The undercovered dark cloud in the shrinking-deficit story

Flurry of articles was welcome, but some cautionary notes deserved greater play

The federal budget deficit has been shrinking like a wool sweater in a clothes dryer, but that fact seems mostly lost on the American people. A Bloomberg poll found in February that 62 percent of Americans thought the deficit was growing; only 6 percent knew it was shrinking. In numerous talks and radio shows I have done since then, people have asked me repeatedly about the “growing” budget deficit.

So it was encouraging that new projections from the Congressional Budget Office a few weeks ago, forecasting even more rapid reductions in the deficit—the CBO now projects that the fiscal 2013 deficit will be $642 billion, or 24 percent less than its February estimate of a $845 billion shortfall—prompted a flurry of news reports. The brightening picture for state budgets, particularly in famously troubled California, drew a series of stories, too.

Unfortunately, there’s a potential dark cloud to this silver lining. Some of the unexpectedly sharp additional drop in the 2013 federal deficit—and in rebounding state revenues—reflects a temporary effect and a one-time event, as we shall see. And while it’s not entirely clear yet what that means for the overall economy or government budgets, these effects deserved more, and more prominent, coverage than they generally got.

The federal budget deficit was 10.1 percent of the economy in 2009, a figure that included the stimulus approved by Congress at President Obama’s urging. It’s now expected to be about 4 percent of the economy for the current fiscal year, and to fall further in the next couple years before gradually growing again. Obama’s office projects the deficit at 2.3 percent of GDP in 2018—still less than the 2.5 percent average over the previous three decades, dating back to before Jimmy Carter’s inauguration.

As for the sharp reduction in the current fiscal year—part of it is spending cuts agreed on by a now tightfisted president and Congress, part is an improving economy, and part paybacks from bailout beneficiaries including Fannie Mae and Freddie Mac, the federally chartered home loan corporations.

But many reports paid too little attention to another factor: the 2013 tax rate hikes and their effects on high-income taxpayers.

For example, Annie Lowrey’s May 15 New York Times article cites the economic recovery and fiscal austerity (both tax increases and spending cuts) as causes of the shrinking deficit. Not until the 14th paragraph did readers learn that the revenue picture was not entirely about an improving trendline:

The C.B.O. said it had bumped up its estimates of current-year tax receipts from individuals by about $69 billion and from corporations by about $40 billion. The office said the factors lifting tax payments seemed to be “largely temporary,” due in part, probably, to higher-income households realizing gains from investments before tax rates went up in the 2013 calendar year.

In a post at Time’s website, Christopher Matthews was even more focused on trendline factors:

Basically, the change can be explained by a combination of a recovering housing market—which has improved the finances of government-owned Fannie Mae and Freddie Mac—combined with a better-than-expected economy overall, which is boosting corporate and personal income tax revenues. This economic improvement is happening despite higher taxes and budget cuts enacted as part of the fiscal cliff deal reached in December, and the sequestration-related budget cuts that went into effect recently.

The framing was similar, though with slightly different emphasis in a piece by The Wall Street Journal’s Damian Paletta, who reported up high that the CBO “attributed the drastic shift to higher-than-expected individual and corporate tax payments, due in part to [economic] growth and higher [tax] rates that kicked in at the beginning of the year.” Farther down, the story points to “higher individual and corporate income and one-time moves made by wealthier taxpayers.”

A closer look at the numbers offers a clearer picture of what that means. Look at the monthly Treasury Statements for the current year and previous years, and there is a clear surge in April. Federal receipts grew almost $88 billion to $406.7 billion, up more than 27 percent from a year earlier. That $88 billion is largely from a combination of increased corporate tax revenues and both individual income and payroll taxes.

Federal revenues should grow much faster than the economy in a recovery, even a weak one. That’s because tax rates are higher on higher incomes, and the data available so far (which don’t come up to the present) show incomes rising only at the top since the depths of the recession. For the bottom 90 percent of Americans, average real incomes were actually down 6.7 percent from 2008 to 2011, according to the latest analysis of tax return data by economist Emmanuel Saez of UC Berkeley.

Ordinary income includes wages, salaries and the exercise of stock options. In 2012 the top marginal tax rate was federal 35 percent, but in 2013 that rose to 39.6 percent on taxable incomes above $400,000 ($450,000 for married different-sex couples). In addition, there is a new Medicare surcharge tax of 0.9 percent on salaries and other earned income above $200,000 for singletons ($250,000 for married couples).

The top tax rate on investment income also rose, from 15 percent to 20 percent, prompting many people to sell profitable investment at the close of 2012. And capital gains are extremely concentrated, IRS data show. In 2010, just 7,747 taxpayers—out of 143 million—reported 38 percent of all capital gains. High-income taxpayers also pay a 3.8 percent Medicare tax on most of their capital gains, dividends, interest, rents, and most royalties.

That means that the rise in revenues that helped reduce the 2013 deficit may not owe much to broadly-shared growth—and a good bit of it may just reflect the richest households shifting the earnings away from future years into 2012. A similar surge occurred in 1986, when wealthy Americans took income to avoid paying more the following year once the Tax Reform Act took effect.

That could be especially problematic for state governments, which have to balance their budgets and are vulnerable to swings in payments from rich households. The Nelson A. Rockefeller Institute of Government, which studies state finances, warned in a May 8 report that a surge in state tax revenues may be a one-off event driven by changes in federal policy. (The report came out a week before the widely cited CBO revisions, but got little play.)

The higher-than-expected revenues could be a sign that the economy in 2012 “was stronger than previously believed,” wrote researchers Don Boyd and Lucy Dadayan. But another possibility is that “the temporary surge in income may mask underlying weakness in the economy. Over the longer term, this could be bad news.”

That’s a perspective that merits more attention in all the budget and deficit coverage—but particularly for state budgets.

What would that look like? Consider this generally sunny account of California’s fiscal picture a week before the Rockefeller report came out, by Chris Merrigan of the Los Angeles Times. The article mentions up high that April 17 was the “third-highest single-day collection in California history,” but puts this warning deep down

Meanwhile, lawmakers, state officials and financial experts have cautioned that the spike in revenue may not hold.

It’s possible that Californians, fearing federal income tax hikes stemming from the budget standoff in Washington, cashed out investments late last year. Jerry Nickelsburg, senior economist at the UCLA Anderson School of Management, said federal statistics suggest many people did so.

That kind of cautionary note should go high up, even in the lede or second graf.

And as a general rule, reporters should always question any number that is sharply larger, or smaller, than expected to ascertain if it is a blip or part of a trend.

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David Cay Johnston covers fiscal and budget matters for CJR’s United States Project. He is a reporter with 46 years of experience, including 13 at The New York Times; a columnist for Tax Analysts; teaches tax and regulatory law at Syracuse University Law School; and is president of Investigative Reporters & Editors (IRE). Follow him on Twitter @DavidCayJ. Tags: , , , , , ,