Tax timing, Fannie and Freddie help cut federal deficit in half

Washington didn’t take much time to celebrate the dramatic reduction in federal deficits announced by congressional budget analysts a week ago, but Wall Street saw it as reason to cheer and send stocks to record highs. For many investors, the more than halving of the deficit from a high of $1.55 trillion during the depths of the recession is the latest sign that the economy finally has turned the corner and is on a solidly upward path.

Nearly all of the improvement in the government’s finances is a result of the economy, most notably a surge in revenue on corporate bonuses, stock dividends and capital gains payments at the end of last year that was timed to beat the Jan. 1 start date for higher tax rates on wealthier citizens. That helped fill the Treasury’s coffers with a surge of nearly $100 billion in revenue to a monthly record of $407 billion when the tax bills came due in April. At the same time, the government got a big boost from $95 billion in dividend payments from Fannie Mae and Freddie Mac, the two bailed-out mortgage giants that turned profitable at the end of last year amid a rebounding housing market.

The combination of windfalls enabled the Congressional Budget Office to slash its deficit forecast by a record $203 billion for this fiscal year to $642 billion — the deficit’s level before the crisis broke out in 2008. The CBO’s projections show further significant improvement in the next five years as the deficit falls to $378 billion, or 2.1 percent of economic output by 2015 — a fraction of the worrying 11 percent peak hit in 2009 — before turning up again.

While some argue that the April surge in revenue was only a one-time affair, and the long-term deficit problem generated by fast-growing entitlements is far from solved, there are some promising long-term trends. For one, higher tax rates put into place this year ensure that revenue will continue to pile in at higher rates and hit 19.3 percent of economic output by 2015, up substantially from the recession-induced low of 15 percent in 2009. Moreover, while a portion of the spring dividends from Fannie and Freddie were results of one-time tax factors, the mortgage giants must continue to turn over the billions of dollars they make in profits to the Treasury unless and until they are reformed or eliminated.

Perhaps most important, on the spending side of the ledger, Congress and the administration — with help from the slowly mending economy — have made significant headway at reducing outlays from a high of 25 percent of economic output in 2009 to 22 percent today. The CBO outlook even contained a kernel of good news on entitlements: A trend toward slower growth in enrollments and health care spending prompted the nonpartisan budget office to slash its deficit forecasts for the next decade by nearly $200 billion — a promising turn of events that could help solve the long-range deficit problem.

Wall Street notices

The reversal of fortunes has not been lost on Wall Street.

“The most threatening artifacts of the financial crisis — financially damaged households and destabilized public finances — are to a very large extent history,” said Michael Gavin, an analyst at Barclays Research, noting that the combination of economic growth and vigilance by Congress has pushed down the deficit to pre-crisis levels. “We think it is likely to get better before it gets worse.”

Confirmation that the turnaround was mostly the result of an improving economy comes from the 50 states, most of which also are reporting better-than-expected revenue this year. A handful of states — including California, whose financial picture has brightened dramatically in recent years — are even debating what to do with unexpected surpluses.

“The U.S. economy is in much better shape today than was expected four years ago, and the federal budget outlook is significantly better today than was expected four years ago,” said Wall Street economist Scott Grannis, noting that the improving economic and budget trends “go a long way to explaining the equity market rally that began four years ago and continues today.”

“The main driver of higher revenues is simply the ongoing growth of the U.S. economy, which in turn has boosted incomes, corporate profits and capital gains,” he said. “The bigger story, however, is the huge decline in federal spending. No actual cuts were necessary to reduce the burden of government spending by over 3 percentage points in just four years.”

After years of fearing the worst about the deficit, investors and analysts are starting to hope for the best, Mr. Grannis said. “Where once there was no hope whatsoever, there is now reason to be optimistic.”

Deja vu

For longtime budget analysts, there is a sense of deja vu. The economy historically has been a more important factor than Congress in reducing deficits, as seen after World War II and during the 1980s and 1990s. Some analysts predict that the economy will continue to surprise with further dividends, as it did in 1996 when a monumental budget battle between Republicans in Congress and a Democratic White House was largely resolved when the robustly growing economy started flooding the government with revenue.

Sy Harding, founder of Asset Management Research Corp., said the economy could repeat its surprise performance of the 1990s, which has many parallels with today. Then, as today, a sluggish period with high joblessness followed the recession. But after a slow start in the 1990s, the expansion blossomed into a period of robust growth with a stock market boom and record low unemployment that helped turn large budget deficits into unprecedented surpluses by the turn of the century. Some economists think something similar could happen this time.

“The last of the 2008 doomsday scenarios is fading away” and is being replaced with a tentative sense of optimism that the economy is back on track, Mr. Harding said.

He noted that spiraling deficits were one of the biggest fears the public had coming out of the Great Recession.

“One at a time, we’ve seen the doom-and-gloom fears drop by the wayside,” he said. “The Great Recession ended and an economic recovery has been underway since mid-2009. The stock market has fully recovered and gone on to new highs. We’ve seen the loans to automakers and banks fully paid back (with interest). The fear of spiraling inflation did not materialize.

“Now it looks like the fear of the record government debt load may also be fading away. The trend reversal is clearly in the right direction,” he said, though “there’s still a massive problem in the record level of the overall federal debt” facing Congress, he said.

The CBO projections show that the accumulated public debt will start growing again after declining to 70.8 percent of economic output in 2018 and will reach 73.6 percent by 2020.

Deficit-hawk groups such as the Concord Coalition say the near-term improvement in the deficit should prompt Congress to focus all the more on the long-term problems with entitlements such as Social Security and Medicare, which are headed toward insolvency. Federal Reserve Chairman Ben S. Bernanke on Wednesday urged Congress to reverse some of the $85 billion in across-the-board spending cuts imposed this year and replace them with longer-term reforms in entitlements. He said that would be the best approach for the health of the economy.

To date, though, Republicans in Congress appear determined to extract further deficit-reduction measures as the price for increasing the government’s debt limit later this year.

“From the perspective of informed conservatives, the continually growing deficit is still a problem,” said Cullen Roche, founder of Orcam Financial Group. “Sure, the deficit might be shrinking, but that’s like the fat guy who is putting on 20 pounds a year, vows to lose weight and then celebrates next year when he only puts on 10 pounds. It’s the absolute size of government spending relative to the economy that worries conservatives.”