What Put A Dent In The Deficit

The stock market played a big role

It's amazing how quickly the budgetary debate can change in Washington. A year ago, Congress was projecting a $124 billion deficit for fiscal 1997 and focusing on how to close the budget gap. A year later, after the deficit came in at a scant $22 billion, Congress is debating what to do with future surpluses.

Are the politicians jumping the gun? To a large extent, the answer depends on whether last year's startling deficit decline was a one-time fluke or a reflection of persistent new trends.

Economist David A. Wyss of Standard & Poor's DRI, a unit of The McGraw-Hill Cos., which also owns BUSINESS WEEK, is cautiously optimistic, anticipating "good news on the budget" for some years to come. According to his analysis of last year's budgetary performance, it is the impact of the stock market on revenues that probably holds the key to the positive fiscal outlook.

Wyss attributes about half of the unforeseen $100 billion decline in the fiscal 1997 deficit to unexpectedly high economic growth and low inflation, a combination that boosted revenues and reduced outlays on social programs. Part also reflected tax receipts on income growth that far exceeded the rise in gross domestic product--a discrepancy that suggests that the economy may have been even stronger than reported.

The real puzzle, however, is the reason for an additional $50 billion in unexpected personal income-tax receipts--a puzzle that won't be resolved until more precise data are released in a few years' time. It's this revenue windfall that Wyss attributes to the booming stock market. A clue is the sharp rise in the effective tax rate on personal income (chart), which suggests that the revenues came disproportionately from high-income individuals who have by far the largest stock-market stakes.

To be sure, much of the $50 billion apparently took the form of taxes on ordinary income rather than capital-gains taxes. But Wyss points out that many capital-gains realizations aren't counted as capital gains. When executives' stock options are exercised, for example, the gap between current market value and their cost is treated as ordinary income. Since high-income execs are taxed at high rates, the current options boom is boosting tax receipts.

Income from 401(k) and IRA plans, which may have big stock holdings, is also treated as ordinary income rather than capital gains. And not only are many retirees now drawing on such plans, but over half of workers who change jobs cash in their 401(k) accounts--thus raising their tax bills.

Finally, Wyss notes that the mutual-fund explosion means that a lot more people now get hit with long- and short-term capital gains each year because of high stock turnover rates. And when the stock market takes off, such gains are inevitably larger, causing an even quicker rise in tax revenues.

If Wyss is right and the recent surge in tax revenues is stock market related, will it continue? Noting that households have accumulated roughly $3 trillion worth of capital gains in recent years, DRI's economists think the chances are good this year and perhaps for several years more. But the huge stock market gains of recent years cannot last forever. "Over time," says Wyss, "we expect smaller and smaller surprises."

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