The Deficit and Your Portfolio

What Are the Causes of the Deficit?

In his budget message, President Bush said that "a recession and a war that we did not choose have led to a return of deficits." Call this the cyclical view. A major cause of the surplus that during the Clinton administration, according to this view, was the revenue bubble that went along with the stock market bubble.

Soaring stock prices produced soaring tax revenue. And when the bubble burst, tax revenue went into a steep decline. Tax revenue fell in 2001 and 2002, the first back-to-back decline in 40 years. The 7% revenue decline in 2002 was the steepest drop since 1946.

The good news in this bad news is that, if the deficit is a result of a cyclical decline in tax revenue, then an economic recovery that produces a cyclical increase in tax revenue should rapidly eat into the deficit.

But what if the deficit isn't cyclical but structural? According to this view, the Clinton-era surpluses were temporary and misleading. The surplus was an accounting fiction caused by baby boomer revenue that was arriving before the costs of benefits and retirement for that generation came due. If you looked at the surplus in a longer time frame than an annual budget, it disappeared -- eaten up by increases in health care costs, for example. If you agree with the structural viewpoint, then the temporary surplus should have been saved to meet the bills that were rapidly coming due.

The Bush administration and its allies among supply-side believers have an answer for the structural deficit camp. The Bush tax cuts will create enough extra growth and generate enough extra revenue to meet these future bills.

The structural deficit believers argue the tax cuts make the structural problem worse. They guarantee that when the economy does come out of its cyclical trough, the tax rates in effect won't generate enough revenue to get us back to even a Clinton-era surplus, let alone the kind of surpluses necessary to fund the bills coming due.