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July 11, 2025 | 13:28
Big Beautiful Bump (to Growth)
Economics
Economics
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Fixed Income Strategy
Economics
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Economics
Economics
Fixed Income Strategy
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Economics
Big Beautiful Bump (to Growth)After slowing partly due to the trade war, the U.S. economy will get a lift from the new budget bill. |
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On Independence Day, Congress passed the sweeping One Big Beautiful Bill Act (OBBBA), meeting a self-imposed deadline. The centrepiece of the Act are tax cuts and more spending on defence and border control, partly offset by reduced funding for health care, food stamps, and student loans. Analysts expect the Act to raise the budget deficit and lift the economy in the near term. But by how much? Taxes cutThe OBBBA’s marquee revenue measures include the permanent extensions of the tax cuts from 2017’s Tax Cuts and Jobs Act (TCJA) that were slated to expire January 1, 2026. For example, most of the seven personal income tax rates were poised to rise between 3 and 4 percentage points (ppts). In addition to being extended permanently, some TCJA measures were also enhanced. For example, the child tax credit, scheduled to drop to $1,000 next year from $2,000 currently, was lifted to $2,200 and will now be adjusted for inflation. Also, instead of being extended at $10,000, the SALT (state and local tax) deduction was temporarily lifted to $40,000. And other TCJA measures that were already being phased out were revived, such as bonus depreciation. The TCJA’s original 100% rate began dropping by 20-ppt annual increments in 2023 (to 40% for 2025). This is now set permanently at 100% beginning this year. The enhancement and revival of TCJA measures added to the price tag of the extension. The Committee for a Responsible Federal Budget (CRFB) pegs the TCJA-related total impact at $4.6 trillion, compared to the Congressional Budget Office (CBO) baseline. (Going forward, all dollar figures refer to 10-year totals over the budget period ending 2034.) The OBBA’s other major revenue measures (see Table 1 at the end) reflect some of the tax cuts promised during the election campaign. For example, no taxes on overtime pay or tips (both with limitations), along with a new tax deduction for auto loan interest and an increase in the standard deduction for seniors. (The latter is in lieu of more costly tax-free Social Security benefits that were promised.) Elsewhere, bonus depreciation was expanded to new factories. Note that all the new measures mentioned above sunset after 2028, partly to keep their total deficit cost down. Still, they amount to around $700 billion (CRFB), resulting in $5.3 trillion worth of total (gross) tax reductions. Interestingly, the OBBBA’s revenue offsets add up to just over $700 billion (CRFB), led by the repeal and reform of Inflation Reduction Act (IRA) tax credits (worth almost $545 billion). All in, the CBO estimates total revenue will fall by $4.5 trillion compared to the budget baseline. Spending sliced, but by lessThe OBBBA cuts total spending by $1.2 trillion compared to the CBO’s baseline. The largest slices to outlays occurred in three buckets. The first was health care, with a $1.1 trillion hit (CRFB). The bulk of this was reduced funding for Medicaid via establishing work requirements and tightening eligibility/enrollment rules, along with ‘savings’ in administering the Affordable Care Act. The CBO estimates that millions of Americans could lose health insurance coverage as a result. The second bucket was student loans, with a reduction of more than $305 billion (CBO). This mirrors stricter loan repayment and Pell Grant eligibility rules, along with lower borrowing limits and thus lower loan volumes over time. Note that under federal budget accounting rules, the ‘subsidy costs’ of student loans over their lifetime are measured on an accrual basis and recorded in the first year of the budget. As such, $172 billion in ‘subsidy savings’ on student loans are recorded in FY2025, amplifying the improvement in the budget but with little real economic impact. The third bucket was the Supplemental Nutrition Assistance Program (SNAP, a.k.a. ‘food stamps’), with an impact of around $185 billion (CRFB). This includes more stringent work requirements and eligibility rules, along with passing more of the program’s costs to the states. The CBO estimates that several million people could lose access over the budget period. Spending on defence and border security saw the biggest boosts, with their (committee) outlay envelopes expanding by $150 billion and nearly $130 billion, respectively (CBO). The latter includes $45 billion for expanding Immigration and Customs Enforcement (ICE) detention capacity to facilitate mass deportations. This could have significant negative impacts on industries that (knowingly or unknowingly) employ undocumented workers such as agriculture, construction, and hospitality. Current law vs. current policy |
