3




The revenue side

he biggest surprise in the advent of the surplus, however, has come from the revenue side of the ledger and in particular from the extraordinarily rapid growth in individual income tax receipts since 1994 (see Figure 5). From 1994 to 1999, income tax payments outpaced GDP growth, increasing from 7.8 percent to 9.6 percent of GDP, the highest level in the postwar period. No new tax legislation is responsible for that increase — the 1993 tax act raised tax rates for the richest taxpayers and that was largely reflected in 1994.


Figure 5

The CBO attributed the growth in individual income tax receipts in excess of GDP growth to four factors over the period 1994-98. The first is an increase in the share of GDP that is taxable personal income, and it accounts for almost 20 percent of the excess growth in individual income taxes. The second factor is the explosion in taxable capital gains, which grew even faster than taxable personal income. It accounts for 30 percent of the income tax surge. (Capital gains realizations close to tripled over this period, with most of the increase occurring before the cut in capital gains taxes in 1997.) The third factor, accounting for 10 percent of the income tax increase, comes from a rapid rise in assorted retirement income like 401(k) plan distributions.

The most important reason for the growth in income tax receipts, however, accounting for more than 40 percent of the increase, is a rise in the effective tax rate on adjusted gross income. The effective tax rate increased for two reasons. One was an increase in real incomes, which moved more taxpayers into the highest brackets — what might be called "real bracket creep." (The income tax was indexed for inflation, but not for increases in real income.) The other factor increasing the effective rate was the relatively rapid growth in income among those taxed at the highest rate. Estimates suggest that from 1994 to 1998, the share of total adjusted gross income (agi) received by the 1.6 percent of taxpayers with incomes of $200,000 or more increased from 15 percent to 22 percent, and their share of tax liabilities increased from 30 percent to 40 percent.

The factors underlying the surge in revenues are not easily predicted. Rapid growth in the economy does not necessarily produce the kinds of changes in the income distribution or increases in capital gains that have occurred since 1994. cbo and other forecasters could not have anticipated these unusual changes. And once they occurred, there was no way to know how long they would last.

There are two additional factors that I believe contributed significantly to the evaporation of the budget deficit. One is the absence of legislation that meddled with the economy or that had major, long-run spending consequences for the budget. The ambitious Clinton health plan likely would have had such an impact on the budget, and in addition could have had a damaging effect on the economy. Gridlock seems to be good medicine for the economy.

The other factor is good luck. The surprises that occurred after 1992 turned out to be beneficial to the budget, on both the revenue and outlay sides. The stock market boosted revenues, the slowdown in medical cost increases and the switch to managed care slowed Medicaid costs, the Asian financial crisis helped lower our consumer prices by providing us with cheap imports. But such good luck cannot always be counted on.

Will the surplus last?

he sudden appearance of the surplus in 1998 brought to mind the old Cole Porter song: "Is it an earthquake, or only a shock? Is it the good turtle soup, or merely the mock?" Similarly, do we have huge surpluses as far as the eye can see? Or is it only a mirage? Obviously, a projection is just that. One way to assess the uncertainty surrounding a projection is to look at alternative projections based on alternative assumptions about the economy. The cbo report on the budget outlook provides two alternatives to the baseline projection, one based on more optimistic assumptions and the other based on pessimistic assumptions (see Table).

TABLE
CBO Estimates of Total Budget Surpluses (Deficits)
Under Alternative Assumptions (billions of dollars)




2000
2005
2010
Total 2001-2010

Economic Scenario: Assumes Discretionary Spending Is Held To CBO's Estimates of the Caps Through 2002, then Grows With Inflation

Optimistic

208
700
1,317
7,864

Baseline

176
376
633
4,234

Pessimistic

141
(4)
(142)
22

Economic Scenario: Assumes Discretionary Spending Grows With the Rate of Inflation After 2000

