One week ago (January 31^st), the Congressional Budget Office (CBO) released its latest federal budget and economic outlook for the U.S. In the associated report, they explain that their ten year “baseline budget projection” (through 2022) is not a forecast of future events. Instead, it is provided as a policy benchmark that reflects what will occur to the federal budget and deficits if the existing taxation and spending laws are kept intact (or allowed to expire) without additional legislative actions. Of course, we are now within nine months of a major Presidential and Congressional election where a key issue will be what changes are needed to address our present fiscal woes. After the state of the economy and the unemployment situation, voters consistently rank the federal deficit as their third most important concern. As a result, how the November elections turn out—and in particular the Congressional elections—could have a substantial effect on the kinds of new policies that are put into effect to reduce our massive deficits and growing national debt.  In this Weekly Market Update, we’ll take a look at the new CBO report and how the November Congressional elections are shaping up.

A Review of 2011

Total government revenues in 2011 were $2.3 trillion as the chart below illustrates. This equaled approximately 15% of last year’s Gross Domestic Product (or GDP). The largest contributor to federal government revenues was personal income taxes which were $1.1 trillion. Out of this total, 70% was paid by households in the top 10% of wage earners (i.e. those making over $115,000 per year in adjusted gross income). In contrast, those earning under $33,000 in adjusted gross income (the bottom 50% of wage earners) contributed 2% of all federal income taxes paid by individuals.

The second largest category of contributions to federal revenue was social insurance payments. These consist primarily of employee contributions to FICA (the Federal Insurance Contribution Act, commonly called Social Security) along with employer matching payments. The remaining two categories are corporate income taxes (8% of the total federal revenues) and the “Other” category which includes excise taxes, estate taxes plus customs and duty fees.  Perhaps the most surprising statistic in this chart is that U.S. corporations contributed less than 10% to the overall receipts by the federal government—especially in light of the record profits many large corporations recorded in 2011 along with the near-record net profit margins realized by S&P 500 companies. In past decades (i.e. the 1950’s and 1960’s), this share has been as high as 30%.

 

Total federal government expenditures for 2011 were $3.6 trillion as illustrated in the chart below. This equaled 24% of last year’s GDP.  The various types of government spending can be divided into two categories: Discretionary and Mandatory. The former is spending that can be changed over time (through annual legislative appropriation acts) depending on the needs of our country and political sentiment. One example of this is defense spending which has fluctuated substantially over the years in periods of war and peace. The latter category consists primarily of long-term benefit and entitlement programs which Congress controls by setting and modifying eligibility thresholds and benefit formulas. Medicare, Medicaid and Social Security are three examples of these kinds of programs.

As the chart below shows, mandatory programs accounted for about 60% of total federal spending in 2011. If we add interest on our national debt (not a benefit or entitlement program but certainly mandatory spending if we hope to continue borrowing), this percentage rises to about 67% or two-thirds of all federal spending. Mandatory spending has not always been the lion’s share of total federal expenditures. In fact, as recently as 1980, it was only about one-third (33%) of the total federal budget. But because spending on these programs has been growing faster than discretionary spending (and faster than our overall economic growth), mandatory spending has been taking an increasing share of the overall federal budget and is the key driver behind the growth in the size of the federal budget.

Beyond defense spending, the other category of discretionary spending (“Non-defense”) consists of government programs related to income security (e.g. unemployment insurance, education, transportation and many other activities—plus what is termed “pork barrel” spending —although this is hardly the only category where this occurs).  

Both defense and non-defense spending has been elevated in recent years due to outlays to support the wars in Iraq and Afghanistan, and unemployment benefits related to the Great Recession and its aftermath. And while it is easier from a conceptual standpoint to make year-to-year modifications in overall discretionary spending, the legislative reality is that each Senator and House Representative has his or her own pet projects they fight to protect (or increase) spending on. In other words, proposing a (e.g.) 5% cut in discretionary spending from a top-down perspective (to save “X billion dollars”) is much easier than finding the specific programs that will be cut or eliminated that sum up to those “X billion dollars”. Such is the reality of our current legislative process.

