The Deipnosophist

Where the science of investing becomes an art of living

My Photo
Location: Summerlin, Nevada, United States

A private investor for 20+ years, I manage private portfolios and write about investing. You can read my market musings on three different sites: 1) The Deipnosophist, dedicated to teaching the market's processes and mechanics; 2) Investment Poetry, a subscription site dedicated to real time investment recommendations; and 3) Seeking Alpha, a combination of the other two sites with a mix of reprints from this site and all-original content. See you here, there, or the other site!

14 February 2007

Federal deficit vanishing act

The following commentary is by Scott Grannis, Chief Economist at Western Asset Management.
-- David M Gordon / The Deipnosophist

Federal revenues have grown over 12% a year for the past 30 months, 11.5% over the past year, and at a 9% annual rate in the past six months. Things have cooled off a bit, but revenues have far exceeded expectations and continue to grow at an impressive rate, thanks to corporate profits, capital gains and incomes that continue to beat most expectations. Meanwhile, despite President Bush's inability to wield his veto pen, and despite the military buildup and the Iraq War, federal government spending has grown only 6.5%, 5.6%, and 3.2% over those same periods. The result is a dramatic decline in the budget deficit, which totaled only $192 billion in the 12 months ended January, or about 1.4% of GDP. At this rate, budget surpluses could be making headlines before the 2008 presidential elections.

[click on each image to enlarge]
Although the deficit is already in the region where it matters very little (if at all) to either the economy or the financial markets, politicians often march to the beat of a different drum. There are still many who favor higher taxes, but those that do are finding it a hard sell given these new budget realities. So instead of banging on the deficit drum, some are trying to focus attention on the future, monster deficits that are likely to be generated by social security and medicare. The problem with that approach is that those deficits are so far out on the horizon that they are pretty intangible to most folks. Others are focusing on the alleged widening gap between rich and poor (I say alleged because credible people like Alan Reynolds claim it does not even exist), or on saving the planet from the excesses of human consumption.

Budget opportunists might argue that since conditions have rarely been so good, now is the time we are most able to afford higher taxes. After all, unemployment is low, inflation is relatively low, credit spreads are relatively low, financial market volatility is relatively low, the stock market is rising, household net worth has soared to $53 trillion from its $41 trillion peak before the stock market bubble burst, and the global economy has never been so strong.

Let's stipulate, for the sake of argument, that by next year the electorate generates enthusiasm for a presidential candidate that proposes tax hikes on the rich and profitable, in the spirit of Hillary Clinton's recent declaration: "I want to take those [oil company] profits, and I want to put them into a strategic energy fund … ." In other words, higher taxes are OK because some parts of the economy are doing too well, while others aren't. What impact would this likely have on the overall economy, considering that the new president probably couldn't pass any major tax-hike legislation until the middle of 2009 or later?

As Art Laffer has taught us, higher taxes, especially on those that are the most productive, would probably be bad for the economy ("tax something more and you'll get less of it"). However, Art also reminds us that the prospect of a future tax hike would likely have the perverse effect of boosting the economy in the short run. That's because as people anticipate that taxes will be raised significantly at some future date, they are likely to do everything possible to accelerate and realize income and gains before the tax hike takes effect. It is only after the tax hike takes effect that economic growth would be likely to fall off. Thus we might see the stock market decline in 2008, in anticipation of the weakness to come in 2009 or 2010, even as the economy was to all appearances quite healthy. The bond market might also have some difficulties around that time, since a stronger economy would increase the Fed's concern over the risk of higher inflation.

Some things to ponder and worry about, since otherwise the only obvious negative out there is the ongoing housing market correction which, so far, the economy has been able to digest relatively easily.


who's online