Research

Surprising jump in tax revenues: Will it last?

Recent estimates of the United States' federal budget deficit just keep getting better. On July 11, the president announced that after a record $413 billion shortfall in fiscal year 2004 and a $319 billion deficit in 2005, the deficit estimate for 2006 was $296 billion, down from the original estimate of $423 billion. On August 4, the Congressional Budget Office put the deficit estimate for fiscal year 2006 (which ends September 30) even lower, at $260 billion. Although the tide of red ink is ebbing — thanks to higher corporate and individual tax receipts — the good news stems from factors that may be only temporary, according to experts at the W. P. Carey School of Business.

2006-09-13

Recent estimates of the United States' federal budget deficit just keep getting better. On July 11, the president announced that after a record $413 billion shortfall in fiscal year 2004 and a $319 billion deficit in 2005, the deficit estimate for 2006 was $296 billion, down from the original estimate of $423 billion. On August 4, the Congressional Budget Office put the deficit estimate for fiscal year 2006 (which ends September 30) even lower, at $260 billion.

Although the tide of red ink is ebbing — thanks to higher corporate and individual tax receipts — the good news stems from factors that may be only temporary, according to experts at the W. P. Carey School of Business. Bush, who credited his first-term tax cuts for the decreasing deficit, conceded the White House Office of Management and Budget (OMB) expects the deficit to rise to $339 billion in 2007.

And the national debt, the accumulated red ink of government deficits and the interest paid on them, has risen about $3 trillion in the past five and a half years and currently stands at about $8.4 trillion. Although interest on the national debt has sometimes eaten up more than 13 percent of annual budgets, the figure dropped as low as nine percent in recent years — despite the Bush administration deficits — because interest rates were so low early in his term.

That trend is reversing, just as mortgage rates are on the rise for homeowners. Budget balance, of course, is a matter not just of receipts but also of spending. The OMB says that tax receipts totaled $1.969 trillion through July, a 12.8 gain over 2005. But spending increased by 7.8 percent, rising to $2.209 trillion.

Gains yield tax surge

Sanjay Gupta, faculty director of the W. P. Carey School's master of accountancy and information systems and master of taxation programs, attributes the surge in tax revenues to higher corporate profits and their positive effect on the stock market.

"This has also led to a large increase in executive compensation packages, which are being cashed out, including stock options," Gupta says. He believes the large compensation packages — and the corporate profits that prompt them — may be only temporary and have little to do with tax rates.

"Partly this is simply a business-cycle story," Gupta says. "We have had a recession prior to this period, and we are now in a recovery mode." Gupta says interest rates also are a big — and changing — factor. "Over the last several years, we have had historically some of the lowest interest rates," he says. Low-interest leverage increases returns to stockholders. "If the cost of debt is very low, as it was in the last few years, even small profits can boost returns to shareholders."

Gupta also attributes increased profits and tax revenues to temporary or cyclical factors: corporate belt-tightening, including layoffs, and decreased technology spending relative to the large outlays leading up to the Y2K scare. Another important part of the improved deficit figures is the increase in corporate tax revenues, Gupta says — about $100 billion higher in 2005 than during the previous couple of years. This surge has taken place despite the fact that corporate tax rates have not changed since 1993.

There are probably two likely candidates that explain a significant portion of the increase, Gupta adds. The one-time dividend repatriation tax benefit enacted by the American Jobs Creation Act of 2004 dramatically lowered the effective tax rate on dividend repatriations by U.S. multinationals from 35 percent to just 5.25 percent. It is estimated that U.S. multinationals have repatriated around $300 billion last year: Tax impact — about $17 billion.

Then there are oil company profits. The price of crude fell to as low as $10 a barrel in the late 1990s due to the Asian crisis but now exceeds $70 a barrel. "I estimate from financial statements that the taxable income of just the big three U.S. oil companies (Exxon-Mobil, Chevron-Texaco and Conoco-Phillips) went from about $44 billion in 2003 to over $100 billion in 2005," Gupta says. "This does not take into consideration independent oil and gas producers or independent refiners and marketers — both groups saw an increase of over 90 percent in their incomes."

