econ.la - Trillion Dollar Fiscal Deficits Will Pose Severe Challenges for the U.S. Economy Ahead

Trillion Dollar Fiscal Deficits Will Pose Severe Challenges for the U.S. Economy Ahead

June 3, 2009
Roubini Global Economic Monitor

The U.S. economy may run trillion dollar deficits in the next few years despite Obama and Geither's statements recently to reduce the deficit to 3% of GDP by 2013. This is because fiscal stimulus and bailout measures will raise spending while tax revenues boom from the corporate and financial sector will slow sharply. Entitlement burden will increase ahead on aging population and health care reforms being debated by the Treasury and Congress will require large resources as well. Rising debt burden poses risk of higher nominal and real interest rates and crowding out of investment in the medium term. Treasury's stance to raise taxes (on high-income individuals, corporates, fund managers, cap-and-trade) to shore up revenues in the coming years may also stifle recovery in private demand

Bernanke: Given budgetary challenges associated with baby boomers, continued increases in medical costs and an already elevated debt/GDP ratio, we will not be able to continue borrowing indefinitely to meet these demands. Also, unless there is a strong commitment to fiscal sustainability (a situation in which the ratios of government debt and interest payments to GDP are stable or declining) in the longer term, there will neither be financial stability nor healthy economic growth. This will require making difficult choices: Controlling spending, deciding how much economic resources can be devoted to federal government programs, including entitlements, and setting tax rates at a level sufficient to achieve an appropriate balance of spending and revenues in the long-run

While tax collections usually boost April revenues, a fiscal deficit of $20.9 bn was reported in April 2009 (first time since 1983) as spending rose 17.5% y/y while revenues fell 34.1% y/y. This took the ytd deficit for FY2009 to $802.3 billion. Corporate tax receipts are down 58.6% ytd while Individual income tax collections are down 24.2% ytd. On a net present value basis, the $184 billion spent on TARP and the $130.7 billion to purchase mortgage debt from GSEs including Fannie and Freddie, has been accounted in the budget

Forecasts for 2009 deficit: Treasury: $1.84 tr; Merrill Lynch: $1.5 tr; JP Morgan: $1.5 tr; Goldman Sachs: $1.86 tr; Morgan Stanley: $2 tr; CBO: $1.85 tr. Forecast for FY2010 deficit: govt: $1.26 tr; CBO: $1.38 tr. FY2008 fiscal deficit: $454.8 bn (3.2% of GDP)

Fiscal deficit includes money injected into banks so far via TARP but excludes the cost borne on Fannie and Freddie. Obama plans a $634 bn health reserve fund to expand health insurance coverage and require insurance companies participating in the Medicare to enter competitive bidding. Entitlement programs such as Medicare, Medicaid and Social Security, bank bailout costs and interest payments on the federal debt will total $2.3 trillion (60% of budget) in FY2009

CBO: Taking into a/c Obama's FY2010 budget plan, fiscal deficit would reach $1.85 trillion in 2009 and $1.38 trillion (9.6% of GDP) in 2010. Deficits would shrink to about 4% of GDP by 2012 and 4-6% of GDP through 2019. Deficit estimates include govt expenditure (i.e. cost of purchase - risk adjusted net present value of expected future earnings) on TARP and GSEs). Fiscal stimulus will add $185 bn to 2009 deficit and $399 bn to 2010 deficit. Fed interest payment on reserves starting Oct-08 will reduce Fed’s payments of profits to Treasury and therefore federal revenues; Fiscal stimulus of 2008 will raise deficit by $152 bn in 2008 ($124 bn in 2008-18); Housing Bill may cost $2.7 bn during 2008-13; War spending will rise to $188 bn in 2008 ($1.2-1.7 tr during 2001-17)

Roubini: Fiscal stimulus package to contain the recession and socializing private sector losses imply increasing public debt and risking to create a sovereign debt problem, and thus increasing the overall leverage of the economy. Higher debt burden will be a medium term drag on growth and might lead to an increase in real interest rates that may crowd out private spending

Auerbach and Gale: Assuming an orderly recovery, economy returning to full employment, the provisions in the stimulus to expire, taking no account of new outlays under housing or financial stability plans, the deficit will average at least $1,000 bn a year over the next decade

