Fiscal Policy

Highlights Treasury yields have tumbled despite a solid U.S. economy: The 10-year Treasury bond yielded just under 3% when we started beating the below-benchmark-duration drum last summer; now it’s hovering around 2.3%. The golden rule of bond investing argues against positioning for further declines, … : The returns to duration strategies hinge on the difference between actual and expected moves in the fed funds rate. With the money market looking for two cuts over the next twelve months, the fed funds rate is more likely to surprise to the upside than the downside. … but could a lack of borrowing keep yields low?: If debt-fueled spending has gone out of fashion in the U.S., global savings could overwhelm investment, and rates might have to fall further to bring them back into balance. Feature The ride has gotten bumpier as the trade tensions between the U.S. and China have heated up, but our recommendations have held up well since last summer. Equal-weighting equities, underweighting bonds and overweighting cash helped preserve capital during the fourth-quarter selloff, while our early and late January upgrades of equities (while downgrading cash) and spread product (while further downgrading Treasuries), respectively, have proven to be beneficial.1 On a total return basis, the S&P 500 is up over 12% since our upgrade, and the Barclays Bloomberg Corporate and High Yield Indexes have generated excess returns over Treasuries of around 175 and 75 basis points (“bps”), respectively, despite ceding much of their previous leads.2 Even the TIPS ETF (TIP) has held its own with the equivalent-duration nominal-Treasury ETF (IEF). The below-benchmark duration call has eroded some of the overall outperformance, however, and there has been some debate within BCA about whether or not we should change the view. We still do not believe the monetary policy outlook merits a duration-view change. We remain constructive on the outlook for global growth, despite the escalation in tensions between U.S. and Chinese trade negotiators, and therefore do not see a fundamental reason to expect lower real rates. The idea that soft credit growth could hold rates down is interesting, but one would have to believe the spendthrift U.S. leopard really has changed its spots to position a portfolio in line with it. Fed Policy Chart 1Caution: Falling Rate Expectations As of Thursday’s close, the money market was pricing in a 100% chance of a 25-bps rate cut by Thanksgiving, a 100% chance of a 50-bps rate cut by this time next year, and a 45% chance of a third cut by Thanksgiving 2020 (Chart 1, bottom panel). The FOMC has paused its rate-hiking campaign, to be sure, but the idea that it will soon embark on a rate-cutting campaign seems like a stretch. The minutes from the FOMC’s April 30th-May 1st meeting, released last week, painted a picture of a fundamentally solid economy. The balance between hawks and doves remained roughly equal, with “a few participants” calling for a coming need to firm policy, given the swiftness with which inflation pressures can build in a tight labor market, while “a few other participants” noted that the unemployment rate is not the be-all and end-all measure of resource utilization. From an investment strategy perspective, we think our U.S. Bond Strategy service’s golden rule provides the best insight. Below-benchmark-duration positioning will outperform if the Fed cuts less (or hikes more) over the next twelve months than markets expect; above-benchmark-duration will win if the Fed cuts more (or hikes less) than markets expect. Some strategists within BCA have raised the possibility that market expectations could force the Fed’s hand. The reason that the Fed is especially loath to disappoint markets in what might be called the forward-guidance era of central banking, but we think there’s an important distinction between taking care not to surprise markets and surrendering one’s free will to them, as parents of young children can attest. Bottom Line: We think the money markets are significantly overestimating the possibility that the Fed will soon cut the fed funds rate, increasing the potential returns from below-benchmark-duration positioning. The Rates Checklist Table 1Rates View Checklist We developed our rates checklist3 to provide a list of real-time measures that bear on our rates view. Of the eleven items on the list, only three have met our threshold for reassessing our bearish rates call at any point over the last eight months, so we have stayed the course (Table 1). The checked boxes indicate that the evidence has been moving against us, though we would argue that the stingy 10-year Treasury yield has gotten overly carried away with discounting that evidence (Chart 1, top panel).  Policy Perceptions The spread between our monetary policy expectations and the markets’ remains wide, so the prospective returns from our Fed call remain ample, and the first box remains unchecked. Thanks to last week’s two-day, 11-bps decline in the 10-year Treasury yield, we have again checked the inverted yield curve box, which first inverted for five days near the end of March, and has inverted for four days so far in May. Our empirical study of the inverted curve’s recession-signaling properties used month-end closes for the 10-year Treasury yield and the 3-month Treasury Bill rate, and found that an inverted curve had called the seven recessions that have occurred over the last 50 years with just one false positive (Chart 2). Now that the curve has inverted over a couple of daily stretches, clients have asked us just what constitutes bona fide inversion. Chart 2Accurate Yield Curve Signals Tend To Last Per the curve’s moves over the last 50 years, we would say inversion doesn’t issue an actionable signal until it persists for at least a few months (Table 2). 