If a Deficit Falls in the Forest, Do You Hear It?

Aug. 11 (Bloomberg) — If a deficit falls in the forest, does anyone hear it? And if no one hears it, did the deficit really fall?

That's the question that administration officials must be asking themselves after the report that the Congressional Budget Office issued earlier this month. The CBO announced that the federal deficit is indeed falling, or narrowing, the more precise verb for the phenomenon.

This year, the new report says, the deficit will be $260 billion, or $111 billion less than the CBO estimated in March. For 2006, the government deficit will be 2 percent of gross domestic product, down from the old baseline prediction for 2006 of 2.6 percent. On Aug. 17, when the more extensive annual Update of the Budget and Economic Outlook appears, that 2 percent figure is likely to show up more definitively. But neither the budgeteers' news nor the prospect of a confirmation of it is generating much discussion.

This is surprising. The Economic Report of the President shows the federal deficit for 2004 was 3.6 percent. A narrowing of more than 1 1/2 percentage points in such a short time is itself a story.

The U.S. deficit is worth comparing, for starters, with the data for European nations. In the Maastricht Treaty of 1992, European leaders set a deficit goal of 3 percent of GDP. EU member countries have had trouble meeting that target since.

A shortfall of 2 percent of GDP is also news in the U.S. context. Sure, there was the surplus in the second half of the 1990s. But 2 percent is below the average for the federal deficit between 1980 and 1995.

Times of War

The 2 percent figure stands out when you compare it with the deficit level in other periods of war. In 1944, as the U.S. poured its energy into winning World War II, the federal deficit widened to 22.7 percent of GDP. In 1968, the year of the Tet Offensive in the Vietnam War, the deficit was 2.9 percent of GDP.

Much of the narrowing of the deficit in the 1990s — and even the surplus of the late 1990s — came because of reductions in military spending following the end of the Cold War. This was the short-lived peace dividend. The late 1990s boom also played a role: It brought in hundreds of billions more than forecast.

Also interesting is what caused the change between spring 2006 and summer 2006. Thrift on the part of lawmakers, needless to say, isn't the cause, though one reason the deficit narrowed is that the government hasn't been able to spend all the cash it had allocated for projects this year.

Unexpected tax revenue also contributed to the narrowing. Some of this money is payroll taxes. With employment so high, more workers are paying into Social Security and Medicare than predicted.

Higher Earners, Higher Taxes

Yet another source of cash is income taxes. Over the years, the tax distribution tables shifted so that higher earners paid a much larger share of income taxes. Their payments are less predictable than those of lower earners, who don't exercise options, receive bonuses or have as much discretion in choosing when to realize a capital gain.

Extra corporate taxes also flowed in and are 27 percent higher than in the year-earlier period. Overall, the data suggest that tax revenue as a share of the economy for 2006 will be 18.4 percent of GDP, above the average for the past 30 years.

All this good news doesn't preclude budgetary bankruptcy in the future. Only structural change that includes both an overhaul of Social Security and reversal of the Bush administration's Medicare drug plan can do that.

No Spinning Here

This last point is likely to be in the headlines whenever the CBO story finally does splash. So too will be the argument that government economists are being crafty. Republicans used to accuse the CBO of depriving them of an opportunity to cut taxes by low-balling its revenue estimates. For years, House Speaker Newt Gingrich entertained editorial boards with rampages about the uncooperativeness of then-CBO director June O'Neill. O'Neill, a steadfast numbers person, blithely ignored him.

These days, the Democrats are the ones doing the accusing. They charge that the Office of Management and Budget and the CBO fiddle with their revenue estimates and low-ball them in the same fashion that corporations do for earnings forecasts. They also say the goal is the same: to create a pleasant surprise when the real data turn out better than expected.

This last argument has as little merit now as it did in O'Neill's day. The CBO's mandate is to stay neutral. CBO's acting director, Donald Marron, is likewise impervious. Even if Marron were the spinning type, it would be in his interest to produce objective figures. He hopes to be confirmed in his job next year, a time when Democrats may control the House.

Yet such details obscure the larger meaning of the deficit change. The new data supply evidence that President George W. Bush is right: lowering tax rates doesn't cause deficits, and can even diminish them. Meanwhile, the U.S. economy is forging through a whole forest of difficulties right now — the war, higher energy prices, a cooling housing market.

The narrowing deficit of 2006 is worth noting. To find your way out of the woods, you have to know what goes on inside them.

(Amity Shlaes is a Bloomberg News columnist. The opinions expressed are her own.)

© Copyright 2006 Bloomberg

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