Government operating under a revenue cloud

In making a newly urgent case for restraining federal spending, the White House's top budget official is warning that this year's dramatic drop in government revenue has one ominous distinction.

It was already clear that the costs of the war on terrorism and sharp increases in other spending were going to drive up the budget deficit this year, but this has been accompanied by an unexpectedly sharp drop in tax receipts. Although revenue almost always drops during a recession-as it did during the recession of 2001-Office of Management and Budget Director Mitch Daniels said that 2002 is apparently the first time that revenue has dropped for an extended period while the economy was growing.

Daniels, who has made this observation to reporters, said it showed how uncertain the government's finances were in the near future and thus why it was imperative to control spending. In lining up votes for his $1.3 trillion tax cut last year, President Bush promised to support some expensive increases in domestic spending, such as the $80 billion rise in farm spending he signed in May. More recently, with defense costs mounting, the administration is threatening to veto spending bills unless they are trimmed down.

A good deal of the budget problem, though, comes from the plunge in revenue, which the government can do little to affect. The fact that tax receipts have continued to fall during the current recovery suggests that the months ahead may hold more unpleasant surprises.

In a sense, the picture is much worse than Daniels admits, because he doesn't mention that this year's revenue drop is larger, in percentage terms, than any on record-including those that occurred during recessions and growth periods.

According to the latest Congressional Budget Office figures, revenue fell from $1.83 trillion last October to $1.66 trillion in August 2002, or about 9.3 percent during that 11-month period. Compare that to the 1981-1982 recession-probably the worst since the Great Depression-when revenue fell only 1.4 percent.

Until now, the biggest revenue losses were associated with the recessions of 1953 and 1974, but in both downturns, revenues declined by less than 9 percent. Once tax receipts are tallied for September, the final month of the 2002 fiscal year, the loss will be far and away the biggest ever.

The popular explanation for this drop-and for the fact that it is still occurring despite the economic expansion-is that it comes from the popping of the stock market bubble, and in particular from the loss of capital gains tax revenue. As distinct from income, profits from stocks sold after more than a year carry a federal tax of 20 percent, and revenue from this source exploded during the bull market of the 1990s. It is only natural, according to this argument, that revenue artificially inflated by capital gains would revert to normal after the mayhem on Wall Street.

But capital gains turn out to be a small part of the story. Before the 1990s, capital gains accounted for about 2 percent to 3 percent of tax collections; they peaked at 6 percent in the late 1990s. Even though these receipts have probably fallen by 40 percent to 50 percent, capital gains end up being only a small part of the 10 percent drop in revenue expected this year.

In an analysis of why its own forecasts were off, CBO estimates that about half the decline in revenue in fiscal 2002 came from slower growth: The economy, following the recession that ended this time last year, grew at an annual rate of only 2.9 percent for the nine months that ended in June.

Incidentally, little of the revenue loss in 2002 can be blamed on Bush's tax cut. Only $31 billion of the $172 billion drop comes from the first installment of the cut. The administration heavily loaded the costs and benefits of the tax cut into the latter part of the decade, in part to improve the short-term budget outlook. The White House even monkeyed with other tax rules to help reduce the immediate impact of the cut-$23 billion of corporate tax revenue from the previous fiscal year was shifted over to 2002, and without it the true cost of the tax cut ($54 billion) would have registered.

A clue to what is happening with revenue shows up in the latest revision by CBO. Since March, almost all of the unexpected loss in revenue has come from "technical changes," which don't include capital gains tax revisions or simple losses from a slower economy. The $104 billion in technical revisions since March has to do with changes in who is paying taxes on what. For example, because higher-income households pay taxes at higher rates, income losses for the rich hit revenues much harder than do losses for the poor, who pay far less to Uncle Sam.

This has important implications for the months ahead, because many economists feel that economic growth will be more evenly distributed than it was in the 1990s, when higher-income earners reaped a large proportion of the gains. With the stock market in the doldrums, more gains will go to lower- and middle-income earners, who pay taxes at lower rates. A narrowing of income inequality, which widened so dramatically in the 1990s, spells more bad news for federal revenues, which might not bounce back as quickly as they have before.

Even if Mitch Daniels succeeds in restraining spending, the revenue cloud over federal finances will probably remain.