January 29, 2003 (CBO Byte)
Lower Capital Gains Taxes Raise Deficit Projections
January 29, 2003
By Dean Baker
The Congressional Budget Office (CBO) acknowledged that the deflation of the stock market bubble will seriously depress capital gains revenue in its new economic and budget projections. Prior to this year, CBO had continued to project that capital gains tax revenue would be larger than its historic share of GDP over its ten-year projection period. It clung to these projections in spite of the fact that its own profit projections implied that the stock market was hugely over-valued and was virtually certain to collapse within its projection period.
The downward adjustment in the projections for capital gains tax revenue has a serious impact on the future budget projections. The new projections show that revenue from capital gains taxes will be $428 billion less than was indicated in the January 2001 projections (for the over-lapping years), which were the most recent projections at the time President Bush’s tax cut was approved. Including the effect of interest, the 10-year surplus projections would have been $516 billion lower in 2001, if the current capital gains projections had been used.
The current economic projections include two other aspects which may lead to errors in the projections. The projections assume that the dollar will decline only modestly in coming years, leaving the current account balances slightly higher than current levels. This path implies a large increase in negative net asset position of the United States. It implies that the net asset position of United States will be negative $4.5 trillion by the end of 2005, a shortfall that exceeds the projection for publicly held debt at that point. By the end of the projection period in 2013, this assumption implies that United States will have a net foreign debt of more than $10 trillion, or more than $30,000 for every person in the country.
This assumption seems implausible. If true, it implies that the United States will be selling off much of its wealth, even as the baby boom generation is preparing for its retirement. More likely, the dollar will fall sharply within the projection period – raising the inflation rate, but bringing the current account closer to balance. It is not clear how the Federal Reserve Board might respond to inflation induced by a falling dollar, so it is difficult to determine its impact on the budget.
The other likely source of error is the failure to account for the impact of a serious correction in the housing market. The rise in home prices has exceeded the overall inflation by more than 30 percentage points over the last seven years. If home prices fell back in-line with the overall rate of inflation (they generally had risen at the same pace in prior years), it would destroy $3 trillion in wealth. This amount is considerably less than the $8 trillion destroyed by the collapse of the stock market bubble. However, housing wealth is far more evenly distributed than stock ownership, so the effects on consumption and the economy could be comparable. A collapse of housing prices could lead to a sharp reduction in consumption, throwing the economy back into recession.
One important assumption which may prove overly pessimistic is the long-term unemployment rate projection. CBO projects that the unemployment rate will average 5.25 percent, after it has recovered from the current recession. While this is lower than the 6.0 percent unemployment rate conventionally assumed prior to the late nineties, it ignores the fact that inflation remained stable even as the unemployment rate fell to 4.0 percent in 2000. If the projection instead assumed that 4.5 percent unemployment was a sustainable level, it would increase annual revenue projections by approximately $40 billion. Including the savings on interest, this change would raise the projected surplus by more than $500 billion over the projection period. Whether the unemployment rate if allowed to fall toward the 4.0 percent level reached in 2000 will ultimately be a policy decision made by the Federal Reserve Board.