Gridlock means a static fiscal outlook

| January 25, 2019

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.

A standoff between Congressional Republicans and a Democratic Clinton Administration in the 1990s produced gridlock at a time when booming tax receipts generated federal budget surpluses, leading to the widely-held assessment among financial market participants that “gridlock is good.” The current gridlock is occurring in an environment of massive budget deficits and major structural imbalances in entitlement programs that need to be fixed. The political standoff may reduce red ink on the margins, as any conceivable area of bipartisan agreement – on infrastructure spending or rolling back the SALT limits – is presumably out the window; but trillion dollar annual deficits are now projected for the foreseeable future.

Federal Budget Outlook

FY 2019 Outlays.  Federal outlays rose by 3.2% in FY2018, an understatement of the trend pace of spending gains (due to a calendar quirk, there were only 11 sets of turn-of-the-month payments sent out in FY2018).  A return to normal in the pattern of entitlement checks in the current fiscal year will help to push the growth in outlays to a big gain, perhaps more than 7%, which would be the fastest advance since 2009.  The other two factors likely to push spending up in the current fiscal year are surging interest costs and a sizable rise in discretionary outlays, as the budget accord struck in early 2018 will drive a jump in defense and domestic appropriated outlays.

FY 2019 Revenues.  After paltry increases in FY2016 and FY2017, federal revenues might ordinarily have been expected to rebound in FY2018 given a strengthening economy.  However, the substantial tax cut passed in December led to a sharp drop in corporate tax receipts.  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 (i.e. over a third of the way through fiscal year 2018), and April tax payments reflected 2017 liabilities. Individual income tax receipts are likely to underperform relative to the speed of nominal GDP growth this year – ordinarily, in a strong economy, individual tax revenues would increase a little faster than nominal GDP gains – while corporate income and payroll tax receipts may bounce back to solid growth going forward.  Fed remittances will likely decline substantially as the Fed’s balance sheet continues to shrink.  Overall federal revenues should rise at about a 3½% clip in FY2019.

FY2019 Deficit.  The budget deficit may rise in FY2019 to around $965 billion, in line with the estimate from three months ago.  Relative to October projections, $20 billion has been shaved off of both revenues and outlays estimates.  The FY2019 forecast could yield a deficit-to-GDP ratio of 4.5%, which would be up from 3.8% in FY2018 and would be the highest reading since 2012.

FY2020 and Beyond

Revenue losses associated with the December 2017 tax cuts (relative to a hypothetical pre-legislation status quo) may approach $200 billion per year in FYs 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 partly though certainly not entirely “pay for themselves,” but the costs are front-loaded, while the dynamic effects will show up mostly in the out-years, so that the negative budget impact will be substantial in the next few years.  Thus, the bad news on the revenue side is that the tax cuts are subtracting significantly from the revenue tally.  The good news is that beginning in FY2020, revenue growth should get back to normal.

Meanwhile, after a period of several years where discretionary spending was growing very slowly, the budget deal struck by Congress ensures a steeper pace of increase over the next few years and likely lays a path for faster gains well into the next decade.  Expect the defense buildup that was begun with the early-2018 budget deal to be extended. It is hard to imagine that there will be a renewed enthusiasm for austerity in the next few years, especially in the near term as a presidential campaign gathers steam.

Independent of the impact of policy changes, the budget was already poised to deteriorate in coming years, mainly reflecting two very powerful forces. First, we have entered the timeframe when the retirement of the baby boomer generation 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. These two programs already account for over 40% of the overall federal budget, and are going to grow at an accelerating pace as baby boomers retire in massive numbers.

Second, an extended period of zero rates from the Fed hid the deterioration in the nation’s finances during and after the financial crisis by keeping interest costs unsustainably low. The normalization of monetary policy is causing interest costs to balloon and Fed remittances to wane. Federal interest expense in FY2018 was over $100 billion higher than three years before, near the end of the zero-rate era.  Federal interest costs by 2020 are likely to be nearly double what they were through 2015, adding almost $250 billion per year to overall annual spending relative to the 2011-2015 period.  At the same time, Fed remittances are dwindling and should by this fiscal year or next reach less than half of the approximately $100 billion annual pace seen when the balance sheet was at its peak and rates were at the zero bound.

The medium-term revenue outlook is more optimistic, as the economy should be bolstered by solid growth and rising inflation. Nominal GDP is expected to rise in a 5%-to-6% range rather than a 3%-to-4% range over the next few years, due in part to the boost from tax reform. Increases in tax receipts lagged nominal GDP gains substantially last year and may do so again in FY2019, due to waning Fed remittances and lower marginal tax rates, before returning around FY2020 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.  This could well turn out to be a perfectly fine trade-off, and the pickup in growth in 2018 suggests that the payoff has already begun.  However, if the economy fades into recession at any point in the next two years, as the consensus seems to 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 instead 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, though if the tax cuts “work” as advertised, they should help to accelerate and extend the expansion.

The federal budget deficit is projected to swell to about $1.05 trillion in FY2020, about $10 billion larger than forecast three months ago.  Looking ahead to FY2021, the budget deficit may continue to creep higher, as it is simply difficult for revenue to keep up with spending growth when interest costs are rising, entitlement obligations are advancing rapidly, and discretionary spending is increasing as well.  The FY2021 deficit is expected to rise to about $1.13 trillion, roughly $15 billion more than the projection three months ago.  As a percentage of GDP, these deficits would be over 4½%, unsustainably high but well below the readings in the first few years after the financial crisis.  There is little reason to expect substantial narrowing of federal budget deficits in 2022 and beyond, though if the economic expansion continues for several more years, 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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