Corporate Tax Number to Blame for Growing Federal Deficit

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. The U.S. budget deficit grew in fiscal 2016. I'm here with Bob Johnson, our director of economic analysis, to see what was driving that, and what are his projections and what it's going to look like in the future.

Bob, thanks for joining me.

Bob Johnson: Great to be here today.

Glaser: So, let's look at this fiscal 2016 data. Where did the budget deficit come out?

Johnson: Yeah. We came in at a deficit of $588 billion when we adjust that number for the Medicare payments which were double-dipped in 2016. So, we are at about $588 billion. To put that in some perspective, that's up from the $435 billion or so the previous year which was the low of this cycle. And it's now about 3% of GDP versus about 2.5% of GDP. So the deficit has clearly worsened after many years of nice improvement.

Glaser: So is this a story of spending going up considerably or is it that less money is being brought in through tax revenue?

Johnson: Well, the really big problem is on the revenue side, but let's talk about the expenses first. They were up about 4.6% year-over-year which was actually less than the year before and the big driver of that was the entitlement programs or the mandatory programs, if you will, of Social Security, Medicare, and Medicaid. And you roll those together and they were up a fair amount, but the other category was only up 3%. So that was some good news that that remained under tight control, largely as defense spending still remains pretty close to zero year-over-year. So spending was not really the problem.

Glaser: But if bringing in revenue was, what segments are not doing as well?

Johnson: Yeah. The corporate tax number looked just awful. I mean, for the full year, corporate tax collections were down 12%. So that's a pretty big number and people had thought this wasn't going to be a great year for collections. But this was kind of truly awful. And we knew it wasn't--or we all suspected it wouldn't be a great number because they made a bunch of tax law changes. A lot of the credits and so forth that were set to expire in December were eventually renewed at the eleventh hour. So people had accrued for those and they did end up having to pay them. So kind of went as a credit against future tax bills and that went retroactively. So that certainly hurt the number and we suspected it would. But thought we'd kind of lap that phenomenon and that maybe corporate profits would creep up a little bit and then you combine the two, it wouldn't be quite the disaster that it was, but it didn't. In fact, the September, which is a big collection month for corporate taxes, looked almost as bad as some of the other big collection months of the year. So no improvement on that front yet, which is problematic longer term because it's an important part of the data set.

Glaser: So, any prospects of that looking better next year? I know as we enter earnings there aren't a lot of--or there isn't a lot of excitement that corporate earnings are going to look much better.

Johnson: No, we're not in great shape there. I mean, I think if you look at a lot of the forecasts that are out there, the September quarter is now projected to be another lackluster earnings growth period, especially for the S&P 500, maybe not as down as much it was but the expectations are still for a down year-over-year profit number yet again. So that's a bit of a problem, and certainly we didn't start out the earnings season with a boom. Alcoa certainly kind of laid an egg with their numbers and got us off to a bad start on earnings season.

Glaser: So, looking at individual taxes, capital gains had driven some better numbers there, but that wasn't the case this fiscal year?

Johnson: That's right. I mean, on the total individual tax collection number, the numbers looked relatively dismal. There was actually no growth in that which might--we'll get to why, but overall the number was about zero and a lot of it related to, as you said, there weren't as many capital gains. So people didn't have to pay taxes on them and that kind of went away. Small business profits kind flow through the individual line, the ones that aren't organized as corporations and certainly that hasn't been a great number either. And kind of some of the bonus-type income wasn't as great as it had been. It wasn't disastrous but they weren't as good as they had been. So we had no growth from those sectors which are often higher earners, didn't do quite so well with absolutely no growth there. And again, remember, spending was up 4.6% and we got corporate down; we've got total individual flat. So it certainly wasn't a good news story.

Glaser: But there was at least one bright spot?

Johnson: There was and that's the payroll taxes. We've talked about the employment growth being good, not necessarily great, but we've certainly seen some improvement in the number of workers and we've seen some improvement in hourly wages. And you put those two together and Joe Taxpayer kicked in about 5% more in taxes than a year ago. So that was the one really bright spot in the number and because that's a pretty big category, that just about offset the corporate tax decline. So the two canceled each other and we got about kind of a net flat number for total tax collection.

Glaser: So then what do you think payroll taxes could look like in the coming years? Is this a category that can keep growing?

Johnson: I believe it is and we will lose some ground in number of employees, I think, but what will offset that is, I think, wage growth will be better. We've talked again and again about the demographics and tight labor markets, and we saw even in last month's employment report the one bright spot, at least if you're an employee, was that year-over-year hourly wage growth was at about 2.6%. And as soft as the employment market may be, I think everybody still thinks it will grow at least 1%. So you add those two numbers together, and you're at a pretty healthy number there. You are more at the 3%, 4% level at least. So I'm not expecting a dramatic slowing.

And then the other thing we'll have happening in payroll taxes is again, while there won't be any COLA Social Security, we're going to have two years of catch-up in the maximum amount that can be taxed for Social Security. That's going to go up about $8,000 from about $118,000 to $126,000, so again kind of September or October of next year when a lot of people fall out of paying Social Security, there may be a little bit goose to the numbers at that time frame.

Glaser: And when we look at some other labor market data that we got this week that kind of supports that thesis of reasonably slow growth but still growth?

Johnson: Yes, we did. We saw the Job Openings and Labor Turnover report, the acronym being JOLTS, and what that report showed is that there were fewer job openings than the previous month. Now, we saw a huge revision to the numbers for July, almost up to 5.9 million openings which was kind of a high for the recovery, but we did see a big drop in the August data which we received this week and that dropped to 5.4 million openings, one of the larger drops that we've seen in openings, and it also depressed the year-over-year growth rate in jobs openings which had been slowing for some time which is actually more problematic to us. The falling openings isn't necessarily dreadful month-to-month, but what's really important is, what's happened to that growth rate and it has come in for some time which is usually consistent with slower employment growth six to nine months out.

So, clearly, it's not a great news that the openings are slowing, but this is kind of unusual times. I mean, the openings have gotten so huge relative to hires that it really is kind of a problem. And in fact, openings are still higher than the number of hires this month of about 5.4 million openings and 5.2 million hires, and the hires didn't fall off nearly as much as openings did. So that actually may say there is a little bit of matching going on out there that finally supply and demand is kind of matching up a little better than it was. So that's a bright spot out of the JOLTS report along with the number of quits still remained near a recovery high of about 2.1% of the workers quitting, and obviously, if workers quit, they've got enough confidence that they are going to find another job. So that was certainly some decent news in the opening openings report too. And the number of unemployed compared to the number of openings was also relatively high--or low yet. So that was good news too.

Glaser: Overall though, when you look at fiscal 2017, would you expect the deficit to continue to creep higher or are there signs that spending could come in more that we could see some surprises at revenue?

Johnson: Well, I think, this year the Medicaid number won't be as big and I think we probably past in the last couple of years our big wave of new Medicare people and that will continue to be at a high level but we may have hit the peak of the growth in that in the number new Medicare enrollees. So I would suspect that on the spending side we're probably OK. I think defense spending, it's hard to imagine it's going to go down a lot more than it already has. So we'll be OK there. The COLA adjustment on Social Security, again will probably be relatively de minimis. So that won't hurt on the spending side. It will depend on the next Congress how we do on the "other" category. But for the first few months, obviously, the budget has been a stop-gap measure at about where we were last year. So the first three months shouldn't be too bad, but we'll see what happens with the new Congress next year.

Glaser: Bob, as always, thanks for your analysis today.

Johnson: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.