By combining the numbers in the two charts above for 2011, we end up with the federal government having run a deficit of approximately $1.2 trillion. Revenues were approximately 15% of GDP while expenditures were approximately 24%, meaning the deficit equaled 9% of overall GDP.  Another way of framing the deficit is that we borrowed roughly $0.36 of every dollar that we spent last year on a federal level. Some readers may have also noticed that last year’s total federal revenues ($2.3 trillion) equaled last year’s mandatory expenditures. In other words, all we need to do in order to balance the federal budget—without raising taxes—is completely eliminate all discretionary spending programs. That’s a facetious way of trying to point out that the likelihood of balancing the federal budget without some increase in revenues (tax increases) or modification to slow entitlement program spending growth (or both) is essentially nil. It will require some combination of cuts and revenue increases to reach that elusive goal.  

The CBO report also defines the size of our national debt (like our budget deficit) as a percentage of GDP. In 2011, while the federal budget deficit was 9% of GDP, our national debt held by the public was approximately 73% of GDP. The words “held by the public” are italicized because this doesn’t include our federal debt held by other federal government agencies such as the Social Security Administration. For years, we have been using the surpluses generated by Social Security insurance premiums to buy U.S. Treasuries issued by the federal government. And when this debt is added to that “held by the public,” our gross national debt as a percent of GDP increases to approximately 102% as of year-end last year.

In the chart below, we plot our 2011 national budget deficits and debt expressed as a percent of GDP against the European Union countries, some of which (like Greece) have received substantial media attention because of their indebtedness. In fact, our levels of deficits and indebtedness place us in the same category as many European Union countries. It is only by virtue of our relative size, growth, credit rating and having the dollar as the world’s de-facto reserve currency that we have not had to face the scrutiny and pressures that some European nations have in terms of borrowing costs and investor concern. But the chart below is certainly a sobering view of how far along our own deficit spending and national debt has progressed. Again, there will be substantial pressure post-November and our national elections to address this challenge.

Political Maneuvering and Failure

What most people remember about 2011—from a government budget standpoint—was the U.S. lost its triple A (AAA) credit rating with Standard and Poor’s credit rating agency . But that event was preceded and followed by a substantial amount of legislative action and frustration. It began in May when the U.S Treasury announced the existing national debt limit of $14.3 trillion dollars had been reached but said it could keep the government functioning by “extraordinary means” through the start of August. Negotiations began in May between the two major parties in Congress (along with the President) regarding a deal to raise the debt limit and address the deficit, but fell apart over differences regarding whether (and how much) to raise taxes. In an eleventh hour compromise on July 31^st, a short-term deal was reached to that would raise the debt ceiling by $2.4 trillion in two steps, which was projected to be enough (at current deficit levels) to maintain borrowing into early 2013—beyond the Presidential and Congressional elections this November. The debt ceiling was increased immediately to $15.2 trillion last August with an additional jump to $16.4 trillion in January. (The Republican vote for a “resolution of disapproval” in the House to oppose this latest increase was purely symbolic and voted down by the Senate at the end of January.)

The other aspect of the compromise last July was the creation of a Congressional budget super committee charged with the task of finding a “grand compromise” that had eluded the two parties leading up to the credit rating downgrade on U.S. government debt. And, as a motivation to force a compromise, a provision was added stating that failure by the super committee to reach a compromise would trigger automatic cuts in spending for a number of programs including the military, transportation, education, health care providers and Medicare. With the failure of the super committee efforts in November, these automatic cuts became law (the Budget Control Act of 2011).

