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November 29, 2024 | 14:02
America’s Coming Fiscal Follies
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Fixed Income Strategy
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Economics
America’s Coming Fiscal FolliesDuring the election campaign, sizeable spending and tax cuts were key Trump/GOP talking points. But the fiscal and social realities are constraining for both pursuits. |
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The new Republican-led Congress begins on January 3 with President-elect Trump’s inauguration on January 20. The new Congress and Administration have an ambitious fiscal agenda full of spending and tax cuts. However, they are inheriting fiscal fundamentals that are meaningfully weaker than they were the last time the GOP ruled the roost (Table 1). For example, the budget deficit is currently running above $1.90 trillion or 6½% of GDP, compared with well below $700 billion and 3½% eight years ago. Debt held by the public has popped by a third to top 100% of GDP. This fiscal deterioration is the joint legacy of tax decreases under Trump 1.0, spending increases under the Biden Administration, and pandemic-related measures under both regimes. |
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The new Congress and Administration will also face another fiscal issue at once. The debt limit becomes binding again after January 1. The ceiling was suspended in June 2023 and will be set at the current level of debt outstanding with no buildup of extra cash reserves allowed. The new Treasury Secretary will inherit the task of employing ‘extraordinary measures’ to keep funding the government for a few months more, until these measures are exhausted on ‘X-date’. This is when the government will be unable to honour all its spending obligations and possibly default on its debt unless the limit is lifted or suspended again. Presumably, the new Congress should have no problem passing legislation long before X-date with either of the two options, with President Trump signing it into law. Correct? Meanwhile, there’s also the chance that a government shutdown will greet the new Congress and Administration. This would be avoided if the old (split) Congress passes another continuing resolution (CR) to replace the one that expires on December 20, which we reckon is likely (but not guaranteed). Then the new Congress must pass a full budget (no CRs) by April 30 (which is already seven months into the fiscal year); otherwise, defense-heavy automatic spending cuts kick in. With a policy agenda pushing for across-the-board spending cuts along with lower taxes (or, at least, preventing the tax hikes that are scheduled in less than 14 months), we also reckon the GOP will be embracing the ‘budget resolution’ process as quickly as practical for both this and next fiscal year. The budget resolution process allows the government’s spending, tax, and deficit proposals to pass with a simple majority in the Senate, thus minimizing Democratic roadblocks. To use this process, the House and Senate must agree identically on the broad budget amounts (at the committee level for spending). There are restrictions that prevent ‘extraneous items’ (politicians’ pet projects) from being piled on and Social Security cannot be touched. There is also a restriction that beyond the budget projection window (typically 10 years) the deficit is not allowed to increase. The latter gives rise to the ‘sunset’ of measures such as the reversal of personal tax cuts effective January 1, 2026. This was included in the 2017 Tax Cuts and Jobs Act to abide by the budget resolution process. But the Republicans must first agree amongst themselves on the broad budget amounts including the increase in the deficit (a.k.a. ‘The Number’). This agreement is not a bill, so it doesn’t cross the president’s desk, but it must pass the House (with the GOP’s 2-to-4/5 seat majority) and Senate (with the GOP’s 3 seat majority). It’s not the Democrats that are the issue here, it’s the Republicans’ fiscal hawks. The current deficit profile is already considered to be unsustainable, according to even Fed Chair Powell and, likely, the kettle of fiscal hawks in the GOP. Making unsustainable more unsustainableThe new Congress is inheriting a deficit profile that starts this year at $1.94 trillion (6.5% of GDP) and improves to $1.76 trillion (5.5%) by FY2027 (Chart 1). Then it begins deteriorating to top $2 trillion (6%) again by FY2030 and hit $2.8 trillion (7.0%) by FY2033-34. There are three things to emphasize here. |
First, the Congressional Budget Office (CBO) projects the various budget amounts based on enacted legislation. So, the deficit improvement through FY2027 reflects the reversal of the 2017 tax cuts (the corporate tax cut is permanent). But this will likely not happen because, for example, the scheduled increase in personal tax rates will cause a hit to disposable income that will likely cause GDP to contract… the proverbial fiscal cliff. Extending the expiring tax measures through FY2034 would add $4.0 trillion to the cumulative deficit, according to the CBO. Second, the underlying steady deterioration in the deficit reflects the steady climb in interest on the debt (Chart 2). It’s topping a record $1 trillion this year (3.4% of GDP) and projected to climb to $1.7 trillion (4.1%) by FY2034. Last year it surpassed defense spending as a budget item and this year it will surpass