Don't Be Deceived by the Deficit Dip

Recent budget reports have been encouraging. Revenues are rising faster than originally expected, and deficits are running lower. Some of this improvement is real, but, sadly, not all of it. Much that has produced this good news will not recur. Indeed, in one respect, the good news, welcome as it is, has a dangerous aspect. By removing Washington's sense of urgency on budget matters, it could delay still-needed fundamental tax and spending reform.

According to the latest Treasury report, the federal budget this year is doing much better than even the optimists had expected. The deficit for the fiscal year through May amounts to $626 billion, implying a figure of $939 billion for all of fiscal 2013. That amount would be 14% below the fiscal 2012 deficit and 5.3% below earlier estimates of the White House's Office of Management and Budget. Most of the improvement reflects a surge in revenues, to $1.8 trillion for the year so far—up a whopping 15% from the comparable period in fiscal 2012. There was some help from outlays as well, which, at $2.4 trillion through May 2013, hardly grew at all from the comparable period in fiscal 2012. Some analysts, by extrapolating this improving trend, point to a fiscal 2014 deficit of less than 4% of gross domestic product (GDP), still high by historical standards, but much more manageable and much less alarming than the deficits of two or three years ago, which amounted to 9% of GDP or more.1

This pleasant prospect is, however, a doubtful one. To be sure, some of the recent budget improvement has firm foundations. The economy, after all, is growing, albeit slowly, and, consequently, is raising revenues from both personal and corporate income taxes. And since the progressive personal tax code takes more on average of each additional dollar, the revenue gains, even in a slow recovery, have risen faster than general income and earnings gains. But other aspects of this good news will not likely repeat.

One is the effect of the 2012 tax avoidance. Fear of tax hikes in the new year prompted many firms late last year to pay employees special bonuses and give shareholders special dividends so that they could book the income under presumably lower-tax 2012 laws. Because these payouts inordinately swelled 2012 incomes, people owed more than anticipated at this year's April reckoning. Tax receipts, accordingly, surged 27.8% above those recorded in April 2012. But this effect will not continue. The close of 2013 will not likely carry an incentive for similar special payouts. On the contrary, last year's hurried disbursements likely took from bonuses and dividend payments that would otherwise have been paid in 2013 and would have generated tax at 2014's April accounting. Indeed, the effect of the 2012 payouts was already ebbing in the May budget report, which saw only a 9.1% jump in revenues from the comparable month in 2012.2

The year did see a permanent rise in tax rates for the wealthy, both from the "fiscal cliff" compromise and from the legislation pertaining to Obamacare. It also saw an end of the prior year's payroll tax holiday. These changes will continue to generate additional revenue flows, as the special bonus and dividend payouts will not. But the surge that occurred with the change will not recur. The same no doubt is true of two other special factors. The healing in the housing market has enabled Fannie Mae [Federal National Mortgage Association] and Freddie Mac [Federal Home Loan Mortgage Corporation] to turn a net draw on tax revenues into a positive contribution this year, while the sequester also curtailed spending after March.3Though both these sources of deficit relief will likely continue, they, like the tax law changes, will not produce the sudden surge in the coming fiscal year that they have in the current one.

Even with this mix of influences operating in fiscal 2014, chances are the deficit for that year will come in worse than the White House's estimates. To be sure, a continuing sequester, ongoing prosperity at Fannie and Freddie, and the take from the new taxes will almost surely hold the deficit below where it otherwise would be. But the White House’s estimates assume unrealistically rapid rates of economic and income growth, anticipating a 4.0% real GDP rise in calendar 2014 and a 4.2% gain in calendar 2015. Though anything is possible, these rates of expansion are far faster than what has occurred so far in this subpar economic recovery, and are not at all likely in the still-constrained environment. On this basis, the fiscal 2014 deficit, despite some sources of relief, will likely come in closer to $750 billion, instead of the $668 billion in the White House's estimate, and closer to 4.5% of the economy than the 3.9% originally estimated.4

Looking out still further, sustaining good news on the deficit becomes even dicier. To be sure, the economy will likely continue to expand, raising tax revenues. But the full implementation of Obamacare will raise entitlements spending still faster, as the Congressional Budget Office confirms with each new look at the legislation. Still more, the retirement of the baby boomers will gain momentum over the longer term, accelerating outlays for Social Security and Medicare. Despite the debate on how much control Washington can exert on Social Security and Medicare, there is no getting away from the powerful demographic pressure, which will, by 2020, reduce the ratio of working-age people to retirees from almost 5.5 at present to barely more than four.5On this basis, it seems almost inevitable that entitlements spending will outpace income and revenues growth.

It was always this longer-term concern that pressed on Congress and the White House to address tax and spending reform. To the extent that the current short-term reprieve delays this still urgently needed action, it is troublesome. In this respect, it may be a good thing that the country will soon come up against its debt ceiling, shortly after September 2, in fact, according to Treasury Secretary Jack Lew, even with the improved budget figures. No doubt the debate and posturing around such an event will cause market turmoil, but it will have a payoff if it reminds Congress and the president of longer-term fundamental budget needs. Either way, the uncertainty surrounding fiscal matters looks set to continue, despite this year's modest deficit reprieve.

1The Department of the Treasury.

2The Office of Management and Budget.

3The Department of the Treasury.



The opinions in the preceding economic commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. This material is not intended to be relied upon as a forecast, research, or investment advice regarding a particular investment or the markets in general. Nor is it intended to predict or depict performance of any investment. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Consult a financial advisor on the strategy best for you.

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