The CBO Baseline and Alternative Projections

The CBO baseline projection expects the budget deficit to equal $1.1 trillion in 2012. That is still a huge deficit, but on the basis of GDP, it is forecasted to decline from 9% in 2011 to 7%. Most of this decline is because—according to current legislation and existing laws—government revenue is projected to rise dramatically from 15% of GDP in 2011 to 16.3% in 2012 and 20.2% in 2015. And what drives this substantial jump in revenues is the assumption that current tax provisions (notably the Bush era tax cuts) will not be extended (and thus expire), raising individual income tax rates. In addition, the CBO’s baseline projection assumes that the brackets defining the Alternative Minimum Tax (or AMT) will not be indexed to inflation, meaning (according to CBO estimates) that the number of taxpayers required to pay the AMT will increase substantially.

On the spending side of the budget, the baseline projection assumes the Medicare reimbursement rate for physicians will decline by approximately 25%. This is perhaps the most unrealistic assumption of the baseline projection since this type of cut has been budgeted for much of the last decade, but then always overridden by Congressional action. But again, the baseline projection is not a CBO forecast of the future but simply what will occur based on current law without additional legislative action. The other key assumption is that the automatic spending reductions required by the Budget Control Act of 2011 take effect beginning January next year. These equal approximately $110 billion per year. Taken together, these (and other) factors mandated by current law will result in government revenues increasing from $2.3 trillion in 2011 to $3.6 trillion in 2015 while spending will only grow from $3.6 trillion in 2011 to $3.8 trillion in 2015. As a result, the federal budget deficit will shrink over the same timeframe from $1.3 trillion last year down to $200 million in 2015.

On the other hand, the CBO’s alternative projection assumes the key changes currently mandated by law and reflected in the baseline projection—which increase revenue and reduce spending growth—are not implemented. In other words, the Bush era tax rates are extended, the AMT is indexed to inflation (thus catching fewer taxpayers), the Medicare reimbursement rate to doctors is not slashed and the Budget Control Act automatic spending cuts are not implemented. In this alternative projection, government revenues will increase from $2.3 trillion in 2011 to $3.1 trillion in 2015 while spending will grow from $3.6 trillion in 2011 to $4.0 trillion in 2015. As a result, the federal budget deficit will still shrink but not nearly as much as in the baseline projection (from $1.3 trillion last year to $900 million in 2015.) The table below summarizes the two projections through 2015.

 

CBO Baseline and Alternative Federal Budget Projections: 2011 to 2015
	2011 (Actual)	2012	2013	2014	2015
Baseline Projection
Revenues	$2.3	$2.5	$3.0	$3.3	$3.6
Spending	$3.6	$3.6	$3.6	$3.7	$3.8
Deficit	-$1.3	-$1.1	-$0.6	-$0.4	-$0.2
Deficit % of GDP	-9.0%	-7.0%	-3.7%	-2.1%	-1.5%
Debt % of GDP	102%	105%	107%	104%	101%
Alternative Projection
Revenues	$2.3	$2.5	$2.7	$2.9	$3.1
Spending	$3.6	$3.6	$3.7	$3.8	$4.0
Deficit	-$1.3	-$1.1	-$1.0	-$0.9	-$0.9
Deficit % of GDP	-9.0%	-7.2%	-6.2%	-5.5%	-5.1%
Debt % of GDP	102%	105%	108%	110%	113%
Source: CBO Budget and Economic Outlook- 2012 to 2022
Note: (1) Dollar amounts shown are in trillions of dollars
(2) Debt as a percent of GDP includes debt held by other government agencies.

 

As one can see from the numbers presented above, the key difference between the CBO’s baseline and alternative projections through 2015 is not spending (where the net difference in spending growth between the two projections is only $200 million per year by 2015) but federal government revenue growth—specifically income taxes. Here, the baseline projection estimates that revenues will increase by $1.3 trillion per year where the alternative projections increase by $800 million per year (a net difference between the two projections of $500 million per year by 2015). And it’s on that topic of taxation that the major battle lines are drawn for the coming Congressional election.