Optimistic

208
591
1,173
6,784

Baseline

176
268
489
3,152

Pessimistic

141
(113)
(286)
(1,058)

NOTE: The main economic assumptions that are varied in the three scenario are -- real GDP growth; the share of wages and profits in GDP; personal income taxes as a percentage of taxable personal income in the national income and product accounts; and the growth rate of Medicare and Medicaid spending. The average annual GDP growth rate over the period 2000--2010 is 3.2 percent under the optimistic scenario. 2.8 percent under the CBO baseline and 2.1 percent under the pessimistic scenario. See Tables 5.2 and 5.3 of the Budget and Economic Outlook: Fiscal Years 2001--2010, Congressional Budget Office.


The differences in assumptions between the optimistic and pessimistic scenarios reflect the dilemma of today’s forecaster, who must decide whether the future will resemble the past — meaning the past couple of decades — or whether the remarkable economic developments of the past few years point to a more favorable outlook. The cbo baseline takes a middle road, but one leaning more toward the optimistic than the pessimistic path. For example, under the optimistic scenario, the real GDP growth rate averages 3.2 percent a year over 2000 to 2010; under the pessimistic scenario it averages 2.1 percent, and for the baseline it is 2.8 percent.

Underlying the differences in GDP growth rates are differences in labor productivity growth, which is projected to grow at a 2.6 percent average annual rate under the optimistic scenario — the actual growth rate of the past three years — and 1.6 percent under the pessimistic scenario — the growth rate of the past couple of decades. The baseline assumes that labor productivity will increase at a rate of 2.3 percent.

Other key assumptions relate to the share of GDP going to income sources taxed at high rates, to personal income tax liabilities as a percentage of taxable income, and the expected growth in Medicare and Medicaid spending. With respect to the two factors that helped produce the surge in revenues over the past few years — increases in capital gains and increases in effective tax rates — the optimistic scenario assumes a continuation of this pattern for several more years, while the pessimistic scenario assumes a gradual reversal of the pattern.

The cbo projections are based on current policy and therefore assume no changes in laws governing taxes or mandatory spending. However, discretionary spending has no clear policy. So cbo assumes different possibilities. Two of these possibilities are shown in the table. The more stringent assumes that the current schedule of caps on discretionary spending are adhered to through the final legislated year, which is 2002, after which discretionary spending grows with inflation. The alternative assumption ignores the caps and has discretionary spending growing with inflation after 2000. Given the current fragility of the caps, the higher spending path is more plausible and could turn out to be an underestimate of discretionary outlays.

The pessimistic economic assumptions are remarkably close to the baseline assumptions of just a few years ago. The optimistic ones reflect the current state of affairs. The outcomes are very different. Under the optimistic scenario, the accumulated total budget surplus over the next decade (2001-2010) reaches $7 trillion to $8 trillion, depending on what one assumes about discretionary spending. But under the pessimistic scenario the surplus turns into a deficit midway, accumulating $1 trillion in deficits over the decade if one accepts the higher spending path for discretionary outlays. (If, under the pessimistic scenario, discretionary spending is held to the current caps, the lapse into deficits is delayed.)

Recently, it has become popular to view as the true surplus the "on budget" surplus, which excludes the surplus in the Social Security accounts (today’s sacred cow). If the pessimistic scenario comes true and discretionary spending grows with inflation, the on budget surplus would vanish and deficits of $3 trillion would accumulate over the decade.

In the near term it is likely that the booming economy will continue to boost revenues, producing a sizable surplus (see Figure 6). How big and for how long are the questions. There are some obvious unknowns with respect to the economy. Is inflation reappearing? Can the Federal Reserve, even with Alan Greenspan at the helm, bring off the proverbial "soft landing"? The more immediate problem, however, is the spending side of the budget. The combination of a potentially large surplus and the coming election may prove too tempting to resist this year, and belts may well be further loosened to allow for a great deal more spending than we have seen for the past few years.


Figure 6

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