1998’s false alarm encompassed just seven days between late September and early October, and covered just one month end. The intuition behind the inverted yield curve’s predictive power is that the bond market sniffs out economic weakness before the Fed officially changes course. Recognizing that the Fed will have to begin cutting rates soon, bond investors buy longer-maturity instruments to reap the biggest rewards. Investors shouldn’t overreact to tentative inversions of the yield curve. Table 2Yield Curve Inversions We have argued that the next recession will not occur until the Fed has hiked the fed funds rate to a level above the equilibrium fed funds rate. Since we cannot observe the equilibrium rate in real time, we have looked to interest-rate-sensitive segments of the economy to gauge if higher rates are beginning to bite. Housing is on the front line of interest-rate sensitivity, and it remains quite affordable relative to history, suggesting that monetary policy has not yet become restrictive. Every time the inverted curve preceded a recession, the affordability index was below its long-run mean or rapidly making its way there (mid-1973); when the yield curve briefly inverted in September 1998, homes remained more affordable than average (Chart 3). Chart 3If Higher Rates Aren't Squeezing The Economy, The Yield Curve May Be Crying Wolf Inflation We concede that realized inflation measures (Chart 4), and inflation expectations as proxied by the difference in TIPS and nominal Treasury yields (Chart 5), have lost momentum since last summer. Washington’s unexpected grant of six-month waivers for importing Iranian oil caused crude prices to plunge, taking headline inflation measures and inflation expectations down with them (Chart 6). Given our Commodity And Energy Strategy team’s view that oil prices will extend their rebound across the rest of this year and into next, we expect that they will again move higher. Chart 4Consumer Price Indexes, ... chart 5... And Inflation Breakevens, ... Chart 6... Are Joined At The Hip With Oil Prices The Labor Market And Imbalances At Home And Abroad The labor market remains tight, so none of the labor market indicators argue for easier monetary policy and lower rates across the term structure. As far as the instability indicators go, there is as yet no sign of unsustainable activity in the economy’s key cyclical sectors. The Fed has stopped emphasizing the idea that financial sector imbalances alone might justify tighter policy, but anecdotal reports about lending standards suggest that potential vulnerabilities remain. There has not yet been an outbreak of major international distress that could deter the Fed from tightening policy, but worsening trade tensions and continued dollar strength would seem to make it slightly more likely. Bottom Line: We have checked a few boxes on our rates checklist, but the available evidence does not support adopting a more constructive view on rates. Hey, Big Spender The American consumer has long been a punching bag for Austrian School adherents and other moralists. As much as they scorn American households for living beyond their means, U.S. consumption has long played a symbiotic role in the global economy. As the engine powering the world’s largest economy, it makes an essential contribution to global aggregate demand, and provides an outlet for export powerhouses like China and Germany. An economy can only run a current account surplus provided that there are other economies running current account deficits capable of offsetting it. Measured inflation and inflation expectations were beginning to get some traction before oil collapsed upon the issuance of Iranian import waivers. In a recent blog post, former BCA Editor-in-Chief Francis Scotland posited that interest rates may not go anywhere as long as American households embrace their nascent post-crisis frugality. Using U.S. household demand as a proxy for global aggregate demand, Francis argues that if households don’t borrow and spend the way they did throughout the pre-crisis postwar era, global aggregate demand will suffer unless another profligate spender emerges to pick up the slack. Add China to the mix, and global savings could swamp global investment. Against that backdrop, savings and investment would only realign if rates fell. Newly frugal U.S. households may be helping to cap interest rates, but it’s too early to declare the end of the Debt Supercycle. Broadening the scope to include all public- and private-sector U.S. borrowing, the nominal 10-year Treasury yield has taken some cues from growth in aggregate borrowing (Chart 7). The relationship with real yields is not as strong (Chart 8), but if borrowing has some relationship to inflation, as under the guns-and-butter fiscal policy of the late sixties, nominal yields might well be a better measure. We can easily go along with the supply-and-demand intuition behind the observed relationship: when there’s stronger demand for credit, rates have to rise to entice savings and discourage investment to bring them back into balance, and vice versa. Chart 7Nominal Treasury Yields Have Been Tightly Linked With The Pace Of Loan Growth, ... Chart 8... And Real Yields Have Broadly Followed The Pattern As Well Government borrowing filled the void left by retrenching households and corporations in the immediate aftermath of the crisis. Household and corporate loan demand has been choppy since, however, and growth in aggregate borrowing has bumped around its mid-1950s lows throughout the expansion. We are not ready