President Obama will deliver his fifth State of the Union Address on Tuesday evening. These speeches tend not to be of much significance for the financial markets, although the topics discussed may be important for certain industries (healthcare, energy, defense). Obama is expected to repeat his request that the sequester, due March 1, be postponed to next year. Doing so would not result in less deficit reduction. Such a move would have to be “paid for” through an increase in tax revenues and cuts in other forms of spending. However, it would limit the economic damage that would follow.
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Last week, the Congressional Budget Office released revised projections for the federal budget deficit for the next ten years. The CBO’s latest forecast incorporates the American Taxpayer Relief Act of 2012 (the fiscal cliff deal). The fiscal cliff deal significantly worsened the long-term budget outlook. However, the CBO bases its budget forecasts on current law. The pre-deal outlook assumed that the Alternative Minimum Tax would take a larger and larger bite, even though it had traditionally been patched each year. The fiscal cliff deal eliminated these annual corrections, at a “cost” of over $1 trillion over ten years. Tax rates were slated to return to their earlier levels, although few expected that to happen.
ATRA substantially reduced the economic impact relative to the full fiscal cliff. The increase in the payroll tax will dampen consumer spending growth to some extent, but the full fiscal cliff would likely have shaved about four percentage points from GDP growth, almost certainly pushing the economy into a recession. The trade-off is we got less deficit reduction.
Still, the deficit is declining. Federal spending, after rising sharply early in the recession, has slowed considerably in the last couple of years (in fact, spending for FY12 was a bit less than in FY11). The CBO expects small increases in spending for FY13 and FY14, but spending is then set to accelerate. Tax receipts are recovering and the gap (relative to outlays) should continue to narrow as the economy improves (note that CBO currently estimates that the level of GDP is about 6% below its potential).
ATRA postponed the sequester by two months, but while major cuts in spending were delayed, this wasn’t exactly “kicking the can down the road.” When the Democrats regained both houses of Congress in 2009, they reinstituted PAYGO rules. That is, if you want to increase spending (relative to current law), you have to raise taxes or find some other spending to cut to pay for that. If you want to cut taxes, you have to find some spending to cut. PAYGO rules don’t apply in recessions (hence, the $838 billion stimulus package in Obama’s first year in office). The point is that the delay in the sequester had to be paid for by reductions in tax breaks and cuts in other spending. The sequester is set to cut spending by $85 billion in the remainder of the year, about 0.7% of GDP (not counting multiplier effects). So, if the sequester is to be postponed through the end of this year, Congress will have to find a way to make up the difference. Not all fiscal tightening is created equal. The problem with the sequester is that half the cuts fall in defense, which generally has a high multiplier. Reducing tax subsidies or cutting other forms of spending would result in a smaller hit to the economy.
Tax expenditures, or deductions, are roughly $1.3 trillion per year. Eliminating some of these would help to reduce the deficit, and should be included in a broad deficit reduction plan.
The sequester also highlights the major confusion about the budget deficit. Large deficits are not a problem in the short run. Indeed, the outlook for the next few years is improving. The problem with the budget is the longer-term outlook, and there’s plenty of time to address that. Doing too much too soon to reduce the deficit in the near term would make things worse.
© Raymond James