The Case of the Missing Tax Billions

By Howard Gleckman

It was late August in Washington, D.C. Ninety-eight degrees in the shade -- if you could find any. The air was thick and wet and steamy. It was the kind of day only my dry cleaner could love. But I had business. Bad business.

Three hundred and seventy-five billion federal tax dollars had gone missing, evaporated like a puddle on an overheated sidewalk. How could even the slippery-fingered pols in Washington lose so much cold cash on a hot day?

My job was to find out what happened to the dough. The New York suits were asking. And when they ask, I answer. After all, I had an air-conditioner repairman to pay.

I got word that hot day about the missing 375 big ones. But the guy who filled me in, Congressional Budget Office Director Dan Crippen, was at a loss as to where the dough had gone. "Astounding," was all he could say.

Dan was one of the town's top fiscal cops. He wasn't dropping the dime on anybody. But if I didn't get to the bottom of this, I was going to have to start mowing that air-conditioner guy's lawn. So I started making calls. Calls to guys who have no names. But usually, they have lots of information. Not this time.

...With apologies to Raymond Chandler

This is what we know: In January, 2001, the CBO expected tax revenues to grow smartly for the foreseeable future, fueling the federal budget surplus for years to come. But the bottom fell out of its forecast. Individual and corporate taxes will slide roughly $375 billion below the CBO's estimate for 2002 alone.

More troubling, this year's revenues are expected to come in $131 billion lower than 2001's take. That's a 6.6% drop, the biggest dive since 1946. And more than anything, it's the reason why the government will rack up a $160 billion deficit this year, instead of the $142 billion surplus the CBO was expecting just a year-and-a-half ago.

Of the $375 billion shortfall, about $75 billion was caused by the Bush tax cut of 2001 and the stimulus tax cut earlier this year. But where did the other $300 billion go? The short answer is: Nobody knows for sure. Tax experts need detailed data from last April's filing season to figure it out. But they won't get those numbers for a year. So they can only guess.


  Two-thirds of the hit, or nearly $260 billion, was through individual income tax. And the experts figure most of that came from high-bracket taxpayers. The reason? The loss was in income not subject to withholding taxes -- earnings from capital gains, dividends, and, to some degree, stock options. Very little of the damage came from withheld taxes on wages.

That has led some analysts to blame the missing revenue on the falling stock market. That goes a long way toward solving the mystery. But it doesn't explain it all.

Capital gains exploded in the late '90s, and taxes on them peaked at $125 billion in 2000. The CBO expected that they would drop to $100 billion by this year. Odds are they've fallen a lot more than that. Here's one clue: Although no estimates of what happened to profits from individual sales of stock exist, the government thinks capital-gains distributions from mutual funds fell by 80% last year.


  But there's a rub. The stock market accounts for only about half of all capital gains. The rest comes from real-estate sales, partnership profits, and the like. So even if stock gains went to zero -- an unlikely scenario -- that would account for just $50 billion or so of the shortfall.

Stock options might be responsible for another chunk. But data on such compensation are even sketchier. In 2000 -- again, the last year for which any numbers are available -- taxes on options might have been as much as $45 billion. But since so many options are now worthless, it's reasonable to figure that taxes on exercised options have plunged.

But that probably accounts for only about 10% of the missing revenue. Congressional tax experts guess that, taken together, maybe one-third of the mystery can be attributed to the falling stock market.


  And the rest? Perhaps the growing use of individual tax shelters accounts for some. But Hill analysts also think it may be the growing disconnect between what tax collections say about personal income and what the gross domestic product reports. The Commerce Dept. reported that incomes were up 5% in 2001. But tax returns suggest that income-tax payments fell by 3%. Both can't be right.

For the near future, these numbers paint a grim picture. Then I remembered that the income taxes Americans paid in April, 2002, were for money we earned in 2001. So, much of today's revenue shortfall reflects the '01 economy, rather than the current state of affairs. And this year's still-sluggish economy and the summer's gut-wrenching slide in the stock market won't be reflected in tax payments until next year and beyond.

Some of the mystery will be solved when the economy returns to solid footing -- the CBO figures growth will average about 3% a year over the next decade. But it'll take more than a resumption of growth to get tax revenues back on track. It'll also require a return to the booming stock markets of the late '90s. And something else: a revisiting of some set of events that analysts still don't even understand. Private economists believe it'll be years before capital-gains revenues return to their levels of 2000.

Combine it all with the growing hit of the Bush tax cuts and the costs of the ongoing war on terrorism, and it looks like the era of the ever-expanding federal revenue machine may have come to an end. As Raymond Chandler might have written, Mr. Surplus no longer cares about the nastiness of how he died or where he fell. Mr. Surplus is sleeping the big sleep.

Gleckman is a senior correspondent in BusinessWeek's Washington bureau. Follow his views every Tuesday in Washington Watch, only on BusinessWeek Online

Edited by Beth Belton

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