to declare that Americans have turned over a new, parsimonious leaf. The federal budget deficit soared following the passage of the stimulus package, and the CBO projects that it will continue to widen. Household debt growth is at its pre-crisis lows, but it has been accelerating ever since 2010 (Chart 9), and with debt service as a share of disposable income at its lowest level in at least 40 years, households have plenty of capacity to borrow. Chart 9Don't Count Consumers Out Just Yet Bottom Line: Interest rates have moved directionally with aggregate loan growth across the postwar era. Tepid loan demand growth may well keep a lid on rates, but we are not convinced that the Debt Supercycle has really breathed its last. Investment Implications Now that the 10-year Treasury yield has drifted back down to 2.3%, we believe the distribution of potential rate outcomes a year from now is skewed to the upside. We are thereby sticking with our recommendation that investors underweight Treasuries and maintain below-benchmark-duration positioning in all fixed-income portfolios. Even if there is not a clear catalyst on the immediate horizon for higher rates, we do not think that either the U.S. or the global economy is so fragile that investors should position for further rate declines. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the January 7 and January 28, 2019 U.S. Investment Strategy Weekly Reports, “What Now?” and “Double Breaker,” available at usis.bcaresearch.com. 2 All return data calculated as of the Thursday, May 23rd close. 3 Please see the September 17, 2018 U.S. Investment Strategy Weekly Report, “What Would It Take To Change Our Bearish Rates View?” available at usis.bcaresearch.com.

Highlights It may seem self-evident that most governments are overly indebted, but both theory and evidence suggest otherwise. Higher debt today does not require higher taxes tomorrow if the growth rate of the economy exceeds the interest rate on government bonds. Not only is that currently the case, but it has been the norm for most of history. Unlike private firms or households, governments can choose the interest rate at which they borrow, provided that they issue debt in their own currencies. Ultimately, inflation is the only constraint to how large fiscal deficits can get. Today, most governments would welcome higher inflation. There are increasing signs China is abandoning its deleveraging campaign. Fiscal policy will remain highly accommodative in the U.S. and will turn somewhat more stimulative in Europe. Remain overweight global equities/underweight bonds. We do not have a strong regional equity preference at the moment, but expect to turn more bullish on EM versus DM by the middle of this year. Feature A Fiscal Non-Problem? Debt levels in advanced economies are higher today than they were on the eve of the Global Financial Crisis. Rising private debt accounts for some of this increase, but the lion’s share has occurred in government debt (Chart 1). Chart 1Global Debt Levels Have Risen, Especially In The Public Sector Not surprisingly, rising public debt levels have elicited plenty of consternation. While there has been a lively debate about how fast governments should tighten their belts, few have disputed the seemingly self-evident opinion that some degree of “fiscal consolidation” is warranted. Given this consensus view, one would think that the economic case for public debt levels being too high is airtight. It’s not. Far from it. Debt Sustainability, Quantified Start with the classic condition for debt sustainability, which specifies the primary fiscal balance (i.e., the overall balance excluding interest payments) necessary to maintain a constant debt-to-GDP ratio (See Box 1 for a derivation of this equation).   An increase in the economy’s growth rate (g), or a decrease in real interest rates (r), would allow the government to loosen the primary fiscal balance without causing the debt-to-GDP ratio to increase (Chart 2).1 If the government were to ease fiscal policy beyond that point, debt would rise in relation to GDP. But by how much? It is tempting to assume that the debt-to-GDP ratio would then begin to increase exponentially. However, that is only true if the interest rate is higher than the growth rate of the economy. If the opposite were true, the debt-to-GDP ratio would rise initially but then flatten out at a higher level.2 A Fiscal Free Lunch The last point is worth emphasizing. As long as the interest rate is below the economic growth rate, then any primary fiscal balance – even a permanent deficit of 20%, or even 30% of GDP – would be consistent with a stable long-term debt-to-GDP ratio. In such a setting, the government could just indefinitely rollover the existing stock of debt, while issuing enough new debt to cover interest payments. No additional taxes would be necessary. In fact, stabilizing the debt-to-GDP ratio becomes easier the higher it rises. Chart 3 shows this point analytically.    