Federal Budget Update

by: Lance Brofman

Summary

The Budgets projected by the Congressional Budget Office and the President's Office of Management and Budget both contain assumptions that may be unrealistic.

We show the implications for the Federal deficit under various economic scenarios.

We also show the implications for the Federal deficit if the Congressional Budget Office assumptions regarding adherence to current law regarding spending limits and tax breaks expiration do not occur.

The Congressional Budget Office (CBO) and the Office of Management and Budget (OMB) have published updated budget paths through 2024. The CBO is obliged to base its estimates on current law, whereas OMB has no such obligation. It therefore reflects the Administration's priorities. As such, the OMB document is as much an economic exercise as it is a political document. In this report, we examine the budget outlook, compare the two documents, and finally, offer some alternative scenarios.

Under current law, the CBO incorporates the effect of the 2013 tax law changes, spending constraints imposed by the Budget Control Act and recently amended by the House and Senate Budget Chairs, and various items that the Congress permitted to lapse at the end of 2013. These include, but are not restricted to the expiration of emergency jobless benefits, amounting to about $25 billion in 2014. There were also approximately 55 tax provisions that expired, and these are worth about $50 billion in 2014 and $100 billion per year by 2024. These cover various R&D credits, depreciation allowances, and various green energy credits.

Both the CBO and OMB budget paths benefit from the fact that the 2013 deficit was significantly lower than expected. In February 2013, the CBO forecast a 2013 deficit of $845 billion, while the OMB's expectation was $973 billion. The actual deficit for 2013 was $680 billion. It would be great if this difference reflected unexpectedly strong economic growth and thus stronger tax revenue, or if it reflected lower spending, or a combination of the two. But it was not. Nominal GDP growth in 2013 was 3%, which was actually lower than originally forecast by both the CBO and the OMB.

The improvement in the deficit was almost entirely due to a windfall of nearly $200 billion gotten from Federal National Mortgage Association Fannie Mae (OTCQB:FNMA) and Federal Home Loan Mortgage Corp. (OTCQB:FMCC). When these entities were bailed out by taxpayers to the tune of $180 billion in 2008 - the terms of the bailout were such that Treasury would receive 80% of the common stock, and that all of the money advanced by the Treasury would be in the form of a purchase of preferred stock that would pay 10% annual dividends. The agencies returned to profitability in 2012-2013, and the Treasury arbitrarily changed the terms of the payback so that in lieu of the 10% annual dividends, the Treasury would receive all of the profits. Shareholders were left in the lurch, but Treasury's bailout turned a profit.

This is currently being challenged in the courts. But in the meantime, Treasury and the taxpayer are reaping the reward. And because the baseline deficit is lower, the benefits feed through into future budget estimates as well. This, coupled with the two-year spending ceiling of $1.014 trillion for discretionary items that was agreed on by House and Senate budget conferees allows for further deficit reduction in 2014-2015, assuming the economy continues growing. By the way, the two-year spending cap is approximately $55 billion above the spending cap mandated by sequestration, so the deficit reduction could have been even greater.

As shown in the enclosed table, both CBO and OMB project a further decline in the deficit in 2014 and 2015. The CBO has the greater decline, with the deficit falling below 3% of GDP in 2015, even though the CBO is forecasting slower nominal GDP growth and slightly higher interest rates than OMB. Remembering that the CBO must follow current law, a major discrepancy between CBO and OMB is that OMB builds into its forecast a restoration of emergency jobless benefits, which would boost outlays. In any event, if either CBO or OMB has reasonably accurate estimates, the deficit for 2014-2015 is a non-issue politically and for the economy.

Beginning in 2016, this changes, however. The CBO and OMB budget paths show a marked divergence beginning in 2016, as shown in the table. The CBO shows that the deficit begins rising in 2016, and it exceeds $1 trillion beginning in 2022. As a percent of GDP, the CBO deficit bottoms in 2017, and then it rises steadily reaching 4% by the end of the forecast period. The debt-GDP ratio climbs gradually to almost 80% by the end of the forecast period.

