The Federal Budget Update

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by: Lance Brofman
Summary

The Congressional Budget Office projects much higher deficits and debt levels than the Trump Administration Office of Management and Budget. Both understate the likely actual deficits because of unrealistic assumptions.

A major reason for the different deficit figures is that the Trump Administration assumes much high real GDP growth.

Real GDP growth depends on the growth of the labor force and the growth of productivity. For many periods in the post WWII period, the labor force grew about 1.5%.

Productivity also grew on average at about 1.5% during those periods. Thus, potential real GDP grew at about 3%. The CBO bases its 2% projection for potential real GDP on the historic rate of 1.5% productivity growth and 0.5% labor force growth.

The CBO's 0.5% labor force growth is based on demographic considerations such as the departure from the labor force of the baby boomer population cohort over the next decade.

The Congressional Budget Office (CBO) released an updated ten-year budget outlook in late January. It incorporates current spending and tax legislation and it assumes current law will remain in effect over the forecast period. As usual, the budget outlook does not forecast any recession even though the expansion is currently four years older than the average economic expansion since 1945.

The Trump administration's Office of Management and Budget (OMB) has not yet released an updated budget outlook. So for comparison purposes, in this report, we rely on its original budget document that was published over one year ago.

The macroeconomic assumptions underlying CBO and OMB budget projections are starkly different. To be sure both suggest a low interest rate environment will prevail over the forecast period. But OMB projects about one percentage point per year faster real GDP growth than CBO forecasts. And upon release of the latest CBO budget document, National Economic Council's (NEC) Kudlow reaffirmed that the Trump administration's projections still call for this divergence in economic growth.

To the administration's credit, real GDP growth was about 3% in 2018 which is higher than consensus economic forecasts and internal forecasts of the Federal Reserve. CBO notes that its budget forecast is similar to the Blue Chip Economic Consensus and to those of the Federal Reserve. Private forecasters have characterized the stellar economic performance of 2018 as a "sugar high" from the 2017 tax cut and one that will not last. Later in this report, we will explain why we think performance may be more than just a "sugar high".

According to CBO, real GDP exceeded potential GDP by $15 billion in 2018. It projects that real GDP will continue above potential this year but then slow to about the growth rate of potential GDP in 2024 and beyond.

Traditional Keynesian economic analysis would contend that during periods when actual exceeds potential GDP, shortages and bottlenecks would appear, raising inflation and inflationary expectations. Perhaps this may yet occur but it has not yet occurred, raising the issue of whether the CBO estimate of potential GDP is valid. Both CBO and OMB would argue that the growth of potential GDP is a function of labor productivity and labor force growth. CBO projects that productivity will rise at about the same 1.5% per year rate that prevailed over the 1950-2000 period. Its estimate of labor force growth is a demographically derived 0.5% per year. The sum of the two equates to its 2% potential GDP path.

OMB is not explicit, but its estimate of potential GDP is based on faster productivity growth resulting from deregulation and accelerated business investment. This is still open to debate. Meanwhile, in our view, faster labor force growth is likely, not from demographics, but from an enduring recovery in labor force participation. Time will tell, but participation rates are, in fact, picking up for a host of reasons which we have documented in past reports.

The issue of potential GDP is crucial because economic growth is the most important variable affecting the federal budget outlook. Through 2028, CBO projects a $1.43 trillion cumulative revenue shortfall versus last year's OMB forecast. So, if this $1.43 trillion growth dividend were realized, everything else constant; by 2029, the overall debt to GDP ratio would be manageable at 87.7% versus the 92.7% that the CBO is officially targeting. Details are shown on the attached Tables I and II.

Spending is not to be ignored, however. CBO sticks to current law and no reform of the budget-busting impacts of rising healthcare and mandatory spending increases. Thus, as Table I shows mandatory spending rises to 15% of GDP by 2029. OMB, on the other hand, projects significant savings from reforming non-social security and Medicare programs as well as savings from a scaling back of expenditures related to the Affordable Care Act (ACA). For the entire forecast period, CBO projects a cumulative $3.89 trillion spending bulge relative to OMB.

Which is the more accurate or more likely less inaccurate? Sequester rules that have been in effect since 2013 impose caps on defense and non-defense discretionary spending. These caps have been abused, but they have not been repealed and they are scheduled to be reimposed after 2019. Coincidentally or not, NEC director Kudlow has stated repeatedly that the next major task of the administration is to get spending under control. And as a down payment, the President has asked all agency heads to submit budgets with a 5% haircut from the 2018 baseline. We shall see how serious an effort is undertaken.

Skepticism is justified. CBO projects that real discretionary spending will decline over the forecast period. But if discretionary spending were to increase with inflation as measured by the employment cost index versus the GDP deflator, more than $2 trillion would be added to the cumulative deficit. There is also the issue of mandatory program spending that very likely will continue beyond their expiration dates. These include Supplemental Nutrition Assistance and Veterans compensation cost of living adjustments among others. A total of these is shown on the attached Table III along with the effects of tax extenders, a permanency to the personal tax cut which expires after 2025 and others.

Table I attached shows a deficit schedule that was published by OMB last year. Assuming all its assumptions are valid, the overall budget deficit would gradually decline over its forecast period never hitting $1 trillion in any one year. In contrast, CBO projects the deficit will exceed $1 trillion in 2022 and remain above $1 trillion per year over the remainder of the forecast period.

