ECONOMIC ANALYSIS: It’s time to get realistic about the federal deficit

Most of us know that the dollar figures used to describe the national economy are awfully large. That includes the dollar totals that pertain to the operations of the federal government as well.

We’re a big country, with a population nearly 300 million strong. We have the world’s largest economy, and, yes, the world’s largest government. And every newly elected congressman or congresswoman soon gets comfortable tossing around multibillion-dollar spending commitments as if they were salt and pepper shakers at the dinner table.

Economists have a way of dealing with huge numbers. When something gets very large, we divide it by the gross domestic product. The GDP is the total output of the national economy, measured in dollars. It’s now $13 trillion. That usually brings most of those sky-high numbers back to Earth.

We like to look at a lot of aspects of the economy and government spending relative to GDP. It’s not because we economists can’t comprehend large numbers, but simply that it makes sense to do so.

So when we look at the federal government finances, we understand that in the context of a growing economy, government grows as well.

On the other hand, growth in spending, revenue or deficits relative to the size of the economy is quite another matter. A scenario where deficits as a percentage of GDP are growing is analogous to an individual household whose loan payments are gobbling up an increasing share of monthly income, and can be cause for serious concern.

You may take comfort in the official projections of the Congressional Budget Office, which show that the federal budget deficit will fall, both in terms of dollars and percentage of GDP, in the 10 years ahead. Thanks mostly to growth in revenue, the deficit is officially projected to fall to less than 1 percent of GDP by 2012, which is quite low by post-Vietnam War standards.

But you cling to that security blanket at your own risk. Not only have CBO projections of deficits proved wildly inaccurate in the past, but in this instance they include assumptions about future spending and revenue that almost all agree are unrealistic.

As currently written into law, the reductions in tax rates, the tax treatment of dividends, and the changes in the federal estate tax are due to expire beginning in 2010. So the CBO projection calls for tax revenue-projected to hover just above 18 percent of GDP until that year-to shoot up to 19 percent beginning in that year. How will the economy react to that change? CBO projections don’t incorporate these so-called dynamic effects.

But there’s another reason to doubt this rosy revenue projection. It’s a nasty, green monster called the alternative minimum tax.

The AMT originally was intended to snare very wealthy taxpayers whose clever use of deductions might allow them to escape paying significant taxes. But it’s been reaching further into the ranks of high-income and even middle-class households with each passing year.

That’s because the thresholds that determine whether one must go through this cumbersome parallel universe of taxation were not adjusted for inflation when the system was implemented. Thus, the AMT essentially amounts to a silent tax increase with each passing year.

Between the years 2005 and 2010, the number of returns affected by AMT is projected to grow 150 percent-to just under 25 million tax returns.

The onerous record-keeping, not to mention the painful tax bite, of this illdesigned system can be expected to raise calls for its overhaul. Yet doing the sensible thing and indexing AMT thresholds for inflation would cost the U.S. Treasury $370 billion over the next 10 years.

And you can guess what that does to the deficit. In fact, when you get more realistic about expiring tax provisions, AMT overhauls and spending projections on things like defense, we’re heading to a world of increasing, not decreasing, deficits. And that’s not a place we should be going.