Given the $4.5 trillion decrease in net revenue and $1.2 trillion drop in net spending, the OBBBA increases the cumulative deficit by $3.3 trillion, compared to the CBO’s baseline (ignoring additional interest payments, which could amount to nearly $715 billion according to the CRFB). The CBO baseline projection is the standard for measuring fiscal impacts of policy changes, and it assumes that policy evolves as existing laws dictate (a.k.a. the ‘current law’ baseline). The CBO’s latest (January) forecast assumed the expiring 2017 tax cuts would, in fact, expire (Chart 1). As a result, the baseline deficit projection shows an improvement as relatively more taxes roll in starting in calendar 2026, despite the economy falling over a fiscal cliff on January 1. The hit to disposable income from higher tax rates alone would be enough to push real GDP growth into negative territory in early 2026. This is one reason that at least some of the tax cuts would have been extended regardless of the outcome of last year’s elections. The CBO can also produce another budget projection based on existing policies remaining in place regardless of what current laws dictate (a.k.a. the ‘current policy’ baseline). This provides a better jump-off point for assessing economic impacts, given that existing tax policies are remaining in place—and then some. Apart from a potential positive impact on sentiment and investment, the extension of the 2017 tax cuts likely won’t have a material effect on the economy. In Chart 2, we show how the OBBBA’s policy changes, beyond extending the TCJA tax cuts, impact the budget balance. Revenues are down almost $830 billion with most of the impact occurring before the new temporary tax cuts end in calendar 2029. Spending is down a net $1.3 trillion, resulting in nearly $510 billion in net deficit reduction. The latter should be a net negative for economic growth over the next decade, although the tax cuts (beyond extensions) should provide some near-term lift. The CBO’s ‘current policy’ baseline sees the OBBBA reducing the budget deficit by $47 billion in FY2025, which normally would ding the economy. But the up-front recording of $172 billion in student loan ‘subsidy savings’ explains the entire improvement in the deficit, which, as mentioned earlier, greatly overstates the negative impact on the economy. Excluding this accounting effect, the OBBBA would actually increase the deficit by $125 billion in FY2025, or 0.4% of GDP. Some of the economic lift will come from a reduction in employer withholding rates on overtime pay and tips. |
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Alas, other policies will likely more than offset OBBBA’s economic push in 2025. DOGE-related cuts to the federal government could ramp up after a recent Supreme Court decision repealed a lower court’s ruling that blocked large-scale layoffs. Deportations are now showing up in the workforce data and could accelerate due to increased funding for immigration enforcement. A recent Dallas Fed study found that real GDP growth could be 0.8 ppt lower in 2025 if current deportation trends (about 88,000 annually) persist and 0.5 ppt lower in 2027, with the latter rising to 1.5 ppts if deportations reach one million annually. |
The trade war will also weigh on growth. Based on work by the Fed, and assuming limited retaliation, a 15% average effective tariff rate on U.S. imports could reduce annual GDP growth by about one-half percentage point. This week’s round of ‘tariff letters’ suggests we could land on a figure 3 ppts higher on August 1. Any new tariffs will help to plug a revenue hole and lower the budget deficit, but will also depress growth. In May, customs duties totaled an annualized $266 billion (Chart 3). However, this figure was flattered by 145% tariffs on Chinese goods, which were lowered to 30% for the second half of the month. Nevertheless, if we assume a 10% average tariff on America’s $3.3 trillion worth of annual imports, this could generate $330 billion per annum, other things equal. However, it’s unclear what portion of the tariffs will be absorbed by foreign exporters and, thus, how much U.S. import prices (and the prices of import-competing goods) will rise. It is also unclear how an erosion of purchasing power will impact tax revenues, though we are assuming some hit. |
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All in, the DOGE cuts, deportations, and tariffs tend to support our call for real GDP growth slowing to 1.0% (on a fourth quarter-over-fourth quarter basis) in 2025 from 2.5% in 2024 Some rolling back of tariffs and more clarity on trade policies are assumed over time, reducing uncertainty and allowing the growth drag to fade in 2026—just when OBBBA’s push will more fully kick in. The CBO’s ‘current policy’ baseline estimates the Act will increase the deficit by $270 billion in FY2026. That, relative to the earlier mentioned $125 billion increase in FY2025 (sans the student loan subsidy savings), amounts to a 0.5 ppt lift to GDP growth in 2026. Some additional indirect support could stem from the accelerated deduction allowances for businesses raising the capital stock, and from lower taxes on overtime pay increasing work incentive. This, together with an assumed fading effect of the trade war and resumption of Fed rate cuts, aligns with our view of GDP growth improving to 1.7% in 2026. Bottom Line: While the economic effects of the OBBBA are uncertain, the heavily front-loaded tax cuts and spending hikes for national security look to more than offset cutbacks, pointing to a potential one-half percentage point lift to growth in 2026. Effectively, the tax cuts for individuals and businesses will paper over higher import taxes. This could reinforce the Fed’s current go-slow approach to easing for now, but may not be material enough to fan inflation, especially given some supply-side response of tax cuts, keeping policymakers on track to gradually restore policy neutrality from the current modestly restrictive stance. |
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