The OMB envisions a brighter financial outlook. The deficit falls through 2018, as shown in the table, and then it only rises minimally over the remainder of the forecast period. According to OMB, the deficit will not approach $1 trillion over the next ten years. As a percent of GDP, the deficit shrinks as well, falling below 2% in 2023. And with this optimistic path, the debt-GDP ratio falls gradually and persistently to below 70% by the end of the forecast period.

As usual, neither CBO nor OMB assume there is a business downturn any time during the forecast period. There is no resumption of costly overseas military operations or serious external shocks. In fact, in the OMB scenario, there are reductions in the military budget that have come under intense criticism from both sides of the political spectrum for its planned deep force reductions and its overall level of spending relative to GDP.

So what accounts for the divergence between CBO and OMB? There are several. First, CBO shows a greater sensitivity to GDP growth versus prior analyses. And OMB has a more optimistic forecast for the economy over the entire forecast period. Both CBO and OMB expect faster economic growth than was achieved in the 2010-2013 period. But OMB is more optimistic; by 2024, its forecast level of nominal GDP is 3.7% higher than forecast by CBO. Further, OMB projects a lower level of long-term interest rates through 2020, and thus, $260 billion less in interest expense in 2015-2024. So, OMB has higher growth and lower interest rates; an optimistic outcome for sure.

Prospective changes in tax and spending policies also color the OMB forecast versus CBO. Beyond 2015, OMB allows for faster discretionary spending than is mandated by the sequester order. Also, OMB drops its prior proposal to scale back cost of living adjustments for entitlement programs. On the revenue side, OMB builds in approximately $1 trillion of tax increases over the forecast horizon. There is about $700 billion in personal taxes and $285 billion in corporate revenue to be gotten from loophole closing and the elimination of assorted subsidies. According to OMB, these would reduce the deficit, but not have any consequences for economic growth.

There is virtually no chance that the OMB budget request will become a reality - at least not this year, given the approaching Congressional elections. Were the Senate to swing to the Republican side, there would be no chance of the OMB budget request becoming reality in 2015 either. But because of the approaching election, we think there may be a decent chance that spending discipline is further eroded. For this reason, and because the CBO has found that the budget is becoming more sensitive to economic conditions, we have run some alternative scenarios that are shown in the second enclosed table. Our reference point is the CBO baseline, from which we develop a slow growth outcome, a faster growth scenario, and finally, a business-as-usual scenario that is conditioned on a breakdown of spending discipline.

Table II details these scenarios. Our low-growth scenario is one in which beginning in 2015, nominal GDP growth is one percentage point per year slower than the CBO baseline. In effect, this growth path would be a continuation of the weak growth that the economy experienced from 2010 through 2014. Lower growth would imply lower interest rates, so the path of the ten-year Treasury note is reduced by one percentage point per year versus the CBO baseline.

The deficit would explode in this scenario. It would climb above $1 trillion in 2018, rising to over $2 trillion in 2024. The deficit to GDP ratio rises as well, reaching 10% in 2024, and the debt to GDP ratio climbs above 80% by 2020, rising to over 90% in 2024. Former Harvard, Treasury, and Administration advisor Larry Summers has recently been writing about the prospect of secular stagnation. This slow-growth scenario is concomitant to such an environment, and it is not pretty.

In our "A Very Long-Term View Of Government Finances - Implications For The S&P 500", which we published on October 11, 2013, we showed that if trend growth could be raised by only 0.2% per year, the budget would come into structural balance in our lifetime. Stronger growth would enable entitlement obligations to be met, and defense spending could be maintained at its historical norm.

Shorter-term support for this shows up in our high-growth scenario. As shown in the table, nominal GDP is one percentage point per year higher than the CBO baseline beginning in 2015. As a consequence, the yield on the ten-year treasury is also assumed to be one percentage point per year higher. The budget deficit is driven steadily lower as a result, and it actually swings into surplus by 2024. The deficit-to-GDP ratio is inconsequential over the entire forecast period, and the debt-to-GDP ratio falls below 70%, beginning in 2017.

