A "Duck-The-Issues" Budget -- Interpreting the Congressional Budget for 2005
revised March 19, 2004 (minor editorial changes)

Will the Congressional budget really reduce the deficit?  The answer is "probably not."  The targets for discretionary spending seem too tight to hold, especially for the military.  Both the Senate-passed budget resolution and the pending House version would make it easier to extend tax cuts for a couple years, but neither comes close to funding a full extension of all the tax cuts set to expire.  The budget wouldn't do much to trim entitlement spending, and it implies a near-doubling of interest costs over the next 5 years. 

In sum, this year's budget will be a stop-gap measure that does not attempt to grapple with the larger fiscal problems facing the nation.  However, recent tough talk against deficits implies that the budget trajectory will probably start to improve in upcoming years.  Centrists.Org will update its long-term budget projections if that tough talk seems likely to lead to actual spending reductions, and it appears some tax cuts will be allowed to expire on their "sunset" dates.

Outline:
Is the Budget for Discretionary Spending Realistic?
The Outlook for Personal Income Taxes
Will Congress Extend the Business Tax Cuts?
Rising Interest Costs
Entitlements, Taxes, and Pay-As-You-Go Rules
Conclusion:  A "Duck-The-Issues" Budget

The Senate passed its budget resolution last week, and the House Budget Committee passed its version yesterday.  Final action in the full House will probably be next week, and the House and Senate will mesh their slightly differing approaches in April.

On spending, the biggest question is whether or not the discretionary spending levels set in the budget resolutions are realistic.  Table 1 (below) shows the differences between the Congressional Budget Office (CBO) March 2004 baseline and the budget resolutions.

On taxes, there are two essential tables that every member of Congress should carry in his or her pocket.  First, according to the most recent compilation from the CBO, it would cost $2.275 trillion over the next ten years to extend all of the tax cuts that are scheduled to expire between 2004 and 2014.

Second, according to the Joint Committee on Taxation (JCT), the tax cut extensions and other tax provisions of the President's Budget would reduce revenues by over $1.4 trillion over the next decade. 

Importantly, the President's Budget omits some big things.  It would extend the fixes to the Alternative Minimum Tax (AMT) for only one year.  After 2005, the AMT would otherwise swallow up the tax cuts promised to tens of millions of taxpayers.  Extending the AMT fixes for the full ten years would cost over $400 billion (assuming other tax cuts are also extended).

Furthermore, the President's Budget would not extend some large business tax cuts enacted in 2002.  This includes the "50 percent partial expensing" provision and other tax breaks that allow companies to accelerate depreciation of certain assets and thereby reduce their taxes.  Extending them would cost $440 billion over ten years.

Table 1. 

Discretionary Outlays
(by fiscal year)	2004	2005	2006	2007	2008	2009
			Billions
CBO March 2004	895	936	956	973	998	1021
Senate Target	895	903	907	903	912	926
House Target	895	927	913	906	923	946
		Growth Rate (Percent)
CBO March 2004	8.5	4.6	2.1	1.8	2.6	2.3
Senate Target	8.5	0.9	0.4	-0.4	1.1	1.5
House Target	8.5	3.6	-1.5	-0.8	1.9	2.5
Source: Centrists.Org
Note: CBO baseline assumes supplemental war spending continues indefinitely.
Senate budget includes one-time war reserve of $30 billion; House assumes one-time
reserve of $50 billion. Both House and Senate "spend out" the reserve at a declining
rate over 5 years.

---

Is the Budget for Discretionary Spending Realistic?  By any measure, the discretionary spending levels in the House and Senate budgets are extremely optimistic, for two reasons.  First, the budgets likely low-ball overseas military and reconstruction spending.  Second, the growth rates used for discretionary spending are very modest -- well below the rate of inflation over the next several years.

Both budgets assume that appropriations for overseas military costs will phase down quickly after 2005.  The House assumes next year's war supplemental will be only $50 billion and that no additional appropriations will be necessary.  The Senate assumes the 2005 war supplemental will be only $30 billion.

By contrast, the emergency war funding passed in late 2003 was $87 billion, and according to some reports, that might not last even through the end of 2004.

Certainly, Centrists.Org can't predict future military costs (nor can anyone else, for that matter).  But it does seem clear that both the House and Senate defense spending levels are so optimistic that they can be described as "unrealistic."  A more conservative forecast would assume overseas military spending continues unabated, as CBO assumes.

