Heroic Assumptions?

The Lehmann Letter ®

Today’s news reported that the President’s budget calculations include the projection that GDP will contract by 1.2% this year and expand by 3.2%, 4.0% and 4.6% in each of the following years. In addition, the budget assumes unemployment will rise to 8.1% this year and fall slightly to 7.9% next year.

Let’s hope so.

Because if those numbers are too optimistic and GDP falls more sharply and recovers more slowly so that unemployment rises to 10% or more, the president’s objective of halving the deficit by the end of his first term won’t be met. Here’s why: Reducing the deficit by half depends upon strong growth in tax revenue, and that depends upon a healthy increase in output and income because federal tax revenues (income tax and profits tax) grow with income. If recovery from recession is robust (V-shaped), as the President’s projection assumes, then surging revenues will swiftly reduce the deficit. But if this recovery is halting (U-shaped) or, worse yet, stunted (L-shaped), the President’s projection will fail.

Recall the rosy forecasts made earlier in this decade of ever-larger budget surpluses for the foreseeable future. Those estimates assumed there would be no recession and no tax cuts, assumptions that the 2001 recession voided. That recession sharply reduced income while tax cuts abridged the tax take from that income. Budget surpluses swiftly became deficits.

The current recession has already reduced output, income and income-tax revenue. The chief question is: How swiftly will they rebound? That depends upon the strength of the economic recovery and the extent to which any tax increases on the wealthy offset tax reductions for the less affluent. Let’s hope the President can get his tax program through Congress. Let’s also hope the President’s GDP and employment projections come true.

© 2009 Michael B. Lehmann