By Christopher Farrell
Call it a case of lag time among the government types. Since last spring, different groups have successively -- albeit reluctantly -- dealt with the fallout from the stock market's decline. Investors were first. Managers and executives were next to confront the painful reality. But it seems policymakers have yet to acknowledge the negative impact the market's contraction is likely to have on federal and state finances.
Investors confronted it early on. When the Nasdaq began its plunge in early March, they painfully reevaluated innovative high-tech companies with plenty of promise -- but no profits. Wall Street held out hope that the rest of the market wouldn't tank. But eventually, both professional and individual investors realized their overall corporate-earnings expectations were far too high.
Next, it was management that tried to underplay the fallout of the falling market. The high-tech wipeout was a much-needed correction for the fast-money crowd, not an ominous sign for the economy or their business, they told themselves. Today, management is hunkering down for tough times by scrutinizing the basics of their operations -- cash flow, accounts receivable, costs, debt, and capital-spending plans.
But policymakers seem stuck in a state of relative denial. The Congressional Budget Office is projecting a cumulative $4.6 trillion surplus from fiscal 2001 to 2010. The White House Office of Management & Budget has a $4.4 trillion figure. Washington legislators assume huge surpluses when they talk about tax cuts.
Yet the decline in the stock market could slice into the expected tax revenues that shore up the surplus projections. The market accounted for about a third of the money that caused the shift from a $204 billion federal deficit in fiscal 1994 to a surplus of $237 billion in fiscal 2000, according to calculations by economic consulting firm Economy.com. "The stock market really permeates the revenue projections," says Rudolph G. Penner, senior fellow at the Urban Institute and director of the CBO from 1983 to 1987.
The key is realized capital gains, an important tax revenue stream for federal coffers. The stock market rose fourfold from 1994 to 2000, and realized capital gains jumped fivefold, from $135 billion to an estimated $5.5 trillion. Yet in a recent report, Mark M. Zandi and Mark McMullen of Economy.com warn the government's capital gains take will dramatically shrink in 2001 and 2002. For instance, many stock-option packages are now worthless, and investors are looking at slimmer gains in their portfolios.
Of course, forecasting capital gains is tricky. Among the key assumptions in their model are a four-year holding period for stocks and that stock trading declines in a weak market. Their model has realized capital gains at a huge $549 billion last year: Despite 2000's poorly performing market, many investors still enjoyed huge gains from four years ago. But if the stock market stays flat for the next two years, realized capital gains could plummet by a third this year, to $374 billion, and drop to $318 billion in 2002.
An unexciting stock market is the main reason why Zandi's and McMullen's long-term cumulative budget surplus is $1.6 trillion less than the CBO's official projection. And their lower surplus figure doesn't take into account tax cuts or any increased spending above the rate of inflation. And both are coming.
It's not just the federal tax coffers that will be less full. Many state governments, such as Minnesota's, have been enjoying huge surpluses in recent years but, as with the feds, will likely collect less in capital gains over the next two years. "After years of positive tax revenue surprises and rising surpluses, budgeters have been able to pay down debt, fill rainy-day funds, and become increasingly aggressive in cutting government taxes and hiking government outlay," write Zandi and McMullen. "At best, there will be significantly fewer such opportunities for policymakers in the coming year, and for some, there will be an increasing number of hard budget choices to make."
It's almost impossible to imagine a return to the sea of red ink that characterized the federal budget deficits of the 1980s. But it's easy to see budget surpluses being lower than the long-range projections suggest. And the sooner the policymakers realize this, the better.
Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over National Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BW Online
Edited by Beth Belton