US reaps rewards of tax cuts but public finances face grim future

IT IS one of the big, untold stories of the global economy. America's public finances are improving at last, to the great relief of the White House but to the puzzlement of much of the commentariat, which cannot fathom how tax cuts can possibly go hand in hand with a smaller budget deficit.

The US budget shortfall fell to $35.3bn (19.4bn) in May, down 43.5% on the $62.5bn seen during the same month last year, thanks to a continuing surge in tax revenues. This year's deficit was the smallest May shortfall since the $27.9bn seen in May 2001, which was also the last year the government ran a budget surplus. This is a much better outcome than almost anybody was forecasting; it follows a series of US tax relief packages between 2001 and 2003, making the lower deficit all the more surprising to most analysts.

This apparent paradox has a simple explanation: President Bush's 2003 tax cuts played an important role in boosting economic growth and share prices; in turn, this triggered an explosion in tax receipts which is now compensating for the revenue lost originally. Of course, there are other reasons why the US economy has bounced back, including the strong international recovery and normal cyclical effects. But there is no doubt that the tax cuts helped a great deal.

Another explanation for why mainstream forecasters got it so wrong is that they attributed the deficit almost exclusively to the president's tax cuts. But the deficit's primary cause was the economy's poor growth after the collapse of the dot.com bubble. President Bush's decision to throw caution and principle to the wind and embark on an astonishing spending binge - much of which had nothing to do with his military or security policies - was an equally important reason.

The deficit could easily be abolished entirely by freezing spending for 18 months or so. Bush now seems likely to meet his campaign pledge to cut the deficit in half as a percentage of GDP by 2009; but if he had the guts and the support of the supposedly conservative Congress, he could easily eradicate the deficit simply by not spending more.

But Bush's and Congress's profligacy remains largely unchecked, with government spending in May hitting $188bn, up 5.7% from the same month of last year. But this was swamped by improved revenues of $152.7bn, up 32.3% from May 2000, led by an exceptional performance from income tax and corporation tax - thanks to, rather than despite, the 2003 tax cuts.

During the first eight months of this financial year, which in the US begins on October 1, the government spent $272.2bn more than it grabbed in revenues; this represented a 21.4% improvement from the $346.3bn run up during the first eight months of the 2004 budget year. For the entirety of the financial year to date, revenues have reached $1.37 trillion, an increase of 15.5%. Government spending is also up significantly but at a slower pace, rising by 7.1% to total $1.64 trillion.

The news has led several investment banks and government agencies to slash their deficit forecasts for the year. The Congressional Budget Office expects this year's deficit to decline to around $350bn, a significant improvement from the all-time high in dollar terms of $412.8bn set last year. The Bush administration, which in February was forecasting the deficit would hit a new record of $427bn this year, now believes that it will be much lower. The administration will release its new forecast later this summer when it presents Congress with a mid-session review of the budget; for the first time in years it will attract good rather than bad headlines.

It is not only the federal budget which is improving: states and cities are also enjoying buoyant revenues. State tax receipts have also surged by 7.5% this year; New York is on course for an unexpected $3bn surplus. Stephen Moore, the former head of the Club for Growth, says that states and cities, led by California, will enjoy net surpluses of at least $50bn and that total government borrowing will come in at below 2.5% of GDP, potentially better than in the UK.

As Daniel Mitchell, a senior fellow at the Heritage Foundation, points out, the key lesson of supply-side economics is that it is not enough merely to cut taxes. Tax reductions only boost the economy if they make engaging in productive behaviour - such as working, saving or investing - more worthwhile. Too many of Bush's early policies failed to do this, thus unnecessarily delaying the recovery. There is a lesson here for governments everywhere, as well as for opposition parties such as the Conservatives in Britain, who will have entirely to rethink their economic policies if they ever wish to govern successfully again.

Bush's early tax cuts looked good on paper but by and large they turned out to be useless at stimulating economic growth because they failed Mitchell's test. As a result, they did more to hinder than to help the Bush re-election campaign - and they boosted the deficit by reducing revenues while not increasing the tax base.

Of the five big provisions of the 2001 tax cuts - a lump sum tax rebate, child tax credits, a starting 10% tax bracket, small income tax cuts and the repeal of inheritance tax - the first two were always going to be ineffective because they were not tied to economic activity. The other three had a minor pro-growth impact: the marginal tax rate on people who earn very modest incomes was reduced, a good thing. However, for most people, income tax rates were lowered by a trivial one percentage point for 2001-2003, with the majority of the income tax reductions postponed until 2004 and 2006, diluting their pro-growth impact. Inheritance tax reform was even more counterproductive: it dropped immediately from 55% to 50%, but the rate will remain at least 45% until 2010, when it finally drops to zero (albeit for only one year).

In stark contrast, the 2003 tax cut, while imperfect, was much more inspired by supply-side principles and played an important part in the US economic recovery. The president's tax cuts on business investment, accelerated income tax cuts and the reduction in the double-taxation of capital gains and dividends were all very positive for growth; even if the accelerated child tax credits did nothing to improve performance and handouts to the US states made matters worse.

Most effective was the reduction in tax rates on dividends from 39.6% to 15% and on capital gains from 20% to 15%. Allowing small businesses to expense all their investment in one go - thus making it tax-free - also gave the economy a fillip, created jobs and boosted tax revenues, in a positive feedback loop. Spending on capital purchases has soared 22% since 2003. The accelerated income tax cuts led to significant across the board reductions and a decline in the top rate of tax to 35% from 39.6% in 2000.

With growth forecasts looking good for the US, revenues are likely to continue pouring in. On Friday, the preliminary June release of the University of Michigan consumer confidence survey came in a long way above market expectations, rising to 94.8 from May's 86.9. This marks the first rise in 2005, following five consecutive monthly falls and confirms that the fears that the US economy was going through a soft patch were largely misplaced. Growth of 3.5% in the first quarter was perfectly respectable; the markets now expect the same for the year as a whole.

Longer term, however, the prospects for the US public finances are as grim as ever. The cost of the US welfare state will explode over the next few decades; on current laws and trends, federal spending will inexorably rise to European-style levels. The biggest culprits will be social security, the US state pensions system and Medicare, which pays for the health care of pensioners.

No amount of economic growth will be enough to rescue the US welfare state; radical reform is the only answer. Unfortunately, unlike cutting taxes, cutting spending is a task that even the most fearless of politicians usually finds too hot to handle. Americans should enjoy their improving public finances while they last.