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Economy in Brief

The Federal Budget--- "Unbalanced" Forever?
by Joseph G. Carson ([email protected])  August 7, 2019

The Trump Administration, with support and consent from Congress, has cobbled together a lopsided federal budget, loaded with upfront stimulus, financed with huge borrowings, only to be reversed in future years with doubtful spending cuts and tax hikes. The uneven and deficit-financed budget creates a number of potential problems.

Although there is no exact tipping point the relatively high and rising levels of federal debt relative to GDP puts the US in a high-risk category, and countries with high debt levels are usually unable to respond aggressively to a downturn. Yet, the bigger long run issue is the "structural" imbalance between the new tax law and spending legislation as current projections show that the budget deficit will continue to widen even during periods of sustained economic growth.

The debt ceiling legislation just approved by Congress is a good example of how short-term political considerations are driving budgetary decisions. Needing to pass an extension of the debt ceiling politicians decided to attach legislation that would extend for another two years the 2017 spending agreement on defense and discretionary spending. The new agreement increases defense and domestic spending by $320 billion over the next two fiscal years—at a time when the budget deficit is already on a path to hit $1 trillion.

But for politicians running for re-election in 2020 the new spending agreement was a "good" deal as it averts a spending cliff—and a negative hit to growth and employment--- since spending authority for defense and several domestic agencies would have been re-set at much lower levels, cutting billions from a wide range of programs.

Politicians used a similar gimmick with the 2017 tax legislation. Faced with a Senate rule that any legislation cannot add to the federal deficit beyond 10 years politicians were forced to agree to a phase out deductions for business investment and to make the individual tax cuts temporary, agreeing to raise all of the individual tax rates back to pre-2017 levels and to reverse all of tax –reducing changes in credits and deductions starting in 2026.

Is it realistic to think that politicians will phase out valuable tax deductions for new investment? The business community will be up in arms in a few years, arguing how "unattractive" and costly it is to invest in the US once the favorable tax rules on business investment are phased out. It's even more unrealistic to think that Congress will reverse the lower tax rates for individuals while maintaining the low tax rates for businesses. The cost of reversing of both items would amount to about $100 to $150 billion of lost revenue per year, climbing to over $200 billion in less than a decade.

Since the large federal deficit is supporting or subsidizing private sector activity the new way to think about how the federal budget is impacting the economy is by adding Federal outlays and the deficit and comparing the aggregate total to the level of GDP. In 2020 the combined amount will be over 25% of GDP, and headed higher over the intermediate term, while the norm is closer to the low 20% during the latter stages of an economic cycle. Each additional percentage point (up or down) is worth approximately $250 billion.

Does it matter? The US is in a unique position in that it borrows in its own currency and can always print money to finance deficits. Meanwhile, the risks associated with operating with a high-debt load in the current environment of very low interest rates are relatively small, unlike the destabilizing effects on the economy if Congress would decide to reduce the deficit.

Yet, the "unbalanced" federal budget does create a new problem. For the first time in modern times, current projections by the Congressional Budget Office show that the federal budget deficit will continue to widen even when the economy is growing in line with its potential. And, the size of future deficits would only get larger if Congress decides to make permanent the favorable tax incentives for business and the individual tax cuts.

As such, the US budget is climbing into "uncharted territory" as it will generate a rising amount of debt every year. The US already ranks the 4th highest among developed countries in terms of government debt-to-GDP. At some point, it would not be big surprise if the credit agencies put the US on "credit watch" or even downgrade it, and the dollar's status as a reserve currency starts to get challenged even more.

Thus, there are several channels the "unbalanced" federal budget could eventually have an adverse effect on the US economy and financial markets, and risks of that eventual negative feedback loop occurring is not that far away.

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