 

The Election Outlook for the House and Senate

One only has to think back to last autumn and the futile efforts of the Congressional budget super committee (which included members of both the House and Senate from both major parties) to reach any kind of compromise to appreciate how far apart the two parties are on the issues of taxes and spending. And 2012 will very likely be a “lost year” in terms of any meaningful movement or process on the budget and our deficits due to the upcoming elections. Hence we have to look beyond November (with different scenarios for how the elections might turn out) in order to anticipate what kind of resolution might be reached on the budget challenge. And we’ll focus specifically on the Congressional elections since this is the arena where the legislative battles will be fought and compromises will be struck.

As the chart below illustrates, the House of Representatives—since the start of the 20^th century—has been dominated by Democratic Party majorities. Most notably, from 1956 until 1994 (38 years), the Democrats were the majority party in the lower chamber of the Congress. But beginning in 1996, that dominance ended and since that year, there have only been two terms out of nine (i.e. 2006 and 2008) when Democrats retained the majority.

 

One forecasting tool we’ll use is the election “handicapping” scorecards for the upcoming Congressional elections prepared by a well-known political analysis firm called Cook Associates. In the table below, we present their January 26^th update summarizing all the races for this November’s House of Representatives elections. Since the term of all House seats is two years, every seat (435 total) is up for election. 434 seats are currently occupied and one is open.

The Cook Associates analysis breaks down the race in each district by (1) whether it is currently occupied by a Republican or Democrat, and (2) the likelihood the race will remain controlled by each party. Of the 193 current Democratic seats in the House, 151 (or 78%) are forecast as a “solid” (more than a 95% chance) to remain Democratic after November. On the Republican side of the aisle, of their current 242 seats, 181 (or 75%) are forecast to be solid post-November. These numbers and percentages help illustrate how dominant “safe seats” (those with little or no competition) are in the Congress.

The real action this November will occur in 52 races (out of 435) classified by Cook Associates as (1) “Leaning” in the direction of the incumbent party, (2) a “Toss-Up” (i.e. too close to call), (3) “Leaning” opposite the direction of the incumbent party, and (4) “Likely” shifting in the direction of the opposite party. We can ignore this last category because it will probably result in a change of party representation and it will be a “wash” (with one seat currently held by each party likely to shift to the other side). That leaves 50 “Leaning” and “Toss-Up” races, 22 currently held by Democrats and 28 held by Republicans.

Readers can perform their own analysis based on these data, but most experts believe—given that the Republican Party currently holds a 25 seat majority—it will be difficult (albeit not impossible) for Democrats to win the 47 of  these 50 races needed to gain 218 seats total and the House majority. The Democratic National Committee has recently launched a “Red to Blue” campaign with exactly that goal. But if the current Cook Associates analysis is accurate and we assume all the “Lean” seats go in the direction forecast plus the “Toss-Up” seats are split 50/50, the result would be Democrats capturing 24 seats with the Republicans capturing 26 of the competitive seats. The net result for the 2013 House of Representatives would be a very slight shift toward more Democrats but still a major Republican majority (240 vs. 195 with a Republican majority of 23—down from the current 25).

 

The U.S. Senate presents a different situation because (i) the margin of the majority (in this case, the Democratic party majority) is much smaller, and (ii) because, the entire Senate does not stand for election every two years, there are many more seats currently held by Democrats (23) that are up for election this year than Republicans (10). And, as the chart below illustrates, majority party changes in the Senate have been much more frequent, especially in the past 40 years—in part reflecting our nation’s broader debate regarding the competing political direction offered by our two major parties.

Given these set of circumstances, Cook Associates has forecast an outlook in the table below for the 33 Senate races in November by party and likelihood of victory (identical to their “handicapping” categories used for the House). The current division in the Senate is 51 Democrats, 47 Republicans and 2 “Other Party” (i.e. Joe Lieberman of Connecticut as an Independent Democrat and Bernie Sanders of Vermont as a Socialist/Democrat. Lieberman is up for re-election, counted among the Democrats in the table below and listed by Cook Associates as a likely winner).

