US deficit shrinks: a vindication for tax cuts?

President Bush promised last year to cut the federal budget deficit in half in five years. Any chance of that?

"I'm very pessimistic," says George Krumbhaar, a senior editor at USBudget.com. Many budget experts would nod their heads in agreement.

But a surge in tax receipts has offered some encouragement. For the first eight months of this fiscal year, the government ran a deficit of $272 billion. That's down from the $346 billion deficit for the same months in fiscal 2004. Receipts were up 15 percent from last year.

While that revenue surprise won't cure the nation's overspending problem, it has set off a flurry of budget speculation. A number of economists are lowering substantially their estimates for this year's deficit. Ed McKelvey, an economist with Goldman Sachs, for example, revised his forecast of the fiscal 2005 deficit to $350 billion, down from $412 billion. Some hope, perhaps unjustifiably, that the deficit will continue to shrink.

Meanwhile, experts are trying to figure out where the extra revenue came from. Leonard Burman, a former Treasury official and now an economist at the Urban Institute, suspects the April-May revenue jump reflects a surge in nonwithheld personal taxes - big bonuses, for instance, paid by Wall Street firms to their executives and other top employees, or handsome capital gains from stock sales in the resurgent stock markets.

Another factor: The well-to-do have been getting richer, and they still face higher tax rates than average taxpayers or the poor, despite the Bush tax cuts.

Thanks to a rise in corporate profits last year, corporate tax payments have also risen 47 percent. Moreover, a special tax break, a bonus depreciation on investments in plant and equipment, expired at the end of 2004.

Perhaps the most interesting speculation revolves around whether long-term effects of tax cuts are beginning to kick in. Many supply-side enthusiasts certainly believe they are. The new tax revenue numbers are "an eye-popping vindication of the Laffer Curve and the Bush tax cut's real economic value," wrote a Wall Street Journal editorial writer.

The Laffer Curve, named after Arthur Laffer, a White House economic adviser during the Reagan administration, is getting renewed attention. Briefly, it says that the tax on the last dollars earned - the so-called marginal tax rate - has a huge impact on individual effort and enterprise. So, the theory goes, substantial cuts in the marginal tax rate will generate lots of new business and, thus, boost tax revenues. An extreme version of supply-side theory says the gain in revenues could fully offset the revenues lost from the tax cut.

This isn't a new observation. Muslim philosopher Ibn Khaldun wrote in the 14th century: "It should be known that at the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments." Even President Kennedy in his 1963 economic report urged trimming the then 90 percent marginal tax rate, noting that "reducing taxes is the best way open to us to increase revenues."

Reagan's tax cuts in the 1980s were so large that they stimulated a decades-long debate over their economic and revenue impact. That debate was never fully resolved. The problem is that thousands of factors affect the nation's gross domestic product - its output of goods and services. Even the most sophisticated models of the economy have trouble sorting out what affects what.

Now the Bush tax cuts are stirring the same kind of debate. Is this spring's revenue surprise the start of a supply-side surge? Supply-side economists certainly think so. They point out that, under Bush, top tax rates on dividends have been slashed from 30.6 to 15 percent and on capital gains from 20 to 15 percent. That should encourage more people to invest, they argue.

But others are skeptical that the Bush tax cuts do much besides giving a short-term boost to the economy. Richard Kogan, an economist at the Center on Budget and Policy Priorities, a Washington think tank, sees the surge as a "Keynesian" phenomenon - the combination of the tax cuts and the swell in federal spending pumping more money into consumers' hands. That kick to the economy peters out quickly. Moreover, the big buildup in federal debt will become a drag on the economy, he says.

So who should you believe? Raise your eyebrows if anyone claims to know for sure. Forecasting federal budgets alone is tremendously complex. That's partly a math problem. The deficit is the difference between two huge numbers - federal revenues and federal outlays. A small shift in either one (both exceed $2 trillion) can cause a sharp deficit change.

Mr. Burman recalls how routinely the Treasury erred in its deficit forecasts when he was an official there in the 1990s. The latest revenue surprise is simply one more sign that budget forecasting remains an art, not a science.