The dividend repatriation tax benefit is strictly a one-time affair, Gupta emphasizes, and the profits of the oil and gas industry are notoriously cyclical. On the individual taxpayer side, government revenues are increasing because investors are quicker to cash in on stock market gains, and not necessarily because of Bush's cuts to the capital gains tax, Gupta says.

"I believe individual stockholders are less likely to sit on gains since the steep tech-related corrections we saw in the stock market in 2001-02. Cashing in the gains results in recognizing the profits and paying taxes. This could easily be interpreted as the lowering of the tax rate causing individuals to cash in their gains; however, the data cannot rule out the first interpretation."

"The problem with capital gains income is that it depends on transactions that may not repeat," Dennis Hoffman, professor of economics and director of L. William Seidman Research Institute in the W. P. Carey School of Business, says of the lower deficit. "Most expenditure obligations are ongoing. Budget challenges will reoccur if taxable capital gains income declines."

Hoffman says Bush's advisers know the current good news is probably ephemeral. Much of the increased tax revenue has come from the selling of stock and real estate, but there are increasing uncertainties in both equity and housing markets today, he says. "A lot of investors cashed out on real estate holdings in the last couple of years," Hoffman says. "The smart money always gets out early."

Corporate tax compliance up

Charles Christian, director of the School of Accountancy at the W. P. Carey School of Business, says part of the improved revenue picture is due to an increase in overall corporate income tax compliance. And, although the Internal Revenue Service has increased enforcement in the area of "income shifting," Christian says, many observers believe that income shifting still may be a growing problem.

Income shifting is misreporting the source of income. It usually is associated with over-reporting incomes in low-tax jurisdictions and underreporting income in high-tax jurisdictions, Christian explains. Multinational corporations are supposed to use fair-market values, but it is hard to determine fair-market in-company transfer prices. There is wiggle room, and it is a judgment call.

Christian says there is overwhelming evidence that companies have grossly undervalued intellectual property, materials and work in process that they transfer to their subsidiaries. The IRS has been aggressively increasing enforcement on these transfer-price strategies, and corporations are striving to be more accountable since the corporate accounting scandals at Enron, WorldCom and other corporations. Both factors tend to increase tax revenue.

"There has been a significant [revenue] increase, in that corporations have become much more conservative in their income tax strategies and income tax-sheltering practices since the criminal investigations that occurred in past five years." Christian says. "I believe it [tax sheltering] is less than it was four or five years ago."

The Sarbanes-Oxley Act, though costly to implement, has tightened accounting, reporting and oversight practices and, Christian says, there has been more of an emphasis on increased corporate citizenship and governance. "Public, congressional and investor sentiment is certainly part of it," he says. Christian believes that because we are in an era of increased scrutiny of corporate governance, it is simply a matter of corporations being less aggressive in their tax-avoidance strategies — off-shore subsidiaries in the Cayman Islands come to mind.

Hence, it is a factor in the surprising surge in federal tax receipts. "I would suggest a general increase in income tax compliance." It is hard to predict whether such volatile revenue increases will continue, Christian says: "It's like forecasting stock prices."

Challenges ahead

Generally, the elimination of the federal deficit in the '90s has been attributed to President Clinton's rescinding previous supply-side tax cuts, robust growth that occurred despite the tax hike, and the success he and Congress had in reining in spending. But revenue coffers swelled in large part due to the rapid expansion of the U.S. economy and domestic equity markets. The S&P 500 index tripled from 1995 to 2000. The economy that Clinton faced was conducive to deficit reduction and the economy that Bush faces is not.

"It's a remarkable thing how quickly the federal deficit disappeared from the early '90s to the late '90s, but efforts to balance the budget today must confront much slower-growing taxable incomes," Hoffman says. And, an even-lower-than-expected $260 billion deficit in 2006 nonetheless is part of a negative reversal of about $560 billion from the $300 billion surplus projected for 2006 when Bush was sworn in. Should, as Bush urges, the tax cuts be made "permanent" in light of looming deficit challenges?