Importantly, last year, CBO contended that the deficit would begin to permanently exceed $1 trillion per year beginning in 2020. The timing was pushed forward according to CBO by lower than anticipated spending under the ACA and a welcome shortfall in expenditures on disaster relief. CBO does not attribute its downward revision to the deficit to positive effects from faster economic growth.

Whatever, CBO now projects that total debt held by the public will reach 92.7% of GDP by 2029 or about 20 points higher than the 2028 estimate made by OMB. And according to CBO, even under a regime of low interest rates, the net interest burden rises steadily such that beginning in 2025 interest takes a larger share of GDP than both defense and non-defense portions of the budget.

From a policy perspective, one has to be skeptical that spending will be brought under control. Indeed, as the presidential election season approaches, professed democratic candidates are already trying to outdo each other with new spending proposals and expanded entitlement programs. On the other side, the President has consistently declared social security and Medicare programs off-limits to spending cuts while vowing to make existing tax cuts permanent, if not reduce the tax burden even more. Federal Reserve Chair Powell has on more than one occasion expressed deep concern over the long-term budget outlook and the rise in national indebtedness as have his predecessors.

The Federal Reserve professes to stay out of the fiscal policy debate and adapt monetary policy to the hand that it is dealt with. But importantly, we think the Fed may be embarking on a different course of action. Historically, the Fed tends to lean against the wind of growth in order to contain inflation. However, its forecasting models have consistently been wide of the mark - too high for growth and too high for inflation. The Fed is now openly questioning the validity of its models which implies that it should also be questioning its assessment of potential GDP - which perhaps it is close to 3% rather than 2%. This would imply that monetary policy has been too tight which is perhaps why growth has been below forecast and inflation has been below forecast.

This could in part explain the Fed's recent decision to alter its interest rate and balance sheet strategy - pausing on interest rates and flexibility in managing the balance sheet instead of rigidly sticking to a preset course. The presumption is that this would allow the economy to run hotter than originally assumed such that if realized, one consequence would be faster revenue growth and thus a lower than presumed budget deficit. The fact that this policy shift was made in tandem with the release of a bleak budget document may just be a coincidence - or maybe not. Regardless, we think this could be an interesting experiment and even perhaps a groundbreaking one.

Table I

CBO Baseline January 2019

2018

2019

2020

2021

2022

2023

2024

2025

2026

2027

2028

2029

Real GDP %

2.9

2.7

1.9

1.6

1.6

1.7

1.8

1.8

1.7

1.8

1.8

1.8

Inflation %

2.2

2.1

2.0

2.0

2.0

2.1

2.1

2.1

2.0

2.0

2.0

2.0

Unemployment %

3.9

3.5

3.7

4.2

4.6

4.8

4.8

4.8

4.8

4.8

4.7

4.7

10-year notes %

2.9

3.4

3.6

3.7

3.7

3.8

3.7

3.7

3.7

3.7

3.7

3.8

Deficit $ billions

779

897

903

974

1128

1139

1091

1212

1204

1192

1435

1370

Deficit % GDP

3.8

4.2

4.1

4.2

4.7

4.6

4.3

4.5

4.4

4.1

4.8

4.4

Receipts $ billions

3329

3515

3686

3841

4012

4208

4448

4647

4956

5254

5446

5672

Receipts % GDP

16.4

16.5

16.7

16.7

16.9

17.1

17.3

17.4

17.9

18.3

18.2

18.3

Outlays $ billions

4108

4412

4589

4814

5140

5347

5539

5859

6160

6446

6881

7042

Outlays %GDP

20.3

20.8

20.7

21.0

21.6

21.7

21.6

22.0

22.3

22.4

23.0

22.7

Mandatory % GDP

12.5

12.7

12.8

13.1

13.6

13.7

13.6

14.0

14.3

14.5

15.1

14.8

Defense % GDP

3.1

3.1

2.9

2.8

2.8

2.7

2.7

2.6

2.6

2.6

2.6

2.5

Nondefense discretionary %GDP

3.2

3.2

2.9

2.8

2.7

2.7

2.6

2.6

2.6

2.5

2.5

2.4

Net interest %GDP

1.6

1.8

2.1

2.3

2.4

2.6

2.7

2.7

2.8

2.9

2.9

3.0

Debt held by public %GDP

77.8

78.3

79.6

81.2

83.2

85.0

86.2

87.7

89.0

90.0

91.5

92.7

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

2029

Increase Regular Discretionary Appropriations

At the Rate of Inflation

0

99

150

177

195

210

224

236

249

262

275

Mandatory Programs Continue

11

22

27

31

36

107

114

125

130

145

149

Personal Tax Cuts Permanent

3

4

4

5

5

12

98

257

275

295

Other Tax-Related

16

21

32

53

71

88

104

127

141

158

Total Tax-Related

19

25

36

58

76

100

202

384

417

453

Total Adjustments

11

139

201

244

289

393

437

564

764

823

877

Realistic Deficit

779

908

1043

1175

1372

1428

1484

1650

1768

1956

2258

2247

As % of GDP

3.8

4.3

4.7

5.1

5.8

5.8

5.8

6.2

6.4

6.8

7.6

7.2

Adjusted debt % GDP

77.8

78.3

80.3

82.7

85.8

88.6

91.2

94.1

97.2

100.6

104.5

108.0

This article was written by Drs. Vincent J. Malanga and Lance Brofman with sponsorship by Beach Investment Counsel, Inc. and is used with the permission of both.

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: This article was written by Drs. Vincent J. Malanga and Lance Brofman with sponsorship by Beach Investment Counsel, Inc., and is used with the permission of both.