US budget deficit may shrink further in ’07

WASHINGTON: A slowing economy will cut the US tax revenue growth from its surprisingly robust pace of the past year, but the federal budget deficit could still shrink a bit further in FY07, some economists say.

Much depends on how quickly and deeply the economy brakes in coming months, and how this affects corporate earnings — a big driver behind the 22.3% reduction in the deficit to $247.7bn in FY06, a figure announced by the Bush administration last week.

“As long as we don’t find new things to spend money on and we have moderately sub-trend (economic) growth in the mid-2% range, it looks as if some improvement (in the deficit) is likely,” said Lou Crandall, chief economist at Wrightson ICAP. A narrowing budget deficit improves the government’s ability to pay for long-term obligations, such as Social Security and health-care benefits, and also tends to push down interest rates.

Crandall is currently forecasting a FY07 budget deficit of $200bn to $250bn. The midpoint of that range would represent a 9.2% narrowing over FY06, which ended September 30. However, if US economic growth slows to around 2% or less in coming months, the deficit will swell, he said.

The announcement that surging tax revenues had trimmed the deficit, which came a month ahead of congressional elections, gave both Republicans and Democrats ammunition for debate over President George W Bush’s fiscal policies.

Bush argued he had reached a goal to halve the deficit from a ’04 estimate three years early because his tax cuts stimulated economic growth and generated more revenues. Democrats countered that the ’04 estimate was inflated and charged Bush had squandered the surpluses he inherited when he took office, leaving the government less prepared to cope with increased demands for health care and Social Security benefits from soon-to-retire baby boomers.

“I worry that the revenue gusher over the last two years is allowing people to feel more complacent about the fiscal picture,” said Robert Bixby, director of the nonpartisan, anti-deficit Concord Coalition. “I’d feel a lot better if the deficit were falling because of reduced spending,” he said. “It would be a mistake to assume that this windfall would continue and that we’ll have a permanently higher level of tax revenues.”

Bixby attributed much of the growth in revenues to strong corporate tax payments in light of bumper profits, as well as taxes on capital gains reaped from a rebounding stock market. Indeed, earnings warnings from US companies were outpacing brighter outlooks as the third quarter closed, indicating businesses had grown less certain on profits. After shooting ahead at a 5.6% annual rate in the first quarter, US economic growth slowed to a 2.6% clip in the second. Forecasters surveyed by the Blue Chip Economic Indicators newsletter expect the economy to expand 3.4% for the year as a whole, but look for it to move ahead only 2.6% in ’07.

“We had above average economic growth which led to higher revenues. That plate has been taken off the table,” said Ken Goldstein, senior economist with The Conference Board in New York.

However, some analysts believe the economy retains plenty of vigour and can absorb a housing-market slowdown, while still generating higher revenues. James Glassman, senior economist at JP Morgan Chase in New York, said rising incomes and lower oil costs should fuel consumer spending, keeping up corporate profits and stock market gains.
“We’re not facing bottlenecks. We’ve got room to grow,” he said. “The economy has more room for improvement, so therefore the budget deficit has more room for improvement.”

Glassman added that fiscal ’2006 outlays had included $54bn in temporary relief spending in the wake of Hurricane Katrina. In addition, he said many investors are sitting on unrealised capital gains that may be tapped in future years.

The decline in the deficit “is a reminder that when the economy recovers, you’re going to restore a lot of lost revenues. The (government’s) response to the economic threats five years ago were appropriate,” he said, referring to large tax cuts pushed through Congress by the White House.

But even if the economy avoids a recession over the next two years and the deficit is drawn down further, spending pressure from Social Security and Medicare will gain momentum and could threaten to swamp federal resources. Milton Erzati, senior economic and market strategist at Lord Abbett, said costs for Medicare and Medicaid alone could rise to 12% of GDP from 4% now, forcing hard choices for benefit cuts.