“Tax cuts without spending cuts are a recipe for disaster.” - Eric Boehm
Yesterday the Congressional Budget Office released its analysis of the recently completed 2018 fiscal year. Unfortunately, despite an incredibly positive economic backdrop the Federal government’s debt and spending levels remain a grave concern - at least for some of us. Under Trump’s White House and a Republican controlled congress the US government posted a fiscal year deficit of $779 billion, up 17% from the previous year. This represents the largest budget gap since 2012 when the economy was still licking its wounds from the financial crisis. What’s even more concerning is that the CBO and White House announced the deficit is expected to trend back towards $1 trillion (with a “T”) for fiscal year 2019.
The chart below shows this year’s deficit in black, and next year’s projected deficit in gray. For additional context the dotted line reflects the deficit as a percentage of gross domestic production. On this more normalized measure one can see that this past year’s deficit was basically on par with the deficits we were running in the early 90’s and early 2000’s even though the dollar amount is much larger.
Typically you would expect the deficit to ebb and flow along with the economy. During periods of weak growth or recession the government might run a larger deficit as a way to inject fiscal stimulus into the economy. Then, during the strong growth years the tax base is lifted by the economic growth, the government can better afford to shrink spending and the budget can move into a balanced or surplus position. So what’s notable about the current situation is that the deficit is getting larger even in the face of strong economic growth.
Budget deficits are obviously a function of two things: tax revenue (income) and government expenditures (expenses). Revenues for fiscal year 2018 came in relatively flat year over year. Trump’s tax cuts obviously played a key role in this, as the boon of strong economic growth was partially offset by the decrease in tax rates that went into effect three months into the fiscal year. Not surprisingly, the largest impact was felt in the corporate sector where tax revenues fell by 31% on the back of a rate cut from 35% to 21%.
On the other side of the ledger, spending increased 3% from the previous fiscal year. This was driven in part by a 6% increase in military spending, a discretionary call that Trump believed was overdue and necessary in order to maintain our country’s high standard of defense and military readiness. Not surprisingly, however, it was the non-discretionary portions of the budget that accounted for the bulk of the increase in expenditures. Entitlement programs, as we all know, are occupying a greater and greater portion of the budget and are projected to run at a $100 trillion deficit over the next thirty years (yikes). A ballooning government debt load and higher interest rates are also hurting us. Net interest expense grew by 14% over the previous fiscal year, and the CBO is projecting that the country’s net interest costs will double as a percentage of the economy over the next decade.
The extreme partisan rhetoric that we’ve all come to expect has, of course, been flying over the past 24 hours. But none of this is as black and white as the headlines would suggest, and the reality is that leadership on both sides of the aisle are culpable in their own ways for the current situation and future trajectory.
Our take is that the immediate drop in tax receipts shouldn’t come as a surprise to anyone in light of the tax cuts, but the bigger question is to what extent they pay for themselves over time by spurring incremental economic growth. The dominant perspectives on this issue are predictably dogmatic and divided along partisan lines, but we would suggest once again that perhaps it’s more complicated than most people think. See our post Cure or Curse? from roughly a year ago for more discussion on the theory of supply-side economics and the Laffer Curve…it’s an interesting topic.
On the spending side of the equation, it just seems to cut against the grain of a politician’s DNA to exercise fiscal restraint. There is an awful lot of talk and very little action. Someone will eventually have to risk political suicide by broaching the topic of entitlement reform (see our two part series on social security), and the entire country simply needs to get more serious about restricting ballooning debt and the interest service cost that comes along with it. Unfortunately large deficits only add to this growing problem.
Regardless of where you fall on the spectrum of economic theory, at a certain point we should all move towards a common point of agreement that smaller deficits and a shrinking debt burden, at least relative to the size of the economy, would be preferable to the alternative. We also can’t take for granted the fact that we have a virtually risk-free credit rating on our bonds and the US Dollar is the world’s reserve currency. The amount of flexibility this affords us in managing cash flows and funding our budget gaps simply cannot be overstated. This is a great privilege and advantage, and one that we should fully utilize in the management of the economy! But we also run the risk of growing lazy and apathetic. The ease at which we can borrow and service debt only enables us to continue kicking the proverbial can down the road. If we’re not careful eventually there will be a tipping point, and things will not take long to deteriorate once we get there - just ask the Europeans.
While the finances of the US government are far more nuanced than mine or yours, at some point the common sense axioms that govern healthy spending and borrowing habits at the personal finance level should carry some weight at the government level as well. We need good faith bipartisan leadership that is willing to guide the country through the tough short-term decisions for the sake of the country’s long-term sustainability. It’s going to require more disciplined spending and tax policies that balance structural economic incentives with the reality of our country’s budgeted spending. If we only have the political will to embrace one without the other we’re setting ourselves up for disaster.
Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.
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