Thoughts

February 28, 2025 | 13:27

GOP Wrestles with Budget Deficit

Economist

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Sal Guatieri

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

By a narrow margin, the House of Representatives passed a budget plan this week. But it will leave little room for the President’s proposed tax cuts, while still increasing an already massive budget deficit. The plan allows for the extension of the 2017 individual and other tax cuts beyond this year. But it also relies on significant cuts to Medicaid, which the President opposes, and to government programs, which he favours. Next up, the Senate’s budget plan could propose even larger tax declines than the House blueprint and even deeper spending cuts. After the two chambers agree on the same plan, a simple majority will be needed for passage before sending to the Oval Office for signing into law.

The House budget plan calls for $1.5-to-$2 trillion of spending cuts and $4-to-$4.5 trillion of tax cuts by 2034. The Committee for a Responsible Federal Budget (CRFB) estimates the plan will add at least $2.8 trillion to deficits over a decade, averaging 6.8% of GDP—one percentage point higher than under current law. The larger deficits (and extra interest charges) would add $3.4 trillion to the federal debt by 2034, lifting the debt ratio to 125% of GDP compared with 117% under current law. The Administration believes that part of the shortfall can be covered by tariffs. A 10% universal levy on all imported goods might raise about $300 billion annually—enough to eliminate the incremental increase in the deficits over the decade. However, this assumes no material decline in imports (which is the main aim of tariffs) and little loss of revenue from the businesses and consumers paying the import tax.

The tax proposals almost wholly include the extension of the 2017 tax cuts beyond this year, which the Congressional Budget Office estimates will cost more than $4 trillion through 2034. This leaves little room for new tax initiatives (unless budget tricks are used), and not nearly enough to cover the trillions of dollars in tax reductions that the President proposed during his campaign: to lower corporate taxes; repeal taxes on overtime pay, tips, and Social Security benefits; and lift the cap on state and local tax deductions. Meanwhile, a portion of the up-to-$2 trillion in spending cuts could start to hit the economy before the tax relief kicks in, risking a moderate drag on the economy this year. The Department of Government Efficiency is already in full swing, and this week the Administration announced even deeper cuts to federal agencies and outside contracts. It also called for a “significant reduction” in federal staff over the next three and a half months. While the military and Post Office are exempt from the layoffs, that still leaves over two million federal workers in fear of losing their job and in no mood to increase spending. A recent court order blocking mass firings at U.S. agencies may only prove temporary, at which time a key driver of overall job growth in the past year will come to a halt.

For the broader economic outlook and other workers, the concern is that spending cuts could outweigh new tax reductions this year, slowing the expansion more than expected. While this could help ease inflation and interest rate pressures, it may also amplify the impact of tariffs. The economy will eventually benefit from lower taxes, but not before it undergoes some near-term pain.