Fiscal Policy: Nothing's Certain with Debt and Taxes

The passage of a two-year budget deal has lifted one great investment uncertainty hanging over 2014 and, along with it, an element of fiscal drag on the economy. Still, the weight of Washington remains going into this new year, as we likely will see in February and March an acrimonious fight over the debt ceiling. Market turmoil will surely accompany the political back and forth, though the inevitable threats of a government shutdown and default will grossly overstate the real danger. A potential bright spot on this horizon, however, is the chance of tax reform, which both Democrats and Republicans say has gained new life from the recent budget compromise. Though the prospects of substantive reform appear slim, especially since the White House is still not on board, the fiscal picture for 2014 is more upbeat on balance than it has been in a while.

Though the budget deal may reflect exhaustion more than the new bipartisan spirit of which people speak, it does resemble a genuine compromise. There is something for each side and reason for frustration and disappointment by partisans on either side. For the Democrats, the compromise offers relief from the sequester that in 2014 would have capped discretionary spending, including defense, at more than $100 billion short of what ongoing budget authority would have allowed. This new budget allows a two-year increase of $63 billion in discretionary spending over current law (as set in last fall's continuing resolution), about $44 billion above the amount a sequester would have allowed. That is considerably less fiscal restraint. But the Republicans have hardly given away the sequester. According to this deal, its caps on discretionary spending return in 2016, unless Congress can arrive at another compromise.1

To keep the budget deficit from increasing with this additional discretionary spending, the deal imposes a mélange of fees and spending cuts, amounting to some $85 billion over 10 years. In one, the Transportation Security Administration (TSA) would raise the fees it charges airlines, from $2.50 per passenger on nonstop flights and $5.00 on flights with a connection, to a straight $5.60 per passenger for each one-way trip, regardless of connections. The deal would for the first time impose a $487,000 cap on the compensation of federal contractors. To prevent fraud, it would for the first time limit access to the Social Security Administration's Death Master File of dead Americans, including their Social Security numbers. This, and fees like it, would, the legislation claims, raise $26 billion over 10 years. More significantly, the deal would ask new federal workers to contribute 2.1% to their pension, up from 0.8% for existing employees. It would also limit the annual cost of living adjustments for military retirees under 62 to the consumer price index less one percentage point.2

For the basic budget picture, the deal does little. The whole picture promises a net deficit reduction of some $23 billion over 10 years—effectively a rounding error. The negotiators did say that they were aiming small, knowing that they could not compromise on anything large or fundamental. They certainly have been true to their word.3Even small in scope, there is much yet to do before January 15, when the continuing resolutions of last fall run out. Committees in both house of Congress must make specific appropriations for various parts of the budget and in the process resolve remaining differences over specific spending priorities as well as disputes over the policy riders attached to the legislation. Even then both houses must vote on the 12 appropriation bills, probably as one omnibus measure. By that time, Congress will have six weeks to resolve the debt ceiling matter before the country hits it, in early March, according to the Treasury Department.4

The specifics of this debate are far from clear, but from statements on both sides, there is little bipartisan spirit when it comes to the debt ceiling. White House press secretary Jay Carney has gone on record saying that President Obama will not negotiate on the debt ceiling. The president wants what he has called a clean increase, meaning with no strings attached. But Congressman Paul Ryan (R-WI), who led the Republican negotiating team on the budget deal, has already gone on record saying that they didn't want anything out of this debt limit.5Like others in his party, Ryan is willing to raise the debt ceiling, but he just wants something back for it. More conservative Republican representatives and senators are talking about major entitlement reforms as their own quid pro quo. Senator Marco Rubio (R-FL) is looking for a package of spending cuts in return for an increase in the debt ceiling.6

Only a fool, though, would try to predict the results of these upcoming negotiations. The president, despite the claims of his partisans, has not always prevailed. Indeed, the sequester itself is a concession he made to resolve the 2011 debt-ceiling negotiations. But even so, it does seem highly unlikely that the Republicans can get significant entitlements reforms out of even the best executed negotiations, much less what they have exhibited to date. The president and the Democratic Party simply hold Social Security, Medicare, and now the Affordable Care system as too sacred. But if it is impossible to determine what will come out of the debt-ceiling debate, it is clear that investors will almost certainly avoid another government shutdown, much less the default that various parties will inevitably threaten. After the agony suffered by both parties last fall, few, if any, have the stomach for a rerun.

If the debt-ceiling matter will likely give markets little cheer, but also little fear, several in Washington have raised the prospect of good news over tax reform. Congressman Ryan, for example, suggested that a tax overhaul could become a real possibility "in the first quarter." Senator Patty Murray (D-WA), who led the Democratic negotiating team on the budget deal, has reinforced the optimism, saying at Ryan's side that Democrats, too, want tax reform.7Senator Max Baucus (D-MT) and House Ways and Means Committee chairman Dave Camp (R-MI) noted that the budget deal did nothing to end tax breaks, and promised that they would come up for consideration soon in tax reform negotiations.8Of course, markets would welcome pro-growth reform. The prospect of lower statutory rates, a broader base, and fewer distorting tax breaks is popular in the finance community. But reform is far from easy and far from done. Such titillating promises have surfaced before. Significantly, the White House has endorsed nothing, and little progress is likely without the president's support. Still, even just the open consideration of such reform could lift investors' spirits, especially once debt-ceiling concerns are behind them.

As ever with Washington, matters are convoluted, and the message to the investment community is mixed. The budget deal, though it lifts a measure of uncertainty that formerly confronted Wall Street and should mitigate the degree of financial drag acting on an already weak economy, is far from an investor's ideal. The upcoming debt-ceiling debate, though bound to create market turmoil, is likely to avoid the most feared outcomes, and the push for pro-growth tax reform, though unlikely to become a reality, especially in the face of White House passivity, will provide a psychological lift simply from the fact that both sides of the aisle are discussing it. On balance, then, the picture, though far from cheery, is less threatening than it seemed in the past.

1Dow Jones News Wire, December 10, 2013.



4Janet Hook, "Parties' Budget Haggling Shifts,"The Wall Street Journal, December 18, 2013.

5Justin Sink, "White House: No Debt Ceiling Negotiation,"The Hill, December 16, 2013.

6Carol E. Lee and Damian Paletta, "Republicans Promise New Fight Over Debt Limit,"The Wall Street Journal, December 17, 2013.

7Russell Berman, "Ryan: Watch for GOP Tax Reform,"The Hill, December 15, 2013.

8Bernie Becker, "Tax Reformers See Hope in Budget Deal,"The Hill, December 15, 2013.

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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