A modest uptick in a gloomy fiscal outlook

| October 26, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Federal budget deficits have widened from a recent low in fiscal 2015 of $439 billion to a high in fiscal 2018 of $778 billion, and the path ahead looks troubling. The deficit is poised to widen sharply in 2019 as the full impact of tax cuts hits while spending continues to surge.  By 2020 and 2021, federal red ink is likely to exceed $1 trillion a year, and that’s assuming that the economy continues to grow robustly.  A recession in 2020 or 2021, as consensus in the financial markets currently expects, would be a fiscal disaster.

A fiscal 2018 recap

The final 2018 budget deficit came in considerably lower than I had projected three months ago as discretionary outlays came in below forecast despite the generous budget deal passed early this year.  Federal revenues barely rose at all, up year-over-year by 0.4%.  Individual income tax receipts increased a robust 6%, mostly reflecting strength in receipts beyond regular payroll withholdings.  But corporate income tax receipts collapsed in the wake of tax reform, sliding year-over-year by more than 30%.  The deficit was larger than fiscal 2017 by more than $100 billion and the largest since 2012.

A fiscal 2019 outlook

Federal outlays rose by 3.2% in 2018, an understatement of the trend pace of spending gains. Due to a calendar quirk, 2018 spending included only 11 sets of turn-of-the-month payments.  A return to normal in the pattern of entitlement checks in the current fiscal year will help to push growth in outlays up by as much as 8%, which would be the fastest advance since 2009.  Exploding interest costs and a sizable rise in discretionary outlays should also push up spending, as the budget accord earlier this calendar year drives a jump in defense and domestic appropriated outlays.  Each of these areas may boost spending over 2018 levels by $70 billion.

After paltry increases in 2016 and 2017, federal revenues might ordinarily have been expected to rebound in 2018, but the substantial tax cut passed in December led to a sharp drop in corporate tax receipts, as discussed above.  The tax cut probably had close to its full effect on corporate tax receipts in 2018, since businesses generally pay taxes quarterly and quickly began to take full advantage of the various breaks that became available to them, such as full expensing on investments.  In contrast, withholding tables for individuals only changed in February—more than a third of the way through fiscal year 2018— and April tax payments reflected 2017 liabilities.  Thus, individual income tax receipts are likely to underperform somewhat relative to the speed of nominal GDP growth while corporate income and payroll tax receipts may bounce back to solid growth.  Fed remittances will likely decline substantially as the Fed’s balance sheet continues to shrink.  Altogether, federal revenues in 2019 should rise about 4%.

The budget deficit may rise in 2019 to around $970 billion, nearly $100 billion lower than my estimate three months ago.  The main changes in the forecast reflect much higher individual non-withheld income tax receipts, to reflect ongoing strength there, and lower discretionary outlays, in response to the 2018 tally ending up lower than previously anticipated.  In any case, such a result could boost the deficit to 4.5% of GDP, up from 3.8% in 2018 and the highest reading since 2012. While the news at the margin is good, the big picture still looks troubling.

Fiscal 2020 and beyond

The impact of tax reform should fully kick in for 2019.  Revenue losses associated with the tax cuts compared to pre-legislation projections may approach $200 billion a year in 2019 and 2020.  Dynamic feedbacks should partially offset the static revenue losses, but those dynamic effects compound over time, so the benefit in the early years is muted.  Over a 10-year horizon, the tax cuts should partially but certainly not entirely pay for themselves, but the costs are front-loaded, while the dynamic effects will show up mostly in the out-years. The negative budget impact will be substantial in the next few years.  The bad news on the revenue side is that the tax cuts are subtracting significantly from revenue.  The good news is that beginning in 2020, revenue growth should get back to normal, which should help to limit the further widening in deficits.

Meanwhile, after a period of several years where discretionary spending was growing very slowly, the budget deal struck by Congress early this year ensures a steeper pace of increase over the next few years and likely lays a path for faster gains well into the next decade.  I expect the defense buildup that was begun with the early-2018 budget deal will be extended, and it is hard to imagine that there will be a renewed enthusiasm for austerity in the next few years.

Independent of the impact of policy changes, the budget was already poised to deteriorate in coming years, mainly reflecting two very powerful forces: entitlements and interest rates.

First, we have entered the timeframe when the retirement of Baby Boomers will send Social Security and Medicare spending to unsustainable heights.  Short of significant entitlement reform, which appears to be out of the question for the time being, there is little chance that the demographic tide will turn.  Social Security and Medicare outlays have been restrained in recent years, the former by the lack of cost-of-living adjustments due to very low headline inflation and the latter mostly by cuts in administered reimbursement rates that cannot be sustained over time.  Going forward, these two programs, which already account for over 40% of the overall federal budget, are going to grow at an accelerating pace, as Baby Boomers retire in massive numbers and cost-of-living adjustments normalize.

Second, an extended period of zero rates from the Fed hid the deterioration in the nation’s finances during and after the 2008 financial crisis by keeping interest costs unsustainably low.  The normalization of monetary policy is causing interest costs to balloon and Fed remittances to wane.  Already, federal interest expense in fiscal 2018 was $100 billion higher than three years before near the end of the zero-rate era.  Federal interest costs by 2020 should double from their 2015 level, adding $250 billion to overall annual spending relative to 2011-2015.  At the same time, Fed remittances are dwindling and should reach less than half of the approximately $100 billion annual pace seen when the balance sheet was at its peak and rates were near zero.

On the revenue side, the medium-term economic outlook looks promising as solid growth and rising inflation should raise revenue.  Nominal GDP should rise faster over the next few years—in a 5%-to-6% range rather than a 3%-to-4% range—due in part to the boost from tax reform.  However, increases in tax receipts lagged nominal GDP gains substantially last year and may do so again in 2019, due to waning Fed remittances and lower marginal tax rates, before returning around in 2020 to a more normal relationship once the tax cuts are fully in place and Fed remittances approach historical norms.

From a fiscal perspective, the duration of the current expansion is critical.  Now is the stage of the economic expansion when federal deficits should normally be declining, as strong economic growth and low unemployment lead to strong tax receipts and slower growth in need-based spending programs.  However, Congress and the administration chose to try to “buy” a longer, stronger recovery with the implementation of tax cuts.  In my view, this could well turn out to be a perfectly fine trade-off, and the pickup in growth over the last year or two suggests that the payoff has in fact already been significant.  However, if, for whatever reason, economic growth fades in 2020 or 2021, or worse yet if the economy falls into recession, as many expect, then just at the point where one might expect to belatedly begin to reap the fiscal benefits of faster GDP growth, the budget would face massive pressure from a softer economy.  Even with solid economic growth, budget deficits are likely to continue to inch higher over the next few years.  In a recession scenario, the widening budget shortfalls could become problematic.  Of course, if the tax cuts work as advertised, and so far they seem to be, then it could be argued that they will accelerate and extend the expansion.

The federal budget deficit will probably swell to over $1 trillion in 2020.  Looking even further ahead to 2021, the budget deficit may continue to creep higher, as it is simply difficult for revenue growth to keep up with spending gains when interest costs are rising, entitlement obligations are advancing rapidly, and discretionary spending is increasing as well.  As a percentage of GDP, these deficits would be over 4.5%, unsustainably high but well below the readings in the first few years after the financial crisis.  Looking further out to 2022 and beyond, there is little reason to expect substantial narrowing of federal budget deficits, though if the economy remains healthy, it is possible that the red ink could inch lower as a percentage of GDP.

john.killian@santander.us 1 (646) 776-7714

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