Bush or Kerry? Regardless, Taxes Are Set to Rise

With John Kerry all but guaranteed the Democratic nomination, attention has now shifted to the election itself and the position of the two candidates on the key economic and political issues. The recent weakness in the jobs market suggests that the economy may no longer be a huge plus for President Bush. However, the outcome of the election may only have a limited impact on the economic outlook. More specifically, regardless of who is the next president, taxes will have to rise.

The Weak Jobs Market Is Beginning to Erode Bush’s Election Margin

Every four years, Global Insight predicts the percentage share of the two-party vote won by the incumbent party. These predictions are based on an equation fitted over the 14 elections since World War II. The key drivers are a combination of economic factors (income growth and the unemployment rate) and pre-determined political factors (incumbency, party fatigue and party affiliations).

In December, the Global Insight Election Model predicted that President Bush would win with a 56.7% margin. Given the continued weakness in the jobs market, Global Insight has lowered its prediction for both jobs and income growth between now and the election (specifically, real per capita disposable income is expected to grow by 1.2% and the unemployment rate is predicted to edge down to 5.5%). Therefore, the Election Model currently predicts that the election margin will fall to 55.5%. Since the standard error of this model is 2.0%, this means there is about a two-thirds probability that the election results will fall between 53.5% and 57.5%.

The Economy Will Have More of an Impact on the Election than Vice Versa

If jobs and income growth fail to meet to expectations between now and the election, Mr. Bush’s election margin could narrow even further. In a pessimistic scenario (which calls for a 5.9% unemployment rate by election time and real per capita disposable income growth of only 0.5%) the margin falls to 53.6%. In such a scenario, the president would be more vulnerable to further bad news in Iraq or a surge in Mr. Kerry’s popularity. Thus, while a faltering economy alone may not be enough to deny Mr. Bush a second term in the White House, combined with other negative surprises, it could make for a close election.

On the other hand, regardless of who wins in November, the economic policy options facing the next president will be severely limited by the worsening budgetary outlook. Whoever is in the White House next year, and whichever party controls the U.S. Congress, fiscal policy will have to be tightened. This will happen either by choice or by coercion (e.g., a bond market sell-off). Thus, from the perspective of the economic outlook for the next couple of years, it may not make a lot of difference whether Mr. Bush or Mr. Kerry is the next president.

Notwithstanding Election-Year Rhetoric, the Next President Will Have to Raise Taxes

When pressed about deficit reduction, Mr. Bush has talked about cuts in non-defense discretionary spending, while Mr. Kerry has advocated raising the taxes paid by the wealthy. Unfortunately, neither of these will put much of a dent in the ballooning budget deficit. Also, neither candidate will be foolish enough to advocate across-the-board tax increases, even though such increases will inevitably have to be a major part of any deficit reduction package.

While some of the deterioration in the structural federal budget balance (adjusted for the business cycle) over the past four years has been due to a rise in spending (on homeland security, wars, and other discretionary spending), the major culprits have been the big tax cuts of 2001 and 2003. Federal spending as a percent of GDP has risen from about 18% in 2000 to about 20% this year, and is well below the levels of the 1980s and early 1990s. However, federal receipts as a percent of GDP have fallen from 21% in 2000 to below 16% this year, and are out of line with their historical average of between 17% and 19%. Similarly, the effective personal income tax rate, which on average was around 21% in the 1980s and 1990s, is currently around 16%. This fall was the result of tax cuts for low- and middle-income families, as well as the wealthy. While these cuts helped dampen the 2001 downturn and provided needed economic stimulus in the early stages of the upturn, they cannot be sustained.

The Global Insight baseline assumes that the federal budget can be brought close to balance over the next ten years using both broad-based spending restraints (with the spending-to-GDP ratio falling from 20% to 19%) and sizeable tax increases (with the revenues-to-GDP ratio rising from 16% to 18%). The Bush budget already includes some explicit tax increases (the expiration of the accelerated depreciation provisions) and some “hidden” taxes (via the greater coverage of the alternative minimum tax). However, much more will need to be done if the administration is serious about cutting the deficit by half over the next five years. Similarly, Mr. Kerry will have to bite the bullet on broad-based tax hikes and spending cuts if he is the one elected to make the tough choices.

The Political Backlash Against Higher Taxes Has Been Exaggerated

Most U.S. politicians are extremely reluctant to talk about tax increases for fear of repeating the mistake of George H.W. Bush, who raised taxes in 1990 (after promising not to) and lost his re-election bid in 1992. This may be a misinterpretation of history. First, the elder Bush’s election loss had as much to do with a weak economy as with the tax increase. Second, during his tenure as president, Ronald Reagan (one of the greatest tax-cutters of all time) raised taxes twice. The hikes neither hurt Reagan’s own re-election in 1984 nor the election of the elder Bush in 1988. Thus, while both the younger President Bush and Senator Kerry will avoid the “T” word during the upcoming election, they will probably not be punished by the electorate for raising taxes after the election.

2004 Presidential Election Model: