Why the federal budget deficit has dropped

President Bush is set to announce this afternoon that the federal deficit will drop to $205 billion, or about 1.5% of GDP, for the fiscal year that ends in September. This is actually a worse deficit than folks were predicting early this year (I think Iraq war spending has had something to do with that), but I still figure the time is right to recycle my explanation of why it is the deficit has dropped so much over the past couple of years, from a column I wrote in March. It has nothing to do with spending; that has kept going up. Instead, the improvement has all been on the revenue side:

... what is it that has driven up tax revenues so dramatically over the past couple of years? "It's actually fairly clear," says the dean of America's tax-policy geeks, the Urban Institute's C. Eugene Steuerle. "It's just the increasingly unequal distribution of income." That is, the federal deficit has been shrinking because the rich have been getting richer. This is not a development the President is likely to brag about the next time he makes a speech about the economy. But, hey, it pays the bills.

When income gains are skewed toward those who pay taxes at the highest marginal rate, which is now 35%, revenues go up faster than if income rose evenly across all tax brackets. And sure enough, the trend toward more uneven income distribution has been boosting the government's bottom line for decades. In 1979 those with incomes in the top 0.1% of American taxpayers (those with $233,539 or more in adjusted gross income) accounted for 3% of income and 7% of tax receipts, according to the IRS. In 2000 the cutoff for the top 0.1% was $1.6 million, and their share had grown to 10% of income and 19% of taxes.

These income and tax shares dropped during the subsequent recession--those on the top rungs of the income ladder get much of their money from stock options, bonuses and other sources more volatile than wages and salaries. But they're climbing again.

The detailed IRS data on this tax swing aren't out yet, but there's plenty of other evidence. For one thing, while income tax revenues are up sharply, Social Security and Medicare tax receipts have remained flat as a share of the economy. "That tells you it isn't the average wage earner whose taxes are going up," says Steuerle. Another sign is that capital-gains taxes, paid mostly by the wealthy, doubled from 2003 to 2006. ...