Evidence continues to mount suggesting that the U.S. budget deficit is falling significantly below earlier projections. With it, the bear camp on the economy and the markets is losing a major component of its case, which has depended greatly upon the risks associated with the very large U.S. trade and budget deficits. The decline in the budget deficit is good news for the U.S. economy and its financial markets, as it is reducing the "crowding out" effects that stem from Uncle Sam's absorption of capital from the private sector.

It now looks likely that the U.S. budget deficit will fall by as much as $100 billion or more in the current fiscal year compared to fiscal 2004 when the deficit reached a record $412 billion.

How can we be so sure? Well, the fiscal year is already three-quarters complete and the deficit is running $76 billion below where it was in the same period a year earlier. Moreover, in an important validation of recent budget trends, the nonpartisan Congressional Budget Office, or CBO, said in its monthly budget review released on July 7 that the 2005 deficit will be significantly less than $350 billion, perhaps below $325 billion. Private forecasts are increasingly moving toward these tallies, with many now forecasting a deficit below $300 billion.

Deficit Reaching Bush Goal Much Earlier

A continuation of the recent trend would put the deficit for next year at $250 billion to $275 billion, which would represent a near halving of the deficit as a percentage of the gross domestic product. Reaching such a target would give a lift to President Bush, who has pledged to cut the deficit in half by 2009.

For the current fiscal year, a deficit of under $360 billion would put it at just under 3% of GDP, a level widely seen as acceptable throughout the industrialized world, particularly in Europe, where members of the European Monetary Union, or EMU, are required to keep their deficits below 3% of GDP. (Several EU countries, including Germany, have seen their deficits rise above 3% of GDP, but have been able to skirt hefty fines scheduled in accordance with rules regarding the EMU.)

The falling budget deficit is allowing the U.S. Treasury department to cut the size of its Treasury offerings, thus freeing money to the private sector. This is a point that the Bush administration has been increasingly vocal about making. On Monday, for example, Tim Bitsberger, the assistant Treasury secretary for financial markets, said that the Treasury had been able to reduce the size of its debt offerings because of stronger tax receipts, which the administration argues is related to strong growth in the U.S. economy.

The cutbacks in the size of the Treasury auctions have been stark. For example, the size of the monthly two-year T-note auctions has been cut $4 billion to $20 billion over the past two months, the largest decrease for a two-month period in at least 20 years and the smallest monthly offering since October 2001.

Similarly, Monday's announcement of $13 billion in five-year T-notes is a cut of $2 billion from two months ago and the smallest monthly offering since November 2001. That's $6 billion per month that won't be going to Uncle Sam and which will instead find its place elsewhere (likely somewhere more beneficial to the economy).

Taxes Flowing Into the Treasury

The main cause of the brighter budget picture is a surge in tax receipts.

According to the CBO, individual income tax receipts accounted for more than half of the revenue growth seen in the first nine months of the current fiscal year, increasing $105 billion, or about 18% above the same period a year earlier. About two-thirds of this increase, the CBO states, resulted from higher receipts from nonwithheld taxes, most of which were recorded in April and May when many taxpayers filed income tax returns for 2004.

Many are theorizing that income tax receipts have exceeded expectations because more of the income received in the economy has gone to workers paying higher income tax rates, owing to the fact that their income levels are higher relative to the national average. Others believe that the gains reflect a broadening of the tax base, which has expanded due to underreporting of gains in personal income.

Corporate income tax receipts are also rising at a rapid pace, increasing by about $57 billion, or 41%, above a year earlier. Although last year's expiration of depreciation provisions enacted in 2002 and 2003 contributed to the increase, it is hardly the best explanation. The economy is at the root of this surge.

The next big news on the budget front will come on Wednesday when the Office of Management and Budget releases its revised forecasts for the 2005 budget deficit. The release will raise investors' awareness of the brightening budget outlook.

In so many of the conversations that I have had with investors and market observers, those who profess to be bearish on the U.S. economy and the markets have oft cited the U.S. budget and trade imbalances. While the trade data isn't likely to improve significantly until either global economic activity accelerates or the price of oil falls, the budget situation looks likely to stay on a path to make for a far more benign resolution than bears have contended would be the case.

Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of

The Strategic Bond Investor. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy. Crescenzi appreciates your feedback;

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