Deficits and Tax System Changes in Bush's Second-Term Economy

By EDMUND L. ANDREWS

New York Times

WASHINGTON, Nov. 3 - Even as President Bush was celebrating his election victory on Wednesday, his Treasury Department provided an ominous reminder about the economic challenges ahead.

After four years of rapidly rising budget deficits, the Treasury announced on Wednesday morning that the government will borrow $147 billion in the first three months of 2005 - a new quarterly record, but one that is likely to be eclipsed before that year is out.

Empowered by his own victory and stronger Republican majorities in Congress, Mr. Bush has pledged to push an economic agenda that could be more ambitious than the $1.9 trillion worth of tax cuts over 10 years that he signed in his first term.

The new economic agenda will focus on two big goals. One is expected to aim for a fundamental overhaul of the income tax, very likely in the direction of a system that lessens even further the taxation of investment income; the other to push for a partial privatization of Social Security that could eventually reduce costs but require borrowing more than $2 trillion over the next two decades.

The challenge ahead can be seen in the fiscal decline that took place between Mr. Bush's first inauguration in 2001 and his second one on Jan. 20, 2005. Federal tax revenue was $100 billion lower this year than when Mr. Bush took office, but spending is $400 billion higher.

The ballooning budget deficits, which could total $5 trillion over the next 10 years if Mr. Bush succeeds in making his tax cuts permanent, could constrain the president's choices far more than they have in the first term.

Foreign investors have thus far been willing to finance the United States' borrowing, but most of that has come from central banks of Asian nations rather than private investors. If foreign appetite for Treasury securities wanes, interest rates would have to rise to make such investments attractive enough to keep money flowing into this country.

"The U.S. bond markets are likely to react very badly,'' said Nariman Behravesh, chief economist at Global Insight, an economic forecasting company, "as investors begin to worry about the impact of these large deficits on U.S. interest rates, the U.S. current account deficit and the dollar."

Making the job more difficult, politically as well as economically, is that higher oil prices have slowed American growth even as job creation continues to languish. Consumer and business confidence have slipped markedly in the last few months. And while oil prices declined modestly over several days until a $1.26-a-barrel rise on Wednesday, most forecasters are expecting economic growth to slow to 3 percent in 2005 from about 4 percent this year.

Slower growth would aggravate Mr. Bush's budget problems. The war in Iraq and the continued occupation of Afghanistan could exceed $100 billion next year, according to a Republican analyst. None of that has been included in an administration plan for reducing the budget deficit by half over five years.

Mr. Bush has also promised to make his tax cuts permanent, which would add nearly $1 trillion to federal debt by 2014. And to avoid a huge tax increase for the upper middle class, he hopes to re-engineer the alternative minimum tax, a parallel tax that was created to prevent wealthy people from overusing tax deductions but that is expected to engulf as many as 30 million families by the end of this decade. That could cost more than $500 billion.

The biggest problem of all is the one that begins at the end of this decade: the looming retirement of 76 million baby boomers, which is expected to add trillions of dollars in new costs for Social Security and Medicare benefits.

Budget analysts say Mr. Bush can no longer blame slower economic growth or a weak stock market for the budget deficit, as he has in much of his first term, and he cannot count on faster economic growth to close the gap over the next four years.

"Policy choices will determine where we go,'' said Douglas Holtz-Eakin, director of the nonpartisan Congressional Budget Office. "We will not grow our way out of this. It is no longer the case that we can blame everything on the economy.''

During his first term, President Bush never vetoed a spending bill, including measures that greatly increased farm subsidies and added more than $140 billion in new corporate tax breaks. But even though Republicans have now expanded their control over both houses of Congress, Mr. Bush is likely to face bruising new conflicts as soon as lawmakers return for a lame-duck session to pass spending bills for the coming year.

He has threatened to veto a three-year bill for highways and mass transportation, which would spend tens of billions more than he wants. Meanwhile, to save money, Republican lawmakers have pared back a number of Mr. Bush's proposals for higher spending on favored programs like space exploration and foreign development assistance.

Mr. Bush could face his first test this month, when Congress tries to pass spending bills covering most areas outside the military and homeland security. The Senate proposals would run $8 billion higher than the House bills, and they include some of Mr. Bush's priorities in education.

William Gale and Peter Orszag, budget analysts at the Brookings Institution, estimated that budget deficits would remain at today's levels - equivalent to roughly 3.5 percent of the gross domestic product - for the next 10 years if Mr. Bush's tax cuts are extended and if Congress extends other tax cuts that have generally been renewed in the past.

And that does not count the $500 billion for repairing the alternative minimum tax. Mr. Bush ordered the Treasury to come up with a comprehensive solution by early next year, and that proposal could form the basis of a broader plan to overhaul the income-tax system. Even if the costs of repairing the tax are submerged in a larger plan, they will be difficult to avoid.

More ominiously, said Mr. Holtz-Eakin, who worked in the Bush White House before becoming head of the Congressional Budget Office, there is little room for error. Almost any unexpected shock - a new recession, or a new military crisis - could push budget shortages higher than the gloomiest forecasters are predicting now.

And even if Washington gets through the current uncertainties, only four years remain until the oldest baby boomers start to retire and the costs of Social Security and Medicare benefits gradually eclipse those of every other part of the federal government.