A Reality Check On The Budget Outlook

Summary

The latest Congressional Budget Office budget outlook shows the deficit reaching $1.5 trillion by 2028.

That deficit projection is unrealistic because it is made using "current law" assumptions, which assume that personal tax cuts will expire in 2025 and that discretionary spending will be constrained.

It is highly unlikely that the personal tax cuts will be allowed to expire in 2025, or that discretionary spending will be constrained by sequestration pursuant current law after 2019.

Making adjustments for what is likely from a realistic political perspective results in the deficit reaching $2 trillion by 2028.

These adjustments would bring the projected treasury debt held by the public to 107% of GDP.

The Congressional Budget Office (CBO) has released its latest 10-year budget outlook, taking into account recent legislation pertaining to tax cuts and a $1.6 trillion spending agreement signed into law by the President. The CBO budget outlook is in sharp contrast to the outlook offered by the Office of Management and Budget (OMB), which also incorporates recent legislation. The two outlooks and their underlying economic assumptions are presented as Tables I and II respectively at the end of this report.

As always, CBO assumes that current law will remain in effect over the forecast period. And as usual, both CBO and OMB do not forecast any business cycle downturn over the forecast period. The differences in the economic and budget outlooks are stark, and they center on wildly differing outlooks for economic growth.

CBO and OMB both agree that tax and spending legislation will give the economy a short-term boost. CBO pegs growth at about 3% for 2018 and 2019, and OMB is just slightly more positive, projecting about 3.1% growth. Beyond 2019, the divergence is magnified. OMB assumes a permanent boost from the administration's policies of tax cuts, regulatory reform and trade policy such that economic growth is projected to remain at about 3% yearly throughout the forecast period. CBO, on the other hand, projects that after a short-term boost, starting in 2020 a return to an underlying trend growth rate of about 2% yearly is most likely.

Economic growth is the most important variable affecting the federal budget outlook. And the difference between a 3% growth path and a 2% growth path is major. Indeed, CBO projects a $1.43 trillion cumulative revenue shortfall from 2020 through 2028 relative to that projected by OMB. On the outlays side, CBO also projects more spending than OMB. Whereas CBO sticks to current law and the budget-busting impacts of rising healthcare and mandatory spending increases, OMB projects significant savings from reforming non-social security and Medicare programs as well as savings from further scaling back aspects of the Affordable Care Act. Cumulatively, over the entire 2018-2028 period, CBO forecasts that spending will exceed the level forecast by OMB by $3.89 trillion.

For the overall deficit, then, whereas OMB projects that it will gradually decline over the forecast period and never hit $1 trillion in any one year, CBO projects the deficit will reach $1 trillion in 2020 and rise steadily to about $1.5 trillion by 2028. It should be noted that before tax and spending priorities were altered by recent legislation, CBO had consistently projected that deficits would begin exceeding $1 trillion annually by 2020. It based this outlook on two phenomena. First was rising expenditures for mandatory spending on entitlements based on aging demographics and a failure of legislators to address the issue. Second, CBO presumed, and continues to presume, an underlying economic growth rate of only 2%. Thus, its bias has been, and continues to be, one of rising spending and slow revenue growth.

With this as a backdrop, CBO projects that total debt held by the public will reach 96% of GDP by 2028, whereas OMB projects a debt-to-GDP ratio of 72.6% of GDP, which is actually lower than the debt-to-GDP ratio in 2017. However, as noted in the table, OMB shows the debt-to-GDP rises through 2022 and then falls off sharply later in the forecast period when the benefits of a steadily higher growth rate kick in.

Importantly, despite significant differences in the respective growth outlooks, both CBO and OMB are pretty consistent in their forecasts for interest rates. While rates are assumed to rise somewhat over the forecast period, both entities presume a continuation of a historically low interest rate environment. Because of OMB's higher economic growth estimate, net interest expense is not a significant factor, and in the out years, interest expense as a share of GDP holds steady at slightly more than 2% yearly. But in the CBO outlook, net interest expense is shown to climb above 3% by 2026. Indeed, according to CBO, beginning in 2026, the interest burden begins to take a larger share than both defense and nondefense portions of the budget. Needless to say, if the interest rate assumptions prove overly optimistic, even with everything else constant, the interest burden would continue rising.

Whether or not one considers the CBO or the OMB to present a more realistic view of the future and the effectiveness of recent economic initiatives, there are technical reasons for believing the budget outlook is worse. For example, the sequester rules that were in effect beginning in 2013, and imposed caps on discretionary spending have been abused in the past few years but they have not been repealed. An unrealistic current law assumption is that the caps will significantly constrain discretionary spending after 2019 and result in significant reductions in real spending for both defense and nondefense discretionary spending programs. A more reasonable assumption might be that these will rise with inflation, and this may be considered overly optimistic.

Using current law CBO projects that real discretionary spending will decline over the 2019-2028 period. A more realistic assumption is that real discretionary spending will remain the same over the 2019-2028 period. To estimate what would happen if discretionary spending were to only increase with inflation, the calculation assumes that discretionary funding related to federal personnel would be inflated using the employment cost index, and the rest of discretionary spending would be inflated using the GDP price deflator. This adjustment would add approximately $2 trillion to the deficit over the 2019-2028 period.

Additionally, the current tax law calls for expiration of the personal tax cut in 2025, while business tax cuts are permanent. This was done to hold down the deficit in the out years so as to comply with budget reconciliation rules. There does not seem to be much opposition to extending the personal tax cut, so any realistic deficit projection should include an assumption that the expiration will not occur. Making the personal tax cut permanent would add $650 billion to the cumulative deficit, according to CBO.