Overall, discretionary spending increased by 7 percent in fiscal year 2000, 6 percent in 2001, 13 percent in 2002, and 12 percent in 2003.  Some of that spending was related to war and September 11 relief, and the creation of new homeland security programs.  However, even excluding those one-time expenditures, the underlying rate of growth of discretionary spending remains well above the inflation rate, which is now less than a 2 percent.

Hitting the discretionary spending targets in the House and Senate budgets implies a reduction of discretionary spending toward its mid-1990s lows as a percent of GDP (see Figure 1).  That seems very unlikely, even if the mood of Congress toward budget deficits is changing.

Figure 1.



Congress has at least started talking tough on spending.  But so far, few actions to actually reduce appropriations have occurred. 

However, the new tough talk matters, and it now seems more likely that Congress will slow the growth of spending toward the rate of inflation.  CBO's baseline growth rate after 2005 now seems plausible, if a little optimistic compared with recent trends. 

On the other hand, it would be very difficult to hit the near-zero growth targets for discretionary outlays in the House and Senate budget resolutions.  We would have to cut many programs in both real (inflation-adjusted) and actual dollar terms, and that is never easy.  We would have to assume no other political or external emergencies impact the budget (earthquakes, floods, terrorist attacks, pre-election pork-barrel spending necessities, and so on).

The Outlook for Personal Income Taxes:  We know why income and payroll tax revenues are weak.  Income taxes are down by almost 4 percent so far this fiscal year.  Although the estimates are sometimes contentious, budget analysts generally believe that about half of the revenue reductions in recent years are due to tax cuts.  (The other half is due to lower-than-expected economic growth or technical estimating revisions.)

Payroll taxes are up by less than 2 percent because wages are growing very slowly (at least for workers below the $87,900 Social Security tax cap).

The House and Senate budgets would make it easier to extend the tax cuts, especially in the short-run.  Payroll taxes should begin to recover as the economy continues to grow and the labor market starts to improve.  But income taxes will remain depressed if we keep cutting taxes.

House Plan Includes $137.580 Billion in "Reconciled" Tax Cuts.  The total tax cut in a budget resolution may not mean much.  What matters is the amount that is protected from filibusters and super-majority procedural votes by the so-called "budget reconciliation" process.

The House budget resolution sets aside precisely $137.580 billion in tax cuts over the next 5 years under reconciliation.  That means that tax cuts of this size can proceed with a simple majority and without delaying tactics.

The $137.580 billion figure is (almost) exactly the same amount that JCT estimates it would cost to extend most of the Bush tax cuts enacted in 2001 and 2003.

(You can look it up on one of those tables in your pocket.  It's under "Total of Extension of Certain Provisions of EGTRRA and JGTRRA," for 2004-2009, toward the top of the Joint Committee's table on the revenue provisions in the President's Budget.  Curiously, the JCT estimate is actually for $137.581 billion, which means the Ways and Means Committee would be $1 million short.  Fear not, Ways and Means can work around the glitch.)

In fact, the Ways and Means Committee is not obligated to produce a bill with exactly the same provisions as the President's Budget.  But the Budget Committee clearly recommends that Ways and Means follow the President's lead.

Because the Congressional budget is truncated after 5 years, the House and Senate resolutions don't mention that following the President's recommendation to extend tax cuts would cost an additional $1 trillion between 2010 and 2014, and trillions more in the following decades.

The Senate Plan "Reconciles" $80.6 Billion in Tax Cuts.  The Senate budget resolution allows $80.6 billion in tax cuts over the next 5 years to escape a potential filibuster.  However, the However, the Senate amended its budget resolution during floor consideration to require all tax cuts to be fully "paid for" -- that is, offset by specific spending cuts or other tax increases -- or else face a 60-vote procedural hurdle.

The Senate also budgets for additional tax cuts totaling about $65 billion, but those tax cuts would not be subject to reconciliation protections. 

Figure 2 shows the tax cuts assumed in the House and Senate budget resolutions, and compares those amounts with the full cost of extending all the tax cuts.  Needless to say, the budget resolutions don't come close to accounting for all the tax cuts.