Unfortunately, this scenario is not without its own problems. According to CBO estimates, the implication of continuous faster growth is an overheating economy. For 2013, the CBO estimates a $1 trillion GDP gap and a 2.4% unemployment gap. In our faster-growth scenario, these gaps would be filled in 2018, so that if growth continued on a fast pace, it would suggest the potential for an acceleration of inflation and a likely significant shift in monetary policy. There is no avoiding the business cycle in the short term, but if economic growth were to slow to trend after 2018, there would still be progress on deficit and debt reduction. Presumably, this is precisely what the Federal Reserve has and continues to hope to achieve, i.e., significant stimulus, followed by a timely slowing of stimulus, and then a steady state once the output gap has been eradicated. We all hope the Fed can realize this objective.

Our third alternative is suggestive of a frustration with prevailing economic conditions that politicians can no longer tolerate. Perhaps the opening salvo was the two-year House-Senate budget agreement that allowed discretionary spending to exceed levels mandated by the Budget Control Act sequester. Indeed, this was then followed by the OMB budget document, wherein the President termed it as signaling the end to the era of austerity. This was quickly followed by howls of protest from both political parties over the defense portion of the budget proposal. It was viewed as excessively restrictive, even though the OMB request was for spending authority that exceeded the sequester mandate for defense by $115 billion over the five years through 2020.

One could say the proverbial ball has been set in motion, which is why we constructed a business-as-usual scenario. It holds nominal GDP growth and the ten-year treasury rate at the CBO baseline. On the revenue side, we assume that 2013 expiring tax provisions are restored, but the President does not get his proposed tax increases. On the spending side, we assume that emergency jobless benefits are restored; Medicare payments to physicians are maintained at current levels; and discretionary spending rises with inflation, thereby exceeding mandated budget caps.

With these assumptions, the deficit would climb to over $1 trillion by 2020, rising to $1.4 trillion in 2024. The deficit-to-GDP ratio would be around 5% in 2024, and the debt-to-GDP ratio would get to approximately 80%.

Business-as-usual is not as debilitating as the prolonged slow-growth scenario. But it would also imply that the progress that has been made toward structural reform of the budget process was wasted, and that a day of reckoning would only be postponed, not eliminated. We have stated on numerous occasions that while budget discipline is laudable in the long run, it is not without its own costs in the short run. If discipline is abandoned in the period leading up to elections this year and in 2016, the eventual cost may have to be even greater. But that is for another Congress, Administration, and populace to confront.

Actual

Actual

Table I

CBO Baseline

2012

2013

2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

Nominal GDP % change

4.2

6.9

3.9

4.9

5.3

5.1

4.5

4.4

4.3

4.2

4.2

4.2

4.1

10-year Treasury %

1.9

2.1

3.1

3.7

4.3

4.8

5.0

5.0

5.0

5.0

5.0

5.0

5.0

Federal Outlays ($billions)

3537

3454

3543

3783

4020

4212

4425

4684

4939

5200

5522

5749

6000

Federal Revenues ($billions)

2450

2774

3029

3305

3481

3631

3770

3932

4104

4288

4490

4702

4926

Deficit ($billions)

1089

680

514

478

539

581

655

752

836

912

1031

1047

1074

Deficit as % GDP

7.0

4.1

3.0

2.6

2.8

2.9

3.1

3.4

3.7

3.8

4.2

4.1

4.0

Debt held by the Public ($billions)

11281

11982

12717

13263

13861

14507

15218

16028

16925

17899

19001

20115

21260

Debt held by Public as % of GDP

70.0

72.1

73.6

73.2

72.6

72.3

72.6

73.3

74.2

75.3

76.8

78.0

79.2

(Calendar Year Economic Assumptions)

OMB President's Budget

Nominal GDP % change

4.6

3.2

4.6

5.2

5.3

5.3

4.9

4.6

4.4

4.4

4.4

4.4

4.4

10-year Treasury %

1.8

2.3

3.0

3.5

4.0

4.3

4.6

4.7

4.9

5.0

5.1

5.1

5.1

Federal Outlays ($billions)

3537

3455

3651

3901

4099

4269

4443

4729

4964

5209

5485

5694

5912

Federal Revenues ($billions)

2450

2775

3002

3337

3568

3811

4030

4226

4452

4706

4954

5212

5478

Deficit ($billions)

1089

680

649

564

531

458

413

503

512

503

531

482

434

Deficit as % GDP

6.7

4.1

3.7

3.1

2.7

2.2

1.9

2.2

2.2

2.1

2.1

1.8

1.6

Debt held by the Public ($billions)

