"Cliff Notes" on Our Federal Government

Well, here we are. The horizon is no longer filled with Federal deficits for as far as the eye can see. And it all happened in three months.

Magic, you say?

Behold, a ‘New’ Reality from the Congressional Budget Office.

Below are the CBO’s current top line projections for Federal revenue and spending. What you can see is that after all the hullaballoo, we are to achieve the result of returning to historical baselines figures.

Can you believe it? All the noise coming out of Washington DC, and it appears nothing will really change in historical terms.

Or will it?

We Doubled the Nation’s Debt in the Last Five Years.

This is nothing to be proud of. At least it looks like the threshold of 75% of U.S. debt to GDP will be the frontline now. Not 90%.

Consult the U.S. debt to GDP timeline below.

Assuming most of this debt is in the form of current issuance from the U.S. Treasury at rock bottom 2% rates on the 10-year, it looks to be wisdom.

As long as we locked in those low rates. I agree. This is a big question mark.

What Spending Patterns Will Change?

The big spending outlook “what if” in coming numbers assumes sequestration decisions stick as they are. If they do, here is what happens.

First, in terms of Federal spending, the sequestration is to lop off -17% of Defense Discretionary Spending over the next two years. Other Mandatory Spending falls -13% and Non-defense Discretionary Spending falls -13%. Protecting the pay of the actual military likely makes up the difference.

Second, we see a modest rise in Social Security spending of +3%. Major Health Care Programs rise +8%. Assume the former is indexed to the inflation rate in some convoluted way. The latter adds in Obamacare costs and indexing.

Consult the CBO spending table, below, in percent of GDP terms.

Here are category spending changes expressed in GDP terms…

It amounts to reducing spending overall by -1.1% of GDP. Now, what about the Revenue side?

What Happens to Taxes?

First, it looks like on the individual side, taxes rise via the re-introduction of the personal payroll tax rate and the new introduction of taxes from Obamacare on the wealthy.

These play out this year, and next, and raise $420 billion U.S. dollars. $250 billion falls into the Individual Income Taxes bucket, and $170 billion falls into Social Insurance Taxes (funding for Social Security, Medicare, Medicaid) bucket.

That is a +2.7% increase in GDP terms.

Second, expiring corporate tax credits on business investment appears to give us another $140 billion U.S. dollars.

This is +0.9% of GDP.

What Does This Mean for Investors?

In sum, we are going to increase taxes on ourselves by +3.6% of GDP and cut spending by -1.1% of GDP. The remainder in the deficit to GDP percentages of +1.1% of GDP must by made up by a larger, growing economy over a couple years time.

I identified four other budget takeaways.

1. Spending rebalancing would likely hurt the elderly and health care providers and help defense companies.

Republicans have yet to really claim any flesh, in terms of Entitlement reductions. That is where I would look for spending change in the coming two years. Given voter’s power, this will remain contentious.

2. One might look for a burst of capital investment spending by businesses in front of expiring corporate tax credits.

Taxes from Obamacare ended up being a stealth way to increase taxes on the wealthy. Expiring investment tax credits on businesses will spread the burden onto the private sector. Here, you can see the President has already gotten his way, in some sense.

3. There are multiple real GDP consequences to any reduction in QE support.

The Fed’s QE is important in lifting personal wealth via housing values and stock prices and via overall GDP growth, in the face of the rise in personal income taxes.

4. There are also direct Federal budget consequences to any reduction in QE support.

QE directly reduces the tax burden on Federal interest debt payments. $80-$100B in annual U.S. Treasury remittances from the Fed’s mortgage-backed and long-term bond portfolio also help the budget.

Tapering QE is not going to be taken lightly, or soon.

There it is. The “Cliff Notes” on our Federal Government.

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