Crumbling financial markets mean more awful news for governments already reeling from an economic slowdown and mortgage foreclosures. The only glimmer of optimism is that the sluggish revenues and rising spending that are around the corner should only be transitory. Assuming the markets and the economy rebound, these fiscal shocks will be a fading memory after a few years.
That won’t relieve short-term budget pressures. Nor will it make life any easier for a newly-elected President who will take office in the face of a deficit that CBO projected at nearly half a trillion dollars even before the markets cratered this week. But there is a big difference between the kind of one-time budget shocks caused by crashing financial markets and the trillions in long-term unfunded obligations that Washington is happily ignoring. That slow wasting of the nation’s financial underpinnings doesn’t grab headlines, but is far more dangerous.
If the current market correction ends up looking more or less like our last three big financial hiccups in 1987, 1990, and 2001-2003, capital gains tax collections will plunge for a year or two, but then bounce back.
After the market’s crash in 1987, these revenues fell 19 percent in 1988, flat-lined for a year, and then, as the stock market sagged again, dropped another 27 percent by 1991. However, through the rest of the 1990’s, capital gains taxes grew strongly as the market boomed. By 2000, Washington was collecting more than $120 billion in capital gains taxes, nearly four times what it got a decade before.
The pattern held after the tech bubble burst in 2001. Taxes on gains plunged by 59 percent through 2003, but then, with the market, they recovered. By 2005, revenues had climbed 50 percent, even though the top rate on gains had been cut to 15 percent.
Some states did not fare so well. California saw taxes on capital gains and stock options plunge by nearly $10 billion after the dot.com bust. And while those revenues have rebounded, the state has never quite gotten back on its fiscal feet.
Of course, some things are different this time, even for Washington. Thanks to the government’s unprecedented bailouts of Fannie Mae, Freddie Mac, Bear Stearns, and now AIG, Washington is on the hook for tens of billions and perhaps hundreds of billions more in spending that nobody foresaw even a couple of months ago.
It is not possible to put a dollar amount on those new obligations, which is very frightening. If the government ends up nationalizing more failing firms, the fiscal cost could become far more worrisome. But like spending for natural disasters, these bailouts are likely to be one-off expenditures. The government, thankfully, can buy AIG’s toxic assets only once.
Don’t get me wrong. This is all a very, very bad business. But unlike the future prospects for, say Medicare, this grim news has the potential to improve fairly soon.