"One has to look at the amount of spending, where we are spending, whether spending is growth-enhancing, etc.," Hoffman says. "Low tax rates are growth-enhancing, but there has to be a balance between reducing taxes and reducing spending. Historically, critics have derided the Federal Government s 'tax and spend' policies. Today's policies cannot really be labeled 'tax and spend' — they are more properly labeled 'borrow and spend.'

The burden for today's spending is placed on future generations. Frankly, this is fine if the spending constitutes infrastructure investment that leads to growth and higher standards of living for future generations. But much of today's spending is just for today." Gupta says tax cuts might affect the timing of investment decisions but the cuts do not necessarily affect aggregate wealth and well-being.

"This has long been one of the beliefs among academics that if one were to lower tax rates, especially temporarily, then it shifts activities into tax-favored areas," Gupta says. "The best example is that of the response of savings to after-tax rates of return. One would expect that as the after-tax rate of return increases, savings rates should increase." But overall historical data show the opposite is true in the United States.

"Over the last two, three decades, what one finds is that when a tax-favored account is introduced, say such as a 401k, taxpayers are known to shift their savings from some non-tax-favored vehicle to a tax-favored vehicle, but their aggregate savings are not higher simply because there is a tax-subsidy for the savings."

Indeed, Americans have slipped into an overall negative rate of savings fueled by high credit card debt — which is troublesome, especially in conjunction with rising government debt that exerts a downward pressure on programs that encourage education and other future-directed priorities.

"I see this as largely problematic," notes Hoffman. "No good comes from having high credit card debt. Day to day consumption should be financed out of current income. Longer-term investments like tuition need to be aligned with financing mechanisms that are more interest-friendly, like student loans."

Some critics of supply-side tax cuts pose this question: Would current tax revenues be even higher if tax rates were at a Clinton-era level? "Not entirely," says Hoffman. "One major catalyst for the capital gains realization is the dramatic reduction in federal rates to 15 percent. Capital gains used to be taxed at regular income tax rates. It is reasonable to believe that some investors have chosen to realize long-term capital gains under these reduced tax rates."

Gupta and Hoffman fault Congress and Bush for avoiding tough choices.

"All else being equal, of course lower rates are better than higher rates, but you cannot have your cake and eat it too," Gupta says. "You cannot simply keep increasing the expenditure side and cutting taxes at the same time. We have had a tremendous surge on the expenditure side, such as the war effort, prescription drug benefit, etc. I believe it is foolhardy to think that we will grow our way out of the large deficits.

"So if taxes are to be cut, then so must expenditures," Gupta continues. "Further, if taxes are to be cut, there should be an equitable way to think about this issue rather than enacting temporary, ad hoc, targeted tax benefits aimed at further distorting the market forces. Lower rates are a good thing, but you cannot have a lower rate and do nothing to broaden the tax base. Currently the definition of the tax base needs a lot of work to get rid of the myriad exceptions, special deductions, etc. If that is done, then discussions about making the tax cuts permanent makes sense. Not otherwise."

OMB numbers show the United States' percentage of national debt to GDP increased from 33.3 percent when President Reagan took office in 1981 to a peak at 67.3 percent in 1996, then dropped over the next four years to 57.4 percent in 2001, then rose to 63.7 percent by 2004. The United States ranks 35th, among the worst third of the world's nations in this regard.

Will the debt get worse? "You've got a legacy of rapidly increasing debt just as we did in the '80s," Hoffman says. "I would expect it to grow some over the next few years since we seem to have no political will to raise taxes nor to cut spending. That leaves us no choice but to borrow from the future."

Bottom Line:

• Recent estimates of the United States' federal budget deficit for 2006 have been declining, due to higher corporate and individual tax receipts, but the good news may only be temporary.
• Increased corporate profits are largely the result of temporary or cyclical factors such as the increase in oil prices, corporate belt-tightening and decreased technology spending. In addition, the one-time dividend repatriation tax benefit and improved compliance with tax laws have increased revenues.
• On the individual taxpayer side, government revenues are increasing because investors are cashing in on gains in real estate and the stock market.
• The United States' percentage of national debt to GDP is increasing, and will likely continue to do so in the absence of tax increases and/or spending cuts.

Economics Faculty