nondefense discretionary spending. The increase reflects rising debt outstanding (cumulative deficits) and higher interest rates. Gross federal debt held by the public will top 100% of GDP this year and is on track to surpass the World War II-era record highs in two years’ time (Chart 3). Note the gap between total debt and that held by the public is narrowing as the dwindling Social Security and Medicare trust funds have less to invest. Meanwhile, the average interest rate on marketable Treasury debt has been hovering above 3.35% since July, the highest in 16 years. This is going to drift even higher as debt is refinanced with the entire yield curve lying above 4%. Third, there’s a discernible surge in the deficit circa FY2033-34. This mirrors the above-mentioned trust funds starting to become insolvent. The first to do so will be Social Security’s Old-Age and Survivors Insurance (OASI) Trust Fund in CY2033 with the others following suit within three years. When these trust funds become insolvent (meaning current and accumulated surplus contributions no longer cover benefit payments), the residual funding of these mandatory outlays adds directly to the deficit. (At some point, the politicians are going to have to fix this.) Faced with the prospect of deficits topping $2.8 trillion (surpassed only in 2020) and hitting 7% of GDP as the status quo, along with gross federal debt topping $56 trillion or 137% of GDP, we suspect the fiscal hawks will balk at making this unsustainable fiscal picture even worse. Extending (most) of the expiring 2017 tax measures might be written off as an economic necessity, but President-elect Trump’s campaign promises of even more personal and corporate tax cuts are going to be hard to swallow in the absence of meaningful spending cuts. (For the record, the Committee for a Responsible Federal Budget’s mid-range estimate of Trump’s promises, including an offset from higher tariffs, was a 10-year total deficit increase of $7.5 trillion.) |
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Given the fiscal starting point and should Congress want to make room for further meaty tax cuts, the typical nip-and-tuck approach to spending restraint will no longer cut it. Radical surgery is needed, hence the buzz about severing whole government departments such as Education. Enter the new Department of Government Efficiency (DOGE) headed by Elon Musk and Vivek Ramaswamy. Spending cuts are coming |
While a sharp focus on improving efficiency and eliminating waste can probably generate hundreds of billions in savings over the next decade, the DOGE heads argue that they can cut $2 trillion from the federal government’s $7 trillion yearly budget. To put this in context, apart from mandatory outlays (mostly on Social Security and Medicare) and interest payments, total discretionary spending (which includes defense) amounts to ‘only’ $1.8 trillion (Chart 4). The heads have mentioned such radical surgery as reducing the number of federal agencies and employees by some 75%. But the $2 trillion target still can’t come close to being achieved without touching mandatory outlays. Mandatory spending weighs in at $4.1 trillion or nearly 60% of total outlays. They are mandatory because they are governed by separate laws and are not part of the annual appropriations process. The various health care programs (Medicare being the largest) and Social Security are about 60% of the total (Chart 5). Assuming Social Security is off the table for the time being (recall the restrictions of the budget resolution process) along with the federal employee and military retirement programs, any recommended mandatory spending reductions are likely to come in health care and income security programs (e.g., the earned income and child tax credits, and ‘food stamps’). DOGE is expected to conclude its work and make its recommendations by July 4, 2026. It will be up to Congress to pick and choose which ones to follow, although some recommendations could fall under the purview of executive action. Congress has been here before. President Reagan had his Private Sector Survey on Cost Control, better known as the Grace Commission. In 1984, it came up with $424 billion in three-year savings, and Congress mostly didn’t pick or choose. Forty years later, the urgency to right the fiscal ship could make Congress a bit more amenable to radical reforms. But this is a mid-2026 story, and Congress still has to find spending cuts for the next year or two. |
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For the GOP, cutting spending too radically or quickly, with its negative economic and social consequences, could affect their prospects in the 2026 midterm election. It could more than counter the political ‘win’ of preventing most Americans’ taxes from rising. But not cutting spending enough and allowing an already unsustainable deficit profile to get noticeably worse could really bother the bond market. There’s an adage about deficits not mattering until they matter (just ask former British PM Liz Truss). Given the greenback’s reserve currency status and the Treasury market’s world-leading liquidity, the ‘deficit matters’ fuse is much longer in America… but there’s still a fuse. Bottom line: Congress will likely extend the expiring personal tax cuts and pay for them mostly through spending decreases but also via some modest deterioration in the deficit. Other proposed tax cuts might have to wait until we hear from DOGE. |