in restraining outlays in its first four years, notes Daniel Mitchell, an economist with the conservative Heritage Foundation. He's counting on better control in the next four years, plus a supply-side boost to the economy from the Bush tax cuts, to reduce the budget deficit.

So far, the trickle-down effect of tax cuts for businesses and the well-to-do has not produced an exceptionally strong upturn. But economists do expect even moderate growth to eventually step up employment and, thus, tax revenues.

Finally, here's an election-year oddity. The red states that vote Republican, the party pushing for smaller government, usually get more benefits from federal programs than they pay in federal taxes. Contrariwise, the liberal blue states are mostly net losers in that balance, notes Herman Leonard, a Harvard University economist who has studied the issue. So small-government voters benefit most from big government.