Two things could happen.  On the one hand, Congress might choose to let some tax cuts expire.  That would, in fact, help to reduce the deficits.  Alternatively, Congress might extend some popular tax cuts for a year or two under reconciliation, effectively kicking the can down the road to 2005 or 2006, when the larger budget decisions will have to be made.  The latter is the more likely scenario.

Figure 2.



Will Congress Extend the Business Tax Cuts?  In 2003, corporate profits were up by $116 billion (these are "economic" profits as measured in the GDP accounts).  Yet corporate tax revenues fell by $16 billion in fiscal year 2003. 

In fact, since the recession year of 2001, profits are up by almost $250 billion, but corporate profits tax revenues are down by $19 billion.  (These profit and revenue figures are measured in government fiscal years, October through September).

Although most people don't realize it, Congress has also enacted significant business tax cuts in recent years.  The 2002 tax bill included accelerated depreciation of certain business investments, which has the effect of reducing corporate tax rates.  The bill also allowed a longer (5-year) "carryback" period for losses incurred around the recession of 2001, which is also depressing revenues.  In 2003, Congress expanded some of those business tax cuts.

All told, Congress cut business taxes by about $43 billion in 2002, $51 billion in 2003, and $69 billion in 2004. 

The largest of the business tax cuts -- the 50 percent partial expensing provision -- is set to expire at the end of 2004.

The price tag for extending all of the major business tax cuts already enacted is roughly $41 billion in 2005, $75 billion in 2006, and $73 billion in 2007.

Although the corporate tax rate remains at 35 percent, revenues have fallen from 25 percent of economic profits in 2000 to 13 percent in 2003 (see Figure 3).  However, absent the accelerated depreciation and other business tax cuts, the effective corporate tax rate in 2002 and 2003 would have been roughly 20 percent.

Figure 3.



In the first 5 months of fiscal year 2004, profits tax revenues started to rise.  According to CBO's Monthly Budget Review for March, corporate profits taxes are up $10 billion so far this year (after accounting for a gimmicky "timing shift" in an earlier tax cut law).

However, revenues have a long way to go to catch up with profits.

Figure 4 shows economic profits vs. tax revenues (on separate scales) since 1988.  Profits boomed in the mid-1990s, and revenues increased as well.  Since 2001, however, profits are up by almost 2 percent of GDP, but profits tax receipts are still falling. It should be noted that corporate taxes have historically lagged behind corporate profits following a recession. Moreover, profits as measured in GDP do not always correspond to profits as defined by the IRS.

Figure 4.



It seems likely that Congress will extend the business tax cuts for a year or so, if for no other reason than to prevent a slowdown in the growth of after-tax profits and a drop in stock valuations. Legislators may attach the extension to a "must-pass" bill later this year, even if they choose to use the reconciliation protections to extend other tax cuts. 

However, this sort of temporary extension is bad budgeting.  One- or two-year extensions of large tax cuts create a highly misleading picture of the budget.  They cause future revenues to be overstated, especially if Congress really intends to keep extending the tax cuts year after year.

A better solution would be a long-term plan for taxes, and a movement toward tax reform and simplification.

Corporate profits taxes are now a small proportion of overall revenues -- only 1.2 percent of GDP in 2003.  That compares with 7.3 percent for income taxes and 6.6 percent for payroll taxes.

The low corporate profits tax level may signal a need for reform.  The general rule of tax reform is "broaden the base, and lower the rate."

First, it seems obvious that many firms are engaged in tax avoidance behavior -- that is, engaging in transactions that would not be economically efficient absent the tax consequences.  The tax code should be scrubbed for loopholes that cause inefficiency or economic distortions. 

A second reason is simplicity.  Investor Warren Buffett claims the 2003 corporate tax return for his company (a large financial and industrial conglomerate) totaled 8,905 pages, and, in the required duplicate, stood over 7 feet high.

Rising Interest Costs:  One facet of the budget that could be considered a "super-entitlement" is the cost of servicing the national debt.  That is because Congress must pay interest before anything else.

Interest payments hit a 30-year low of 1.4 percent of GDP in 2003.  Budget surpluses in 1998 through 2001 and ultra-low interest rates in the aftermath of the 2001 recession have resulted in the lowest interest burden since 1973.

However, that will change rapidly in the coming years.  The sudden switch to budget deficits in 2002, and the large deficits in 2003 and 2004 will combine with higher interest rates in 2005 to cause a rapid acceleration of debt service costs. 

