Is The Budget Surplus At Risk?

A market slump's uncertain impact

Tax-cut advocates may be counting on a lot of revenue chickens that may never hatch. On the one hand, they point to the hefty $237 billion surplus racked up by Uncle Sam in the past fiscal year and to projections of a near-$5 trillion cumulative surplus over the next decade as proof that a large tax cut is well within the government's means. On the other, they claim the economy has entered a sharp slowdown that requires tax-cut therapy.

One problem, of course, is that any slowdown would carve a sizable chunk out of projected revenues. More important, there's a fair chance that tax collections could take a large hit in coming years even if a recession is avoided. "Many people don't appreciate how much capital gains generated by the stock market boom have bolstered government revenues in recent years," says Mark M. Zandi of Inc., "and how much those revenues could wane if the market moves sideways or posts only modest increases."

In a speech last year, Treasury Secretary Lawrence H. Summers noted that tax collections have risen as a share of gross domestic product even though the federal tax burden for most American families is the lowest since the 1970s. The explanation: a rise in realized capital gains (mainly from stocks), which provide tax revenues but aren't counted as contributing to GDP.

Government data tell the story. In 1994, capital-gains realizations totaled $152.7 billion, slightly higher than in 1993. By 1996, however, they had surged to a record $260.7 billion, and in 1999, by Zandi's estimate, they hit $566 billion, or nearly 6% of GDP.

Meanwhile, tax liabilities on such gains soared from $36.2 billion in 1995 to an estimated $113 billion in 1999. All told, Zandi figures that this trend accounted for a fifth of the swing from a federal deficit of $204 billion in 1994 to a $237 billion surplus in fiscal 2000.

A key question is what happened last year. Economist Joseph A. LaVorgna of Deutsche Bank Securities Inc. thinks capital-gains realizations mainly reflect recent market shifts, so he figures they declined substantially, lowering tax liabilities--and this year's tax take--by as much as $43 billion. Zandi, however, believes realized gains may have risen in spite of the market drop because many people took gains on stocks they had held for years. If so, the budgetary impact this year will be positive as tax bills come due in April, but it could turn sharply negative next year.

In any case, the outlook for big capital gains in the years ahead is dicey, to say the least. Few experts see another market boom anytime soon. And that implies reduced revenues, not only from people selling stocks but from corporations used to posting big gains on their own stock investment portfolios and on their pension fund assets--as well as from executives whose hefty past gains from exercising stock options were subject to the highest income tax rates.

"The impact of a relatively flat equity market on the fiscal health of all levels of government is a story waiting to be told," concludes Zandi.

Before it's here, it's on the Bloomberg Terminal.