The federal government closed the books on fiscal 2005 a little over a month ago, and it was a great year. One of the strange quirks about reporting on the federal budget is that projections—which are ultimately just guesswork—tend to be much more closely scrutinized than the final, actual budget numbers. Because projections have consistently overstated the size of the deficit, many Americans have been misled by bad news, and are not fully aware of the dramatic supply-side success story of the 2003 Bush tax rate cuts.
The bottom line is that the federal budget deficit, contrary to hand wringing in all political corners, came in at only $316.8 billion in 2005. To put that in perspective, it’s 23 percent lower than the 2004 deficit, and 25 percent lower than the White House Office of Management and Budget predicted back in February. Relative to the size of the U.S. economy, the deficit is even more modest, at only 2.6 percent of gross domestic product. That’s smaller than the annual deficit was in every single year from 1980 to 1994, and just slightly more than half the 1985 deficit of 5.1 percent of GDP.
The improvement was not driven by spending restraint, which has been hardly existed over the last five years. (I’m hopeful that the deficit reduction reconciliation bill pending in Congress will turn the tide on that count.) It was driven by a dramatic increase on the revenue side, powered by President Bush’s 2003 tax bill.
It wasn’t revenues that Bush cut in 2003, but rather tax rates, which is a crucial distinction. As both JFKs understood, Jack F. Kemp and Jack F. Kennedy, reducing tax rates is often the most effective was to raise more tax revenue. In particular, reducing taxes on savings and investment increases the incentives to expand production, growing the economy and the tax base along with it. For federal revenues, economic growth is everything.
The provisions most responsible for our accelerating economic recovery were the capital gains rate cut, the dividend rate cut, and small business expensing. These measures boosted the after-tax returns on capital and encouraged a sharp turnaround in business investment, particularly in equipment and software.
Consumer spending never flagged much during the recession, growing by a solid 2.5 percent even in the recession year of 2001. The story of the recession was a collapse in business investment, which declined in real terms two consecutive years, shrinking 7.9 percent in 2001 and another 2.4 percent in 2002. The 2003 tax rate cuts supercharged business investment, which climbed by 4.4 percent in 2003 and an outsized 13.2 percent in 2004.
The result of this robust supply-side expansion has been a gusher of federal tax revenues. Corporate income tax receipts have now logged two consecutive years of real 40 percent increases, nearly doubling between 2003 and 2005. Individual income tax receipts were flat in 2004, but in 2005 they jumped a robust 9 percent as the economic recovery has continued to gain strength. Overall, federal tax revenues, after four consecutive years of decline, have now staged two positive years, growing 3 percent in 2004 and 9 percent in real terms in 2005. Revenues for 2005, at $2,145.3 billion, a hundred billion dollars more than the White House Office of Management and Budget and the Congressional Budget Office were projecting earlier this year.
With tax policies driving such robust revenue growth, it’s a wonder that there isn’t unanimity for extending the capital gains and dividend rate cuts and the expensing provisions. Proponents of big government should recognize that the best way to soak the rich is to keep rates low and the economy rolling along. Congress should act promptly to at least extend these provisions through 2010, which is possible within the upcoming tax reconciliation bill, and continue to push for making them permanent. If Congress can achieve even moderate spending restraint as well, there will be nothing but good news to report on the federal budget deficit.