Global Policy Forum

By Mark Trumbull

With the robust economy, tax revenues are pouring in. But rising costs lie ahead.

Despite the ongoing costs of US military campaigns in Iraq and Afghanistan, the outlook for the federal budget has grown substantially brighter. Tax revenues are rising much faster than spending, according to Treasury Department numbers released last week. The recent trend is strong enough that, were it to continue, the budget could move into surplus in barely a year, one economist calculates. Already, the federal deficit is shrinking toward about half the size that it has averaged since 1970, when analyzed as a percentage of gross domestic product.

The shift reflects a strong economy, with higher incomes and corporate profits generating a bigger flow of tax revenue. In turn, the Treasury's progress could help the economy by buoying investor confidence in the nation's fiscal position. Although it is a welcome change, the improvement does little to stave off the long-run challenges to the nation's financial health, many economists say. Baby boomers are starting to retire, placing new demands on government. Costs for healthcare programs like Medicare are still projected to rise faster than overall inflation.

"The picture is getting brighter," and if there's no recession over the next several years "there are going to continue to be some good strides made," says Mark McMullen, a senior economist at Moody's Economy.com in West Chester, Pa. But "it's unlikely that we're going to see a balanced budget anytime in the near or long term."

Some experts say the budget could achieve balance in the short run of the next few years. In unveiling its proposed budget this month, the Bush administration forecast black ink on the federal ledger in 2012. The nonpartisan Congressional Budget Office (CBO), in its recent annual outlook, also shows a surplus for that year. A year ago, the CBO's forecast for the 2007 fiscal year called for a deficit of $270 billion. In the annual outlook released last month, the 2007 gap is projected at $172 billion.

"Right now, we're in some sense in a relatively good spot," says Jim Horney, a budget analyst at the Center for Budget and Policy Priorities, a liberal think tank in Washington. "We're in the sixth year of an economic expansion," a time when federal revenues often rise along with a growing economy.

But both the CBO and the White House make important assumptions that are far from assured. The CBO's annual outlook assumes that President Bush's tax cuts phase out in 2010 as scheduled, thus adding new tax revenues. Mr. Bush's budget calls for the tax cuts to be made permanent, but foresees a surplus in 2012 thanks to a sharp fall in Iraq spending and robust productivity growth in the economy.

But several issues are unsettled. Among them: How much will military operations in Iraq and elsewhere cost? Will Congress make some of the Bush tax cuts permanent? Will Congress scale back the alternative minimum tax (AMT), which is poised to take a rising tax toll on middle-class Americans in the years ahead? The answers will have a big impact on the budget, and may not be resolved before a new president takes office in 2009. The long-term outlook remains sobering, all sides agree. The cost of Medicare, in particular, is slated to soar due to healthcare inflation and an aging population.

Even the near-term outlook comes with an asterisk. When Bush took office in 2001, the CBO was forecasting a decade of budget surpluses totaling more than $5 trillion. Then came a recession, the terrorist attacks of 9/11, and enormous wartime spending. The Bush tax cuts helped to stimulate the economy, but at the cost of lower tax revenue.

"We had three years where revenues went down," says Mr. Horney. "All that has happened is that we have ... caught up from the really bad decline that we had."

Still, analysts say the recent budget gains are good news for the government and the economy. The budget deficit now stands at about 1.4 percent of the nation's GDP, well below the 2.3 percent that's been the norm since 1970, according to economist Michael Darda of MKM Partners in Greenwich, Conn. "At the current pace, the budget could move back into surplus as early as May 2008," Mr. Darda wrote in a report to clients last week.

That isn't a forecast, but it shows how the nation's fiscal health is closely related to that of the overall economy. A more stable budget outlook, in turn, has benefits for the economy. The less money the government has to borrow to pay its bills, the more is left for investment in new goods and services. Alternatively, the nation will be less reliant on foreign lenders to fund that investment – debt that siphons away a portion of national wealth.

"Unexpectedly strong revenue growth" has improved the outlook quite a bit, says Mr. McMullen. In the CBO projections, for example, the nation's public debt is forecast to fall from 37 percent of GDP in 2006 to 30.5 percent of GDP in 2012. In the longer run, the rise of entitlements such as Medicare could force difficult choices to keep that debt from rising again.

Conservatives say it will be vital to contain costs. "If nothing changes in Washington then both revenues and spending will be higher," says Chris Edwards, a tax expert at the libertarian Cato Institute in Washington. "It'll hammer the economy," he says, as government takes a larger share of GDP.

Others say the answer will probably involve tax hikes as well as some reductions in promised entitlement benefits – and that a modest increase in taxes need not damage economic growth. Both sides agree on the need to tame medical inflation, if not on how to do it.

"If we were able to reduce the growth of the cost of healthcare," says Horney, "that would definitely be good for the economy."