Dramatically Dropping Deficits? Keep Dreaming

The Congressional Budget Office (CBO) recently reported remarkable budget improvements for the fiscal year 2013. It recorded a deficit of $680 billion for the year, still huge, but encouragingly down from $1.089 trillion of fiscal 2012—a stupendous drop of more than one-third, in fact. This kind of progress seems almost too good to be true. In one certain sense, it is. None of this doubt suggests in any way, of course, that Treasury or the CBO has cooked the books. On the contrary, the figures are surely accurate, or as accurate as such figures can be. But still, the progress implicit in this report is deceptive. The gains of fiscal 2013 rely in large part on a number of transitory special influences that will not recur going forward, or not recur with the same intensity. Those who simply extrapolate last year’s gains will be disappointed. Fiscal 2014 at best will only very modestly extend the improvements of fiscal 2013.1

Though the release went largely unheralded in the media, the figures for the fiscal year ended this past September were indeed impressive. According to the CBO, Treasury receipts jumped $325 billion, or 13.3%, which is remarkable, especially given that the economy expanded less than 3% in real terms and that revenues during the prior three years of recovery expanded on average at only 5.2% per year. Outlays fell a modest 2.4%, or $84 billion. Under those two influences, the overall deficit shrank, as indicated, by more than a third. Though during the prior three years the flow of red ink had ebbed, the pace of improvement hardly compares to fiscal 2013. The deficit shrank by a mere 8.3% per year between fiscal 2009 and fiscal 2012, from $1.4 trillion to $1.1 trillion. As a part of the country's gross domestic product (GDP), the fiscal 2013 deficit fell to 4.1%, still high compared with the historical averages, but vastly improved from 9.8% in fiscal 2009, 8.8% in fiscal 2010, 8.4% in fiscal 2011, and 6.8% in fiscal 2012.

The optimist in everyone would dearly love to extrapolate this accelerated rate of improvement and declare Washington's fiscal problems a thing of the past. There is still a chance that Congress will interpret the figures in just this way and use them to dodge pressure for fiscal reform. But such interpretations would mislead and such actions would be negligent. They would ignore the number of special factors that influenced both revenues and expenditures last year and that will not provide the same financial magic going forward, at least not to the same extent.

1) The sequester cut spending after the first quarter of calendar 2013. It is, in fact, safe to say that the entire spending decline was due to it. Had it not occurred, the deficit would have come in at closer to $764 billion—still a significant improvement over fiscal 2012, but less dramatic than was actually recorded. Though the sequester will likely become more significant going forward, additional absolute cuts are unlikely. The law, after 2013, administers the sequester as a cap on actual outlays. The gap between actual spending and still growing budgeted amounts will widen, but these rules will just stop spending growth and not impose any additional cuts. The reduced level of discretionary spending will indeed hold, but it will not likely fall any further, while entitlements spending, which is well over half the budget and subject to neither sequester cuts nor caps, will continue to expand uninterrupted.2

2) Taxes rose in January 2013, because of higher rates on the wealthiest Americans and the end of the holiday on some Social Security and Medicare withholding. These heightened tax rates will continue going forward and continue to generate additional revenues flows to the Treasury. But the one-time leap in revenues that occurred with the 2013 changes in the law will not recur. There is nothing in these now ongoing taxes that will drive up revenues going forward much faster than payroll or income growth.3

3) One-time tax avoidance efforts in 2012 ironically inflated fiscal 2013 tax payments. Because firms late in 2012 feared tax hikes in the new year, many telescoped into the last quarter of 2012 bonuses and dividend payments that they would otherwise have paid in 2013. The effect is significant. In that last quarter of 2012, these special payments help drive up wage and salary income at an 11% annual rate, far faster than the 3.1% rate of expansion averaged during the prior four quarters. Dividend income jumped 16.8% at an annual rate in that quarter, far faster than the 3.9% rate of expansion during the prior four quarters. Though these payments accrued to 2012 taxes, there was little withholding, and so they were mostly paid last April, inflating the fiscal 2013 take. The figure was significant, too. Revenue flows in April 2013 rose by a stupendous 27.8% over April of the prior year. But no such special boost will occur this coming April. On the contrary, because the telescoped payments of 2012 drew from monies that normally would have been paid in 2013, the revenue flow this coming April 2014 may well fall short.4

4) The improvement in the housing market enabled Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corp.) to turn a net draw on Treasury revenues into a positive contribution of $60 billion in fiscal 2013. Alone this swing accounts for more than 25% of the overall deficit improvement. Though a continued improvement in the housing market will enable Fannie and Freddie to enlarge this contribution, the net addition going forward will likely fall far short of the fiscal 2013 swing, not the least because the pace of improvement in residential real estate has slowed.

For all these reasons, deficit improvements going forward will fall far short of the inordinate gains made in fiscal 2013. Some progress is likely. Revenues should marginally outpace overall income growth. After all, the progressive tax code allows the Treasury on average to tax each additional dollar earned at a higher rate, and this effect should more than offset the give back for the revenue collected on the telescoped bonuses and dividend income. Receipts, then, could rise about 5% in fiscal 2014, to $2.913 trillion. On outlays, the Affordable Care Act, though it will eventually increase entitlements spending, will have only just begun next year and so will remain a small factor in the overall equation. Still, along with the other, older entitlements programs, the expansion in this area of the budget should drive overall expenditures up an overall 2.5–3.0%, bringing the fiscal 2014 total to $3.549 trillion.

The fiscal 2014 deficit, under these admittedly tentative calculations, would then come in at about $636 billion, down about 6.0% from fiscal 2013. The smaller figure will be a welcome improvement, but exhibit a much slower pace of progress than last year, slower even than the deficit declines between 2009 and 2012. Still, even this modest deficit drop would bring the flow of red ink to less than 4.0% of GDP in fiscal 2014, finally approaching the levels averaged before the 2008–09 crisis. Still, the result will disappoint any who extrapolate the fiscal 2013 experience whether investors, planners, or members of the government.

1All data herein from the Office of Management and the Budget, unless otherwise indicated.

2Department of Commerce.



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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