The math for upcoming elections in the Senate is different than the House because of the skew in current Democrat versus Republican seats up for election—again, 23 Democrat and 10 Republican seats. With a 52 to 47 majority (again, counting Lieberman as a Democrat), that means the split among those seats not up for election (67 total) is 29 Democrat and 37 Republican, a  reversal in the split among those seats up for election. If we apply the same rules to handicapping the Senate race as we did to the House (based on Cook Associates data), the result would be Democrats winning all 12 of their solid or likely seats, all 3 of their lean seats and 4 of the toss-up seats (19 total). The Republicans would win all 8 of their solid or likely seats, 5 of the toss-up seats and the one Democratic seat listed as “likely Republican” (14 total). Adding these to the totals of seats not up for election (29 Democrat and 37 Republican) could yield a 51 to 48 Republican majority in the Senate (again with Sanders as Independent—although his votes frequently follow Democratic lines.) This would be yet another shift in control for the Senate (the 7^th in three decades) but on a very (razor) thin majority.

One final point of consideration regarding both the House and Senate elections is that history has shown the movements in balance between the two major parties in the House and Senate each election are not entirely independent. In the chart below we have plotted the net change in the number of seats for every election from 1902 to 2010 (every two years) in both the House and Senate.  There is a fairly good correlation that says (e.g.) when Democrats gain net seats versus Republicans in the House, they also do so in the Senate (and the same for Republican net gains).

This makes sense from the standpoint that the two parties do offer some fundamentally different values and views on the role of government (and taxation and spending) in the economy which are consistently expressed by the respective party members running for seats in both chambers of Congress. And as the national mood changes regarding the role of government, parallel shifts in the balance of seats held by each party both the House and Senate tend to occur. The point of this analysis is that—should the Democrats mount a successful campaign to substantially erode the current Republican majority in the House, a parallel shift could occur in the Senate to preserve or even strengthen their current slight majority.

 

 

 

Some Scenarios for Post-November

We’ll sidestep any analysis of the upcoming Presidential election in part because the Republicans have not yet decided on a candidate and because the mechanics of ultimately addressing our federal budget deficits lie in the legislative (not executive) branch of government. So for purposes of presenting some scenarios of the post-November political landscape, let’s assume that President Obama (who is a formidable campaigner, has been raising major funds for his re-election and his party and has the power of the Presidency behind him) wins re-election. In this case, the question (vis-à-vis the national budget deficit) becomes “What kinds of Congressional election outcomes could he face and what would it mean for addressing and resolving our current budget and debt dilemma?”

According to the analysis we’ve presented here, it’s currently likely that the Republicans will maintain their majority in the House of Representatives. In the Senate, one can paint a scenario for control to go either way—and therein lays a challenge for predicting how our current budget deficit might be addressed.  However, based on this analysis, it is currently more likely that the Senate moves from a Democratic majority to either a small Republican majority or even split. In either case, one scenario is that a stand-off between the President and the Congress continues for at least another two years. At that point, two important changes occur: First, a new election for the House of Representatives occurs. Second, President Obama will become (as all two term Presidents do in the last two years of their second term) a “lame duck” President. 

On the other hand, since every President (especially two term office holders) begin to reflect on their “legacy” as the time to leave office approaches, this could usher in the possibility for a “Grand Compromise” that seemed to be in the offing last spring (when Speaker of the House John Boehner took that round of golf with President Obama) but subsequently fell apart. The scenario for a grand compromise is made more likely by the fact that there is no obvious “heir apparent” within the Democratic party should President Obama win a second term—which is to say that Vice President Joe Biden is probably not (unlike Vice President George Bush Sr. after President Reagan’s two terms) going to be the Democratic nominee for President in 2016. Without an heir apparent, President Obama might feel more likely to strike a grand bargain.

