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U.S.: Washington's New Challenge: Black Ink

Business Outlook: U.S. ECONOMY


Big tax cuts may be popular, but they could backfire later on

It is often said that a rising tide lifts all boats. Well, the tide of this rip-roaring economy has accomplished the economic equivalent of raising the Titanic. It has lifted the federal budget into a significant surplus.

Thanks to a record percentage of the population now at work and earning incomes, along with a soaring stock market generating huge capital gains and slower growing but still-high corporate profits, the April budget posted a record surplus for the month of $124.6 billion. The performance exceeded even the optimistic forecasts of most analysts, and it was far above the year-ago surplus of $93.9 billion, the previous April record.

The numbers all but assure a surplus for the 1998 fiscal year, which ends on Sept. 30, of at least $50 billion, and possibly greater (chart). If the expected deficit in the five remaining months is less than that of 1997, a very likely possibility, some forecasters, including the Congressional Budget Office, think the black ink could reach as high as $63 billion. Moreover, revenue growth would have to slow appreciably to prevent the 1999 surplus from topping $50 billion, as well.

The key to the budget outlook in coming months and into 1999 will be the strength of the economy. So far in the second quarter, economic growth shows signs of slowing from the powerful 4% pace of the past six quarters. The question is: Will a cooler second quarter extend into the second half? Based on the latest readings for consumer confidence, home sales, and hiring plans, the jury is still out on that.

BEYOND 1999, the budget outlook is a lot murkier for two main reasons: the economy and politics. Much of the swing into surplus has occurred because of the economy's incredible showing in the past year and a half. That means much of the budget improvement has been cyclical and thus subject to the whims of the business cycle.

To be sure, some of the movement toward surplus reflects true structural change, particularly on outlays. First, greater spending restraint has been built into past budget law. Also, the long unwinding of the defense industry and the shift toward managed care within the Medicare system are other developments that have occurred independent of economic activity.

But on the revenue side of the ledger, much of the surge in tax revenues simply reflects an unusually strong economy. April revenues rose 14.2% from a year ago, to a record $261 billion, and receipts as a percentage of GDP have risen to 21.5%, a postwar record. If the economy turns sour in coming years, revenues will tank, cutting the surplus or even eliminating it altogether. In addition, one of the biggest federal outlays, interest on the public debt, has been whittled down because lower inflation expectations have brought down interest rates.

The cyclical component of the surplus makes the budget outlook particularly sensitive to the current political debate over what to do with the windfall. The House Budget Committee on May 20 approved a five-year plan that cuts taxes by $100 billion now, but which is paid for with $100 billion in spending cuts over five years. The plan is expected to receive a close vote in the full House.

Cutting taxes in an already strong economy would not go over well on Wall Street, especially in the bond market. That's because the cuts would complicate the Federal Reserve's efforts to keep inflation bottled up, especially since extra cash would generate more demand in an economy where the unemployment rate has already fallen to 4.3%.

Tax cuts would also mean that any downturn in the economy in later years will sharply trim revenue growth. For now, the financial markets are betting that President Clinton's desire to use the surplus to shore up Social Security will prevail, although midterm elections could escalate the debate.

THE GOOD NEWS, at least for now and into next year, is that the economy will sleep the budget firmly in the black. Whatever slowdown is shaping up does not appear deep and it may not be lasting. Clearly, manufacturing has pulled back a great deal from its late-1997 pace. Also, a swing in inventory growth, from rapid accumulation in the first quarter to less stockbuilding this quarter, appears set to slow overall growth in gross domestic product.

But despite the Asian-led drag on foreign demand, the outlook for U.S. spending, especially by consumers, is still upbeat (chart, page 31). The latest readings on confidence and home buying show little change in households' willingness and ability to spend.

Moreover, third-quarter hiring plans remain highly aggressive. U.S. companies are planning to expand their payrolls next quarter by the most in 20 years, based on the quarterly survey of 15,600 businesses by the employment agency Manpower Inc. The survey says that 32% of the companies expect to hire new workers, while only 5% plan layoffs. The increase in hiring plans was not large, but it implies a continuing trend of strong job growth. The projected demand for new workers was the strongest in construction, followed by retailers and wholesalers.

THE EVER INCREASING DEMAND for labor is keeping consumers euphoric. The Conference Board reported consumer confidence fell slightly in May, to 135.2, from 137.2 in April. Both readings are near a 30-year high of 137.4 set in February. The index covering expectations slipped to 112, from 115.8 in April, but households' assessment of the current state of the economy rose to 170, from 169.3. Consumers continue to think jobs are plentiful, fueling their expectations for rising incomes.

Greater confidence in the future also continues to buoy the housing market. Although sales of existing homes fell 2.5% in April, to an annual rate of 4.77 million, the March sales rate of 4.9 million was a record. Resales over the past three months are far higher than any readings in the previous year (chart).

Robust demand, in turn, is pumping up home prices. Both the average and the median price of existing homes sold in April were 6.2% higher than houses sold a year ago. Home buyers are willing to shoulder the higher price because low mortgage rates are keeping monthly payments affordable. And a big part of the current climate of low long-term interest rates reflects the dwindling need for government borrowing.

The new wave of black ink also changes economists' view of government economic policy. For years, massive deficits meant that the only policy ship worth sailing was piloted by the Federal Reserve. But now Congress and the White House get to man their own craft. What course they will set is still unclear, but their fiscal decisions will go a long way toward determining the direction of the economy for years to come.BY JAMES C. COOPER & KATHLEEN MADIGANReturn to top

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