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The Incredibly Brief Tax Windfall

By Howard Gleckman At first glance, the news could hardly be better for the nation's budget watchers, a group whose congenital gloom is rivaled only by Chicago Cubs fans in October. Suddenly, federal coffers are being flooded with unexpected tax payments. Collections are up a stunning $183 billion from last year. The dollars are appearing like manna from heaven.

Sadly, though, this is the federal budget, where all silver linings have clouds attached. And upon further examination, there may be less to this boomlet than meets the eye. Says Congressional Budget Office Director Douglas Holtz-Eakin: "There's nothing that looks like the leading edge of a long-term revenue windfall."

OFFSETTING FACTOR. Sure, the tax payments are welcome. Driven largely by a combination of 2004's big increase in corporate profits and a surge in payments by wealthy individuals, the extra cash will bring down this year's deficit by a bit more than 10%.

But budgeteers disagree on whether the windfall will continue for more than a year or two. Most concur that even if it does, it will have little impact on medium and long-term deficits. That future tide of red ink will be driven by a staggering boost in health programs such as Medicare and Medicaid, which threaten to overwhelm any growth-driven surges of tax collections.

Think of it this way: The new tax payments will increase federal revenues to roughly 17.7% of gross domestic product, close to the post-World War II average of around 18%. But spending already tops 20%, and long-term health costs could take that to 25% in just two decades. "No way the current tax system can finance that increase in spending," says Heritage Foundation economist Dan Mitchell.

TOUGH CHOICES. However, the new money should relieve short-term deficit pressure. Most figure it will narrow this year's gap to roughly $350 billion, sharply below last year's $412 billion and CBO's January estimate of $394 billion.

Yet while revenues are rising, so is spending -- up $110 billion already this fiscal year. And analysts fear that better-than-expected taxes will give lawmakers a new opportunity to spend even more, pushing deficits higher.

A big highway bill is in the works, so is a new energy bill. "The risk is that this will focus attention on the good news, instead of the tough choices," says Maya MacGuineas, president of the Committee for a Responsible Federal Budget.

Few expect the good news to continue for long. Economists Ed McKelvey at Goldman Sachs and Mark Zandi at both figure the deficit will remain at $350 billion in fiscal 2006. And both expect the national debt to rise by $4 trillion over the next decade, little changed from earlier estimates.

SHUNNING SHELTERS? To understand why, look at what accounts for the windfall, which was driven by last year's bustling economy. Thanks mostly to the boom in profits, corporate revenues are $142 billion so far this fiscal year, compared to just $96 billion through May 2004.

But the taxes businesses paid in April and May reflected economic activity that mostly occurred in 2004, when profits were up by almost 16%. Other factors may also be at work, including a big temporary tax break for investment in capital equipment and a possible decline in the use of tax shelters.

Will the tax surge continue? Not likely. Profit growth is slackening, and those investment tax breaks have expired. And even if sheltering slowed, says Zandi, "I don't know how long that's going to last."

SMART GROWTH. The individual tax story is also related to 2004's boom. The economy grew smartly. So did wages and personal income. But the increase in tax collections came mostly from those in the top brackets -- probably generated by bonuses, stock options, and capital gains.

Much was likely the result of last year's late run-up in stock prices. In the fourth quarter of 2004, the Standard & Poor's 500-stock index rose by nearly 10%. That put many options back in the money, after years of being underwater. And relieved execs may have cashed out.

The strong fourth-quarter market may also have produced late capital-gains distributions from mutual funds. Finally, analysts are looking at bonuses, both from Wall Street and the booming housing market, where real-estate agents and mortgage brokers scored big.

ENCORE PERFORMANCE? Trouble is, overall economic growth is moderating, the market has been heading sideways, and some early signs indicate housing may be topping out. If those trends continue, don't expect a repeat of this year's revenue surprise come next April.

Analysts see one sign that tax payments may continue to come in a bit higher than budgeteers expect. As the rich get richer, they're paying more taxes. Big increases in income drive wealthy families into higher brackets and generate more dough for the Treasury, a trend government number-crunchers may still be underestimating.

But even if top-bracket taxpayers pay more, they'll never generate enough to support the government's massive long-term liabilities. So while this year's surprising revenue gusher is good news, it won't be much more than a blip on the fiscal radar screen over the next 10 years. Gleckman is a senior correspondent in BusinessWeek's Washington bureau

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