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Lower Deficit Sparks Debate Over Tax Cuts' Role

By Lori Montgomery
Washington Post Staff Writer
Tuesday, October 17, 2006

With great fanfare, President Bush last week claimed credit for a striking reversal of fortune: New figures show the federal budget deficit shrinking by 40 percent over the past two years, a turnaround the president hopes will strengthen his push for further tax cuts.

Bush hailed the dwindling deficit as a direct result of "pro-growth economic policies," particularly huge tax cuts enacted during his first term. "Tax relief fuels economic growth. And growth -- when the economy grows, more tax revenues come to Washington. And that's what's happened," Bush said.

Economists said Bush was claiming credit where little is due. The economy has grown and tax receipts have risen at historic rates over the past two years, but the Bush tax cuts played a small role in that process, they said, and cost the Treasury more in lost taxes than it gained from the resulting economic stimulus.

"Federal revenue is lower today than it would have been without the tax cuts. There's really no dispute among economists about that," said Alan D. Viard, a former Bush White House economist now at the nonpartisan American Enterprise Institute. "It's logically possible" that a tax cut could spur sufficient economic growth to pay for itself, Viard said. "But there's no evidence that these tax cuts would come anywhere close to that."

Economists at the nonpartisan Congressional Budget Office and in the Treasury Department have reached the same conclusion. An analysis of Treasury data prepared last month by the Congressional Research Service estimates that economic growth fueled by the cuts is likely to generate revenue worth about 7 percent of the total cost of the cuts, a broad package of rate reductions and tax credits that has returned an estimated $1.1 trillion to taxpayers since 2001.

Robert Carroll, deputy assistant Treasury secretary for tax analysis, said neither the president nor anyone else in the administration is claiming that tax cuts alone produced the unexpected surge in revenue. "As a matter of principle, we do not think tax cuts pay for themselves," Carroll said.

But, he said, "we do think good tax policy can lead to important economic benefits. . . . The size of the tax base is larger than it would have been without the tax relief."

The subtleties of that argument have been lost on the campaign trail. With less than three weeks to go until the Nov. 7 election, Republicans are promoting the good fiscal news, eager to talk about something other than the House page scandal and mounting casualties in Iraq.

House Speaker J. Dennis Hastert (R-Ill.) claimed credit for "driving down the deficit" and accused Democrats of plotting to roll back the tax cuts if they win a majority in the House, a move Hastert said "would destroy jobs and hurt the economy." Bush, meanwhile, called on Congress to permanently extend the cuts, which are scheduled to expire by 2010, at an additional cost to the Treasury of $2.2 trillion by 2016, according to CBO estimates.

Democrats criticized the president for celebrating a deficit that still ranks among "the largest in our nation's history," as House Minority Leader Nancy Pelosi of California put it. And they pointed to CBO projections that the deficit will rise again next year and balloon in coming decades as 78 million retiring baby boomers make claims on Social Security and Medicare.

"The truth is that the administration's fiscal policies have failed," said Sen. Kent Conrad (N.D.), the senior Democrat on the Senate Budget Committee. "They have not benefited most Americans. They have dramatically worsened our long-term budget outlook. And they are putting our fundamental economic security at risk."

Without question, the deficit is receding. Despite spending swollen by storm cleanup on the Gulf Coast and the war in Iraq, the deficit fell to $248 billion in the fiscal year that ended Sept. 30, down from a record $413 billion in 2004, as higher tax receipts poured into the government's coffers.

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.

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