The House budget resolution assumes that annual interest costs will rise from $153 billion in 2003 to $297 billion in 2009.  The Senate version assumes interest spending of $292 billion in 2009.

However, a more conservative baseline would assume all the tax cuts are extended and that discretionary spending stays at its current level as a percentage of GDP.  That implies interest costs that would rise much faster, to almost $350 billion by 2009, about 3 percent of GDP (see Figure 5).

Figure 5.


Entitlements, Taxes, and Pay-as-you-go Rules:  In general, the Congressional budget does not address the rising costs of Medicare, Medicaid, Social Security or other entitlement programs.  In fact, the Medicare entitlement was expanded last year, and Congress shows no signs of backing off on its promises of better benefits for senior citizen voters.

There will probably be a flare-up in the House-Senate "conference committee" that resolves differences in the budget resolutions over Medicaid cuts.  The House wants them, the Senate does not -- but the numbers are very small either way.

The Senate has passed a "pay-as-you-go" rule stating that any tax cut or entitlement spending increase that is not "paid for" or offset by other tax increases or spending cuts is subject to a special 60-vote procedural hurdle.  This pay-go rule even applies to tax cuts or entitlement expansions that are considered under reconciliation protection, although the reconciliation process does not allow filibusters or stalling techniques.

Meanwhile, the House Budget Committee has cleared a rule implementing the equivalent of pay-as-you-go procedures for bills that would raise entitlement spending, but not for tax cut bills.

The House proposal is unlikely to be effective.  It is reminiscent of the old Gramm-Rudman-Hollings budget targets of the 1980s, which said there'd be hell to pay if Congress overspent, but didn't follow through with the threatened across-the-board budget cuts.

The House would be in much better shape if it adopted the Blue Dog (conservative Democrat) proposal to improve the budget process and implement pay-as-you-go rules on both spending and taxes.

Conclusion -- A "Duck-The-Issues" Budget:  It helps to start somewhere, and all the tough talk on the budget is helpful.  However, it's not clear all the members of Congress really "get it." 

Moderate Republicans in the House quickly caved in to demands from the Congressional leadership that tax cuts not be considered "bad" for the budget. 

And many members of Congress still sincerely believe tax cuts pay for themselves.  (They don't.)

In their still-deluded state, a large number of legislators won't get serious about spending reductions or the inevitable tax hikes.  Some still believe in their hearts -- in spite of the deteriorating budget outlook -- that the economy will come roaring back and fill the Treasury with revenues.  Therefore, there's no need to make politically difficult decisions.

That means more stop-gap extensions of tax cuts, few substantial spending cuts, and a "talk-big-but-duck-the-issues" budget for 2005.

However, the recent expressions of concerns about deficits bode well for the future.  If it starts to look more likely that Congress will follow through with some spending cuts, and will allow some tax cuts to expire on their designated "sunset" dates, we will update our near-term budget projections to reflect the improvement.

Links:
Congressional Budget Office Effect of Extending Tax Provisions That Will Expire Before 2014 (Table 4-10, updated February 11, 2004) from the Budget and Economic Outlook:  Fiscal Years 2005 to 2014 (January 2004)

Joint Committee on Taxation Estimated Budget Effects of the Revenue Provisions Contained in the President's Fiscal Year 2005 Budget Proposal (March 3, 2004)

Congressional Budget Office Monthly Budget Review (March 6, 2004)

Warren Buffett annual letter to shareholders of Berkshire Hathaway Inc. (February 27, 2004)

House Blue Dog (Conservative Democrat) Budget Process Proposal

Sen. George Voinovich Tax Reform Commission Proposal

Centrist Policy Network Some Bigger Ideas for the Presidential Race (January 26, 2004)

Centrists.Org CBO:  Budget Outlook Worsens Slightly, Medicare and Medicaid Spending Up
(February 28, 2004)

Centrists.Org Deep Cuts in Non-Security Spending and Rapid Economic Growth Won't Balance the Budget (preliminary February 2, 2004)

Centrists.Org The Fourth Entitlement:  Interest (December 1, 2003)

New Issue Summary:  Budget and Tax (Basics) (updated February 2, 2004)

No-BS Long-Term Budget Baseline (Jan. 2004) (January 26, 2004)