by John M. Curtis
(310) 204-8700

Copyright April 29, 2002
All Rights Reserved.

ax cuts, recession, and a lack of fiscal discipline aren't the only cause of today's exploding deficits. When Congress passed President George W. Bush's 10-year, $1.35 trillion tax cut last summer, the same crystal ball predicted whopping surpluses into the foreseeable future—arguing that tax cuts were long overdue and only a fraction of the projected $5.6 trillion surplus. Two years after the Clinton-era bull market collapsed, the Treasury Department now estimates the tax shortfall at $102.2 billion compared to last year. Even William Hoagland, GOP staff director of the prestigious Senate Budget Committee, projects that the Congressional Budget Office's $46 billion deficit could double its size. "What's surprising is the order of the magnitude of the reduction not accounted for by the cut," said Hoagland, realizing that the Bush tax cut accounted for less that 50% of the expected shortfall, blaming the discrepancy on a sluggish economy—or maybe something more ominous. Pointing fingers at tax cuts, the recession and fiscal problems can't account for today's exploding deficits.

      Every one-tenth percent rise in unemployment, adds $10 billion to the budget deficit, with unemployment already rising 1.7% since March 2000, erasing a $127 billion surplus and adding a hefty $50 billion to government red ink. "During the late '90s, there was a series of favorable federal income tax surprises that pushed up revenues,' said John Youngendahl, an economist with the New York investment bank Goldman Sachs. "What we're seeing is that these are now reversing," suggesting that the government's revenue stream—especially from the raging bull market—won't return anytime soon. While tax cuts are thought to be a stimulus to the economy, they're not a cure for a lifeless stock market facing reality after five years of bloated growth. Sure, recessions hurt the market by lowering corporate earnings, but they don't account for how inflated markets go bust. "If these trends continue, it's bad news for the budget, and not just this year," said Rep. John M. Spratt Jr. (D-S.C.), the ranking Democrat on the House Budget Committee, beginning to see that increases in the GDP won't replace the government's lost income.

      While some finger Bush's tax plan as fiscally irresponsible, it had the backing of Fed Chairman Alan Greenspan—through Greenspan suggested that monetary policy would have a greater impact on the economy. When the economy stubbornly came out of recession in 1994, tax rates were still disproportionately high to compensate for high unemployment. By the late-'90s, unemployment dropped and government receipts mushroomed, balancing the budget and, yes, eventually producing huge surpluses. But since the market crashed in Spring 2000, capital gains and income tax revenue dried up, leaving the government scrambling to pay its bills. Granting tax cuts were supposed to stimulate the economy, fuel consumer and capital spending, reduce unemployment and expand the tax base. While the latest GDP figures show the economy growing at 5.8%, it doesn't undo the stock market's malaise. Even if the economy expands adding new jobs, it won't automatically make up the revenue lost when the market went south.

      Forced to borrow from Social Security, the White House now faces tough times. As Greenspan found out, lowering interest rates can't provide enough stimulus to spur capital spending, especially when corporations face dismal earnings. Since copious market capitalization is no longer available, few corporations have enough cash to expand. Without new investment, corporations are not in a position to acquire new businesses or turn a profit. Since the Enron mess, creative accounting, to keep debts off the books and profits high, can't hide companies' poor profitability. With the stock market down, market capitalization can't bail out businesses still in the process of developing profitability. Quite simply, when the market tanked, many businesses—new economy and old—could no longer pay their bills without selling stock. Even established businesses have difficulty maintaining bond ratings, when analysts can't see earnings close by. With most new economy businesses unable to pull their weight without selling stock, it's difficult to imagine hefty earnings anytime soon.

      What comes up must come down. Before the bubble burst in March 2000, analysts warned that price-earnings ratios were disproportionately high, triggering the most massive exodus out of stocks since the great depression. Mutual fund outflows reached a critical mass in mid-2001, pulling the plug on long-term investing. To make matters worse, Sept. 11 drove remaining investors into cash, further dropping the DOW and Nasdaq to recent lows. For the next several months, markets rebounded, hit stubborn resistance, and moved sideways testing new lows. Regressing to the mean, markets began to regain affordability, dropping inflated multiples and share prices over 50%. Now comes the dilemma. With far fewer equity investors having faith in the market, it's difficult to expect a return to the kind of momentum seen before the bubble burst in March 2000. With multiples reduced, less investors in the market, and stocks stuck in reverse, it's unrealistic to expect the capital infusion needed to create the next bull market. Given this scenario, the government expects far less capital gains revenue, leaving deficits into the foreseeable future.

      Now comes the hard part. Faced with ballooning deficits, the government can't continue to borrow indefinitely from Medicare and Social Security. Either the government will be forced to live with growing deficits, cut government spending or raise taxes, placing Bush's $1.35 trillion tax cut in jeopardy. While it's true that tax cuts have historically provided economic stimulus, they can't replace the whopping capital gains lost when the market melted down. Few economists predict a return to unprecedented windfalls of the late '90s. Heading into mid-term elections, the White House isn't likely to advocate sweeping cuts in government spending. Right now budget deficits will be tolerated as a necessary evil to allow the current economic recovery to keep going. But once deficits force the government to borrow from private capital markets and raise the national debt, it will put upward pressure on interest rates and threaten a fragile recovery. Alan Greenspan is running out of tricks. Eventually, the government will be forced to live within its means. With surpluses now a fading memory, it's time to face reality and stop juggling the books.

About the Author

John M. Curtis is editor of OnlineColumnist.com and columnist for the Los Angeles Daily Journal. He's director of a Los Angeles think tank specializing in corporate consulting and strategic communication. He's the author of Dodging The Bullet and Operation Charisma.

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