Lower Deficit Sparks Debate Over Tax Cuts' Role

If growth induced by Bush's cuts doesn't explain the surge, where did all those extra tax dollars come from?

The short answer is spectacularly high corporate profits and the advancing fortunes of wealthy Americans, economists said.

Skyrocketing profits caused corporate tax receipts to jump 27 percent, to $354 billion, in 2006, the largest increase in any tax category. "After three years of strong profits, corporate tax receipts as a share of [the economy] are at levels not seen since the late 1970s," the CBO said in its August budget report.

Meanwhile, individual income tax receipts rose 12 percent, to more than $1 trillion, largely on the strength of higher salaries, bonuses and non-wage income from stock market gains, a subcategory that climbed by 20 percent, according to CBO estimates.

Why those earnings are increasing so rapidly is, at the moment, a bit of a mystery, economists said, noting that details of individual tax returns will not be available for analysis until 2008. A robust economy and a strong stock market deserve the bulk of the credit, the economists said, but tax collections are growing far faster than the economy as a whole, so those factors cannot completely explain the Treasury's good fortune or suggest how long it might last.

As recently as March, the CBO was projecting a 2006 deficit of $371 billion, despite a strong economic outlook. And administration officials in February predicted that Hurricane Katrina and its aftermath would help push the 2006 deficit to $423 billion, the largest ever in nominal dollar terms. The record is held by the 2004 deficit, though that budget gap was smaller than some deficits of the 1980s when measured against the size of the economy.

"The money flowed in in a way that no one expected," said Douglas Holtz-Eakin, a former Bush White House economist who retired last year as CBO director. "Good economic growth is not the surprise. The surprise is that profits as a whole are so much higher."

Over the past decade, the budget deficit has tracked the economy with seeming indifference to federal tax policy, shrinking during good times and swelling during downturns. The Treasury last saw a huge influx of unexpected revenue in the 1990s, after the Clinton administration and a Democratic Congress raised taxes.

In 2000, the economy was booming and the budget was in surplus when Bush campaigned for president on a promise to cut taxes. The nation then slid into a recession soon after he took office, a downturn exacerbated by the Sept. 11, 2001, terrorist attacks, the cost of the wars in Afghanistan and Iraq, and big job losses. Tax revenue plunged, spending rose, and the budget swung into deficit.

The White House successfully pushed tax cuts in 2001 and 2003, partly as remedies for an ailing economy. At the same time, the Federal Reserve slashed interest rates to four-decade lows to spur consumer spending. The economy gradually gained steam, growing at a faster-than-average pace of more than 3 percent in 2004 and 2005. The housing market took off, corporate profits surged, the stock market rebounded and many upper-income Americans pocketed big gains.

Holtz-Eakin and other economists said they can only speculate about why that economic growth generated a disproportionate jump in revenue. There have been changes in the tax code, such as the 2004 expiration of a tax that allowed businesses to immediately deduct half the value of new assets. Economists said corporations chastened by recent accounting scandals may also be paying more taxes on more of their income. And with large and growing incomes going to chief executives, athletes, entertainers, and even star lawyers and academics, those people are paying more taxes.

"The simplest way to think about it, I think, is we know we have growing income inequality, especially at the top," said Isabel V. Sawhill, a Brookings Institution economist who worked for the Clinton administration. "The very rich are pulling away from the ordinary rich and the middle class. Those very rich people pay higher tax rates. When the distribution of income shifts upward, as it has in recent years, you get a revenue kicker from that."

Staff writer Nell Henderson contributed to this report.