Oct. 30 (Bloomberg) -- The U.S. Treasury cut the amount it plans to borrow from investors this quarter by 39 percent because of an unanticipated surge in tax revenue.

The decrease might provide a lift to government bonds, which rallied last week on a report of weaker home sales and comments by the Federal Reserve suggesting inflation will slow. The Treasury plans to borrow $63 billion during the quarter, compared with a projection of $104 billion in August.

A 27 percent jump in corporate tax revenue shrank the U.S. budget deficit for the year ended Sept. 30 to $248 billion, the smallest in four years. Lehman Brothers Inc. and Morgan Stanley a year ago predicted the fiscal 2006 shortfall would total more than $400 billion because of spending on the war in Iraq and to rebuild after Hurricane Katrina.

``The improving fortunes of the U.S. budget deficit is one of the great stories for the bond market this year,'' said William O'Donnell, head of U.S. debt strategy in Stamford, Connecticut, at UBS Securities LLC, one of the 22 primary dealers required to bid on government debt auctions.

Yields on benchmark 4 7/8 percent notes due in 2016 fell 12 basis points, or 0.12 percentage point, to 4.67 percent last week after the Fed predicted inflation would cool and prices of new homes fell. Ten-year yields, which move inversely to prices, have dropped 12 basis points since Oct. 13. Treasuries gained 3.64 percent in the third quarter amid forecasts for slower growth, according to data compiled by Merrill Lynch & Co.

The 10-year note yielded 4.67 percent today in New York.

Deficit Reduction

President George W. Bush, who inherited a surplus of $237 billion in 2000, says the reduction of the deficit is evidence his tax reductions are helping the economy. An economic slowdown, costs for the wars in Afghanistan and Iraq and $2 trillion of tax cuts resulted in a record deficit of $413 billion in 2004.

Treasury yields declined during Bush's presidency. The 10- year note's yield, which averaged 6 percent in 2000, hasn't exceeded 5.5 percent since.

``All else equal, rising deficits will lead to higher yields,'' said Gerald Lucas, senior investment strategist at primary dealer Deutsche Bank AG in New York. ``The big caveat is `all else equal.' If deficits go up because growth is slowing, rates will go down.''

The longer-term outlook for the deficit remains bleak, with the nonpartisan Congressional Budget Office forecasting it will widen to $304 billion in fiscal 2009, an estimate that doesn't take into account the likelihood Congress will extend tax cuts that are slated to expire.

The Treasury Department said it anticipates borrowing $175 billion in January through March, eclipsing the record $158 billion it borrowed in the first quarter of this year.

`Serious Mistake'

To extrapolate from the current trend ``would be a serious mistake,'' said Peter Peterson, chairman of Blackstone Group LP in New York and a critic of the budget and trade deficits. ``Sometime in the future, you're going to see a significant drop in the dollar and with that, a significant increase in interest rates'' to attract foreign capital.

The government in May 2003 resumed selling three-year notes after a seven-year break, and increased the frequency of its five-year note sales to monthly from quarterly. It began semiannual sales of 30-year bonds in 2006 after a five-year hiatus, and plans to sell them quarterly starting next year.

Forecasters were surprised by the growth rates of corporate income taxes and individual income taxes on bonuses, commissions and stock options that are not withheld from paychecks, said Stephen Stanley, chief economist at primary dealer RBS Greenwich Capital in Greenwich, Connecticut.

Corporate Revenue

``Tax receipts continue to grow faster than anyone expected,'' Stanley said. ``We've gotten to the point where it's starting to make a big difference in terms of Treasury issuance.'' RBS Greenwich forecasts a fiscal 2007 deficit of about $210 billion and cuts in note auction sizes, Stanley wrote in a report today.

In fiscal 2006, the government borrowed $237 billion from investors, almost $100 billion less than the Congressional Budget Office estimated it would a year earlier.

Corporate profits have climbed 22 percent in the third quarter with more than 300 of the companies in the Standard & Poor's 500 Index having released results so far. At the beginning of the quarter analysts were forecasting earnings growth of 15 percent. Earnings are forecast to rise another 10 percent in the current quarter, bolstering tax payments.

Higher-than-forecast tax revenue also has prompted Spain, Greece and the Netherlands to pare sales of debt this quarter. Portugal and Italy may further reduce the total amount of long- maturity European government debt to be sold this quarter to an estimated 11 billion euros ($14 billion), from 16 billion euros two months ago, according to Deutsche Bank estimates.

A 1 percentage point increase in the deficit as a share of gross domestic product, lasting for three years, adds 0.40 to 0.50 percentage point to 10-year note yields, according to a study last year by the National Bureau of Economic Research.

Reducing Sales

The U.S. government so far has reduced sales of Treasury bills, which mature within six months. Auction sizes for notes and bonds, which mature in two to 30 years, have generally been maintained.

Decreasing the size of an auction is a sign the government knows its finances are vastly improved, said Lou Crandall, chief economist at Wrightson ICAP, a Jersey City, New Jersey-based research firm.

Treasury officials in September reduced the size of the monthly two-year note auction to $20 billion from $22 billion. The government hadn't reduced the size of a note or bond auction since last year. They probably will decrease the quarterly three- year note to $20 billion or $19 billion, from $21 billion, when the sizes of the next quarterly auctions are announced on Nov. 1, Crandall said.

The deficit may decline further if Democrats gain a majority in Congress in next week's elections, UBS's O'Donnell said. Republican control that started in 1995, when Democrat Bill Clinton was president, produced a standoff that allowed revenue expansion to outpace spending growth, resulting in surpluses.

``The smaller these issues get, the better it is for the borrower,'' said Raymond Remy, head of fixed income at primary dealer Daiwa Securities America Inc. in New York.

To contact the reporter on this story: Elizabeth Stanton in New York at estanton@bloomberg.net

Last Updated: October 30, 2006 15:35 EST