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Weekly Economic Briefing


Who cares about the deficit?


To say that we are living in unusual times seems like cliché. But after President Trump did a deal with congressional Democrats to lift the debt ceiling and fund the government until December 15, as well provide $15 billion in aid for the recovery from Hurricane Henry, it is apt. Whether Trump chose this course out of frustration with his own party, or because he recognised that a partisan fight over fiscal issues while large swathes of the country were struggling with the fallout from two hurricanes, his actions could have far-reaching consequences. Not only does it appear to have increased tensions within the Republican Party that were already frayed after the failure to repeal and replace Obamacare. But it also pushes the next round of debt ceiling and budget negotiations into the period in which tax reform was supposed to dominate the agenda. Meanwhile, there is now the tantalising prospect that more policy compromises could be brokered between the President and the Democratic leadership, though neither their differences nor the blocking power of the Republican majority should be forgotten.

A deteriorating fiscal outlook Revenue shortfall

Assuming that a government shutdown is avoided in December and that the debt ceiling is raised before any payments are missed, the most important fiscal question for the next six months is whether there is enough political goodwill to negotiate a tax reform package. At the moment, all the major Republican players remain committed to the principle of reform, while Paul Ryan, the House Speaker, has given up on his controversial plan to introduce a destination-based cashflow tax along with a border adjustment tax in the hope of smoothing the path for more modest reforms and tax cuts. However, the so-called 'Bix Six' administration, House and Senate figures charged with leading the way on tax changes remain a long way apart on the details, including the size of corporate tax cuts, how much high earners should benefit from income tax cuts, and what type of base broadening and revenue raising measures, if any, should be included in the reform package.

These issues are not trivial. They will determine whether or not the tax proposals will represent genuine long-term growth enhancing reform, and how much structural damage they will do to the budget; each one percentage point reduction in the corporate tax rate is alone estimated to lower government revenue by $100 billion over ten years, though that is before any growth benefits are taken into account. Thus, if the statutory rate was lowered from 35% to 15%, up to an additional $2 trillion could be added to the cumulative projected deficits in the current budget window. Any tax cuts for individuals and pass-through enterprises would add to the cost significantly. Keeping in mind that the federal budget deficit has widened from around 2.5% of GDP in 2015 to around 3.5% today, and that the CBO is projecting that the structural deficit will balloon to more than 5% of GDP within the next decade even without any tax cuts, as revenue growth fails to keep up with spending growth (see Charts 1 and 2), the dangers are clear. In the 1980s and 2000s Republican majorities ignored budget neutrality when opportunities to slash taxes became available. We expect it to be no different this time, though we think the size of any package will be more moderate than Trump's initial proposals and the budget rules will be stretched as far as they can to create the impression of fiscal responsibility.

Jeremy Lawson, Chief Economist