The Budget Deficit

The Monthly Treasury Statement showed a large budget surplus for April. Some of that may prove to be temporary. Income was pulled forward into 2012 ahead of expected tax increases in 2013 and that was reflected in higher tax payments in April. Some of it is payback from the bailouts of a few years ago (for example, earnings from Fannie Mae and Freddie Mac). However, much of the improvement reflects a rebound from a severe recession. Tax revenues are recovering and recession-related expenses are trending lower. The near-term reduction in the deficit may limit efforts to address the long-term problem.

For the first seven months of the fiscal year, tax receipts were up 15.9% from the same period last year – individual tax receipts rose 20.0% y/y, corporate tax receipts rose 21.4% y/y, and payroll taxes rose 10.6% y/y.

Outlays are down 0.6% from the first seven months of FY12. Spending for the current fiscal year is likely to be below where it was projected to be back in the summer of 2008. Federal employment is now lower than it was when Obama took office.

The deficit should continue to improve as the economy recovers from the recession. However, short-term efforts to reduce the deficit (the payroll tax increase and sequester cuts) will restrain the pace of the recovery (GDP growth is expected to be about 1.5 percentage point lower this year). We may still see growth in the 2.0% to 2.5% range, but it would have been much stronger (3.5% to 4.0%) without the fiscal restraint.

The fiscal cliff deal at the start of the year limited the self-imposed fiscal contraction in 2013, but did not resolve the debt ceiling issue. Recall that the debt ceiling was breached on December 31, but Congress waved the limit through February 15, then later extended that deadline to May 19. A grand bargain on fiscal policy is unlikely, but there could be some legislative changes in a deal to raise the debt ceiling this week. Lawmakers are well aware that “governance by crisis” is unpopular with the American people. A government shutdown is very unlikely. Remember, the debt ceiling does not authorize spending (that comes from Congress through budget authorizations or Continuing Resolutions). It merely allows for the government to make good on obligations that it has already made.

By now, readers should be well aware of the problems with the Rogoff and Reinhart study that purported to show a 90% debt-to-GDP threshold (beyond which the economy slows). There is no such threshold!

The deficit has been falling and is likely nearing a level that would leave the debt-to-GDP ratio stable or declining. That’s presuming that the economic recovery continues at a moderate pace. If the pace of growth improves more substantially, as would happen as the level of GDP moves towards its potential and slack is taken up, the near-term budget outlook will improve even more dramatically. However, the problem with the deficit has not been the short-term outlook. Rather, the problem is the long-term strains from Medicare as the baby-boom generation retires. Congress continues to focus on unhelpful short-term fixes and is largely ignoring the long-term problem.

© Raymond James

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