If we found ourselves with a Republican President after November 6^th (Election Day), the opportunity for some resolution to the current impasse over the federal budget and deficits could come sooner. With an assumed continued majority the House and a slight Republican majority in the Senate, it is likely that the first legislative actions would be some definitive package to substantially reduce the deficit based primarily (but not entirely) on spending cuts. By necessity, changes and reductions to future entitlement program obligations (notably Medicaid and Medicare) by the government would have to be a key component of a balanced budget bill that did not rely heavily upon tax increases.

A wildcard in this Republican Presidency and Congress scenario could be an attempt to radically revamp the tax code (individuals and businesses) to address all of its complexity, exemptions, loopholes and other breaks. About the only thing people on all sides of the political spectrum can agree upon (which is a near-miracle in itself) is that the current tax code needs serious reform and change. But this kind of serious change would probably require three key components: (1) a major popular vote and Electoral College victory for the Republican candidate (i.e. a “mandate” for serious change; (2) a sustained major majority for Republicans in the House; and (3) a major reversal of control (a near “filibuster-proof” majority for Republicans) in the Senate.

On this last point, keep in mind that 23 of the 33 seats in the Senate up for election are currently held by Democrats, and— of the competitive elections—that ratio changes to 10 of 12 seats. We (not Cook Associates) handicapped the outcome of these 12 competitive races in the Senate as going 7 Democratic and 5 Republican, which still resulted in a change in control with a modest Republican majority of 51 to 48. What if (instead) 9 of these seats went Republican and 3 Democratic? The outcome would be a 55 to 44 majority for the Republicans in the Senate. Not particularly close to the magic number of 60, but close enough to imagine some of the more conservative Democrats in the Senate (especially those up for re-election in 2014) to agree to a major revamp in our federal tax code.

In the final analysis—and unlike many of the fiscally-troubled countries of the Euro Zone—the United States has the growth potential, economic dynamism and size to recover and prosper from our current government debt crisis. The question we have yet to address is how we will achieve this goal in terms of specific policies and how those policies will reflect the values we choose to emphasize for the future. This November’s elections will be a key determinant in the path we set towards tackling these large but ultimately addressable challenges.

 

Visit americancenturyblog.com to read the Weekly Market Update and other economic, market and investment insights from the experts at American Century Investments.

The opinions expressed are those of American Century Investments and are no guarantee of the future performance of any American Century Investments portfolio. This information is not intended to serve as investment advice; it is for educational purposes only.

© 2012 American Century Proprietary Holdings, Inc.

Gross Domestic Product (or GDP) is an aggregate dollar measure for the total value of goods and services produced by our economy in a year.

S&P 500 companies are those included in the S&P 500® Index, a market value-weighted index of the stocks of 500 publicly traded U.S. companies chosen for market size, liquidity, and industry group representation that are considered to be leading firms in dominant industries. Each stock's weight in the index is proportionate to its market value. Created by Standard & Poor's, it is considered to be a broad measure of U.S. stock market performance.

Pork Barrel Spending is federal money spent on specific projects within a Congressperson’s district in order to garner favor with their constituents, or benefit a private company or a campaign contributor. Most of these spending requests are attached as “earmarks” to other (larger) legislative bills requiring a single up or down vote on the entire legislative package.

A credit rating agency is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. In the United States, the Securities and Exchange Commission (SEC) permits investment banks and broker-dealers to use credit ratings from "Nationally Recognized Statistical Rating Organizations" (NRSRO) for similar purposes. As of January 2012, nine organizations were designated as NRSROs, including the “Big Three” which are Standard and Poor’s, Moody’s Investor Services and Fitch Ratings.

The Alternative Minimum Tax (AMT) is a parallel tax system that was created to keep high income individuals from avoiding taxes through various deductions and exemptions.

The Arizona seat held by Gabrielle Giffords—who was tragically wounded a year ago and has recently announced she will not stand for re-election—is open. It will be filled in by a special election among registered Democratic voters in that district this month. The winner will stand for re-election in November.

A better tally in terms of actual voting record would count Lieberman as a true independent (between the two parties) and Sanders as a Democrat.

 

 

 

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