11281

11983

12903

13592

14257

14843

15370

15982

16603

17213

17850

18441

18986

Debt held by Public as % of GDP

70.0

72.1

73.5

73.7

73.4

72.5

71.6

71.2

70.8

70.3

69.9

69.2

68.2

Variations on CBO Baseline

Actual

Actual

Table II

Lower Growth Scenario

2012

2013

2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

Nominal GDP % change

4.2

6.9

3.9

3.9

4.3

4.1

3.5

3.4

3.3

3.2

3.2

3.2

3.1

10-year Treasury %

1.9

2.1

3.1

2.7

3.3

3.8

4.0

4.0

4.0

4.0

4.0

4.0

4.0

Federal Outlays ($billions)

3537

3454

3543

3250

3366

3451

3520

3607

3698

3797

3908

4023

4144

Federal Revenues ($billions)

2450

2774

3029

3801

4064

4286

4535

4833

5129

5432

5799

6074

6376

Deficit ($billions)

1089

680

514

551

698

836

1015

1227

1431

1635

1891

2051

2232

Deficit as % GDP

7.0

4.1

3.0

3.1

3.7

4.3

5.0

5.9

6.6

7.4

8.3

8.7

9.2

Debt held by the Public ($billions)

11281

11982

12717

13335

14021

14762

15578

16503

17520

18622

19860

21119

22419

Debt held by Public as % of GDP

70.0

72.1

73.6

74.3

74.9

75.8

77.2

79.2

81.4

83.8

86.7

89.3

92.0

Higher Growth Scenario

Nominal GDP % change

4.2

6.9

3.9

5.9

6.3

6.1

5.5

5.4

5.3

5.2

5.2

5.2

5.1

10-year Treasury %

1.9

2.1

3.1

4.7

5.3

5.8

6.0

6.0

6.0

6.0

6.0

6.0

6.0

Federal Outlays ($billions)

2450

2774

3029

3765

3982

4152

4341

4574

4800

5030

5318

5509

5721

Federal Revenues ($billions)

3537

3454

3543

3360

3597

3815

4028

4270

4529

4808

5113

5435

5779

Deficit ($billions)

1089

680

514

405

385

337

313

304

271

222

205

74

-58

Deficit as % GDP

7.0

4.1

3.0

2.2

2.0

1.6

1.4

1.3

1.1

0.9

0.8

0.3

-0.2

Debt held by the Public ($billions)

11281

11982

12717

13190

13708

14263

14876

15580

16360

17209

18175

19142

20129

Debt held by Public as % of GDP

70.0

72.1

73.6

72.1

70.5

69.1

68.4

67.9

67.8

67.8

68.1

68.2

68.2

Business as Usual Deficit

Nominal GDP % change

4.2

6.9

3.9

4.9

5.3

5.1

4.5

4.4

4.3

4.2

4.2

4.2

4.1

10-year Treasury %

1.9

2.1

3.1

3.7

4.3

4.8

5.0

5.0

5.0

5.0

5.0

5.0

5.0

Federal Outlays ($billions)

3537

3454

3543

3808

4101

4317

4542

4810.9

5074

5341

5673

5912

6158

Federal Revenues ($billions)

2450

2774

3029

3212

3394

3545

3681

3818.9

3988

4168

4361

4563

4778

Deficit ($billions)

1,089

680

514

595.6

706.5

772

861.5

992

1086

1174

1311

1349

1381

Deficit as % GDP

7.0

4.1

3.0

3.3

3.7

3.8

4.1

4.5

4.8

4.9

5.3

5.2

5.1

Debt held by the Public ($billions)

11281

11982

12717

13380

14029

14698

15425

16268

17175

18161

19281

20417

21567

Debt held by Public as % of GDP

70.0

72.1

73.6

73.8

73.5

73.3

73.6

74.4

75.3

76.5

77.9

79.2

80.4

Click to enlarge

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Please note that this article was written by Dr. Vincent J. Malanga and Dr. Lance Brofman with sponsorship by BEACH INVESTMENT COUNSEL, INC. and is used with the permission of both.