Merrill Lynch (not online): limiting tax subsidies for over $250,000 income-group could have a significant negative impact on growth and forestall the economic recovery which will still be in its early stages when these taxes take effect. It would also raise the after-tax costs of buying a home, placing additional pressure on the housing market

Medicare costs were 3.2% of GDP in 2008. Spending on Medicare will reach a legal limit by 2014. Medicare’s hospital fund will be exhausted by 2017. The trust fund will need an additional $13.4 trillion to meet its obligations over the next 75 years. Social Security benefits represented 4.4% of GDP in 2008. Spending on Social Security is expected to exceed revenues in 2016. The trust fund will need an additional $5.3 trillion over the next 75 years to meet all scheduled benefits. The retirement-assistance program can continue to pay full benefits for about 30 years

Brookings, Heritage: Need to create a sustainable long-term budget for Medicare, Medicaid, Social Security w/ limits set on spending growth; deviations from budgeted amounts should be met by automatic adjustments in benefits/premiums/payments; CBPP: 'automatic' cuts in entitlements won't reduce deficit; need to consider in tax cuts, cost-efficient health care outcomes and pay-go rule

FY2010 Budget:

Obama's $3.6 trillion FY2010 budget cuts $17 billion spending on around 121 federal programs but increases $81 billion in the domestic agenda to $1.30 trillion. Proposed budget cuts face opposition from the Congress. Budget Includes: A $250bn “placeholder” for the financial industry under TARP and will need Congress approval. Abolishes preferential tax treatment for oil and gas companies, $533.8 billion for Defense Department excluding war costs, $5 bn national infrastructure bank, $10 bn in loans for 2009 for carmakers and car-parts suppliers and $15 billion in 2010, $11.7 billion to maintain doctors’ fees under Medicare, reduce farm subsidies, implement a low-cost housing trust fund, spreading automatic 401(k) enrollments, $1 bn for the national direct-deposit retirement-savings system, double foreign aid and scientific research over the years

April 2009: In spite of opposition from Republicans, Congress approved a $3.55 trillion budget plan that sees a 9% increase in discretionary spending and 4% increase for defense. focuses health-care and education reform and spending on climate change. Legislation eliminates Obama's request for $250 billion for further bank bailouts. Budget would end subsidies for student-loan providers, raises taxes on couples earning more than $250,000, permanently extends the estate tax at current rates

Obama plans to finance the FY2010 budget and reduce the deficit by half to $533 bn (3% of GDP) by 2013 by limiting tax deductions for households earning over $250,000 (raising the top two marginal income tax rates to 39.6% and 36%), raising taxes on carried interest of hedge funds from 15% to 20%, letting Bush's tax cuts expire in 2010, raising taxes on corporate income earned overseas, closing corporate tax loopholes and offshore tax havens, eliminating Advance Earned Income Tax Credit. On the spending side, he plans to reduce defense expenditure incl. on Iraq and Afghanistan ($75 bn out of $140 bn in 2010), cut subsidies on Medicare, earn $75 bn in 2012 from a cap-and-trade system to finance clean-energy technology, phase out farm subsidies for farmers earning over $500,000

Risks to govt's budget projections: Given the recession, market slump and declining investment, Obama might wait to raise these taxes until economic recovery begins and Bush's tax cuts expire. Administration's assumption about recovery of GDP growth might be optimistic. Pick-up in private demand and unwinding of bank losses will be slow. This would call for more bailout funds and fiscal stimulus ahead. Slower growth, impact of credit crunch and greater regulation, end of global liquidity and corporate profits boom, jobless recovery will weigh down on tax revenues esp. from corporate income, capital gains, dividends. Expenditure on health care overhaul will need over $1 trillion

Impact on debt:

Obama: Current deficit spending unsustainable and will lead to higher debt burden and interest rates in the future for consumers if the U.S. continues to finance it by borrowing from other countries, thus dampening effect on our economy. This also calls for the need to reduce entitlement costs

Debt held by the public would rise from 41% of GDP in 2008 to 57% in 2009 and 65% in 2010 and then to 82% of GDP by 2019 (CBO)

Public debt will double as a share of GDP over the next decade to 83% (Goldman Sachs)

If all bailouts materialize, govt gross debt would exceed 70% of GDP in 2009 for the first time since 1950s (Fitch)

The increase in taxes/reduction in spending to keep debt/GDP ratio at its current level – is about 7-9% of GDP ($1-1.3 trillion per year) (Auerbach and Gale)