There are additional adjustments that should probably be made. For example, there is a five-year terminus to the expensing provision in the tax law. This is likely to be permanent. There is the assumption that postponed healthcare-related taxes will be reinstated, even though they will also probably be made permanent. There were about 30 tax provisions that expired at the end of 2017 and were extended by the Bipartisan Budget Act of 2018. A realistic assumption is that these will not be allowed to expire. Table III below shows a tally of these and other items, and by the end of the forecast period, CBO projects that these could add about $3.2 trillion to the cumulative deficit. This would push up the deficit-to-GDP ratio to 7.4 percent in 2028 as compared to the 4.6% in the unadjusted CBO estimate, and it would push the deficit to around $2 trillion yearly in 2027-2028. Only time will tell if there is a measurable growth dividend and thus positive budgetary implications. If the growth dividend fails to materialize, it will have serious implications for future tax policy and for the country's overall tax burden. Indeed, even a $2 trillion deficit could be too small, in which case entitlements will surely have to be addressed.

Table I

CBO Baseline

2018

2019

2020

2021

2022

2023

2024

2025

2026

2027

2028

Real GDP %

3.0

2.9

2.0

1.5

1.5

1.6

1.7

1.8

1.7

1.8

1.8

Inflation %

1.9

2.0

2.1

2.2

2.2

2.2

2.2

2.1

2.1

2.1

2.1

Unemployment %

3.8

3.3

3.6

4.1

4.6

4.7

4.8

4.8

4.9

4.8

4.8

10-year notes %

3.0

3.7

4.1

4.2

4.0

3.8

3.7

3.7

3.7

3.7

3.7

Deficit $ billions

804

981

1,008

1123

1276

1273

1244

1352

1320

1316

1526

Deficit % GDP

3.5

4.0

4.6

4.6

4.9

5.4

5.2

4.9

5.1

4.8

4.6

Receipts $ billions

3338

3490

3678

3827

4012

4228

4444

4663

5002

5299

5520

Receipts % GDP

16.6

16.5

16.7

16.7

16.9

17.2

17.4

17.5

18.1

18.5

18.5

Outlays $ billions

4142

4470

4685

4949

5288

5500

5688

6015

6322

6615

7046

Outlays %GDP

20.6

21.2

21.3

21.6

22.3

22.3

22.2

22.6

22.9

23.1

23.6

Mandatory % GDP

12.7

12.9

13.0

13.3

13.8

13.8

13.7

14.1

14.4

14.6

15.2

Defense % GDP

3.1

3.1

2.9

2.8

2.8

2.7

2.7

2.6

2.6

2.6

2.6

Nondefense discretionary %GDP

3.2

3.2

3.1

3.0

3.0

2.9

2.9

2.9

2.9

2.8

2.8

Net interest %GDP

1.6

1.8

2.2

2.5

2.7

2.8

2.9

2.9

3.0

3.0

3.1

Debt held by public %GDP

78.0

79.3

80.9

83.1

85.7

87.9

89.6

91.5

93.1

94.5

96.2

Total Adjustments for Reality

1

14

129

187

227

265

299

333

454

632

686

Realistic Deficit

805

994

1137

1310

1503

1537

1542

1685

1774

1948

2212

As % of GDP

3.5

4.7

5.1

5.7

6.3

6.2

6.0

6.3

6.4

6.7

7.4

Adjusted debt % GDP

78.0

79.4

81.6

84.5

88.0

91.2

94.0

97.0

100.0

103.3

107.0

Table II

Trump OMB Budget

2018

2019

2020

2021

2022

2023

2024

2025

2026

2027

2028

Real GDP %

3

3.2

3.1

3

3

3

3

2.9

2.8

2.8

2.8

Inflation %

1.6

1.7

1.9

2

2

2

2

2

2

2

2

Unemployment %

3.9

3.7

3.8

3.9

4

4.2

4.3

45

4.7

4.8

4.8

10-year notes %

2.6

3.1

3.4

3.6

3.7

3.7

3.7

3.7

3.6

3.6

3.6

Deficit $ billions

873

984

987

916

852

774

672

579

517

450

363

Deficit % GDP

4.2

4.7

4.5

3.9

3.7

3

2.3

2.1

1.7

1.4

1.4

Receipts $ billions

3340

3422

3609

3838

4089

4386

4675

4946

5231

5506

5818

Receipts % GDP

16.7

16.3

16.4

16.5

16.8

17.1

17.4

17.5

17.6

17.7

17.8

Outlays $ billions

4214

4407

4596

4754

4941

5160

5348

5526

5748

5955

6181

Outlays %GDP

21

21

20.8

20.5

20.3

20.2

19.9

19.6

19.4

19.2

19

Mandatory % GDP

12.9

13

12.9

12.8

13.1

12.9

12.7

12.9

12.9

12.9

13.1

Defense % GDP

3.2

3.2

3.3

3.1

3.1

3

2.8

2.6

2.5

2.5

2.4

Nondefense discretionary %GDP

3.2

3

2.6

2.4

2

1.9

1.7

1.6

1.5

1.4

1.3

Net interest %GDP

1.5

1.7

2

2.2

2.3

2.4

2.4

2.4

2.4

2.4

2.3

Debt held by public %GDP

78.8

80.3

81.3

81.7

81.9

81.3

79.9

78.4

76.6

74.6

72.6

Table III

Adjustments for Reality

2018

2019

2020

2021

2022

2023

2024

2025

2026

2027

2028

Increase Regular Discretionary Appropriations

At the Rate of Inflation

9

106

161

190

210

227

240

254

268

284

Personal Tax Cuts Permanent

3

4

4

5

5

11

103

248

266

Other Tax-Related

1

4

20

23

33

50

66

81

97

116

136

Total Tax-Related

1

4

23

27

37

55

72

92

200

364

402

Total Adjustments

1

14

129

187

227

265

299

333

454

632

686

Disclosure: I/we 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.