Ah, one might say: If the government issues a lot of debt, then interest rates would rise, and before we know it, we are back in a world where the borrowing rate is above the economy’s growth rate, at which point the debt dynamics go haywire. Now, that sounds like a sensible statement, but it is actually quite misleading. As long as a government is able to issue its own currency, it can always create money to pay for whatever it purchases. If people want to turn around and use that money to buy bonds, they are welcome to do so, but the government is under no obligation to pay them the interest rate that they want. If they do not wish to hold cash, they can always use the cash to buy goods and services or exchange it for foreign currency. As long as a government is able to issue its own currency, it can always create money to pay for whatever it purchases. Wouldn’t that cause inflation and currency devaluation? Yes, it might, and that’s the real constraint: What limits the ability of governments with printing presses to run large deficits is not the inability to finance them. Rather, it is the risk that their citizens will treat their currencies as hot potatoes, rushing to exchange them for goods and services out of fear that rising prices will erode the purchasing power of their cash holdings. When Is Saving Desirable? The reason governments pay interest on bonds is because they want people to save more. However, more savings is not necessarily a good thing. This is obviously the case when an economy is depressed, but it may even be true when an economy is at full employment. Just like someone can work so much that they have no time left over for leisure, or buy a house so big that they spend all their time maintaining it, it is possible for an economy to save too much, leading to an excess of capital accumulation. Under such circumstances, steady-state consumption will be permanently depressed because so much of the economy’s resources are going towards replenishing the depreciation of the economy’s capital stock.  Economists have a name for this condition: “dynamic inefficiency.” What determines whether an economy is dynamically inefficient? As it turns out, the answer is the same as the one that determines whether debt ratios are on an explosive path or not: The difference between the interest rate and the economy’s growth rate. Economies where interest rates are below the growth rate will tend to suffer from excess savings. In that case, government deficits, to the extent that they soak up national savings, may increase national welfare.   r < g Has Been The Norm Today, the U.S. 10-year Treasury yield stands at 2.69%, compared to the OECD’s projection of nominal GDP growth of 3.8% over the next decade. The gap between projected growth and bond yields is even greater in other major economies (Chart 4). Granted, equilibrium real rates are likely to rise over the next few years as spare capacity is absorbed. Structural factors might also push up real rates over time. Most notably, the retirement of baby boomers could significantly curb income growth, leading to a decline in national savings. Chart 5 shows that the ratio of workers-to-consumers globally is in the process of peaking after a three-decade long ascent. Economic growth could also fall if cognitive abilities continue to deteriorate, a worrying trend we discussed in a recent Special Report.3 Chart 5The Global Worker-To-Consumer Ratio Has Peaked It may take a while before real rates rise above GDP growth. Still, it may take a while before real rates rise above GDP growth. As Olivier Blanchard, the former chief economist at the IMF, noted in his Presidential Address to the American Economics Association earlier this year, periods in U.S. history where GDP growth exceeds interest rates have been the rule rather than the exception (Chart 6).4 The same has been true for most other economies.5 Chart 6GDP Growth Above Interest Rates: Historically, The Rule, Not The Exception What’s Next For Fiscal Policy? Austerity fatigue has set in. In the U.S., fiscally conservative Republicans, if they ever really existed, are a dying breed. Trump’s big budget deficits and his “I love debt” mantra are the waves of the future. For their part, the Democrats are shifting to the left, with the “Green New Deal” proposal being the latest manifestation. The case for fiscal stimulus is stronger in the euro area than for the United States. The European Commission expects the euro area to see a positive fiscal thrust of 0.40% of GDP this year, up from a thrust of 0.05% of GDP last year (Chart 7). This should help support growth. Chart 7The Euro Area Will Benefit From A Modest Amount Of Fiscal Easing This Year Additional fiscal easing would be feasible. This is clearly true in Germany, but even in Italy, the cyclically-adjusted government primary surplus is larger than what is necessary to stabilize the debt ratio.6 Unfortunately, the situation in southern Europe is greatly complicated by the ECB’s inability to act as an unconditional lender of last resort to individual sovereign borrowers. When a government cannot print its own currency, its debt markets can be subject to multiple equilibria. Under such circumstances, a vicious spiral can develop where rising bond yields lead investors to assign a higher default risk, thus leading to even higher yields (Chart 8).   Mario Draghi’s now-famous “whatever it takes” pledge has gone a long way towards reassuring bond investors. Nevertheless, given the political constraints the ECB faces, it is doubtful that Italy or other indebted economies in the euro area will be able to pursue large-scale stimulus. Instead, the ECB will keep interest rates at exceptionally low levels. A new round of TLTROs is also looking increasingly likely, which should protect against a rise in bank funding costs and a potential credit crunch. Our European team believes that a TLTRO extension would be particularly helpful to Italian banks.  Even in Italy, the cyclically-adjusted government primary surplus is larger than what is necessary to stabilize the debt ratio. Despite having one of the highest sovereign debt ratios in the world, Japan faces no pressing need to tighten fiscal policy. Instead of raising the sales tax this October, the government should be cutting it. A loosening of fiscal policy would actually improve debt sustainability if, as is likely, a larger budget deficit leads to somewhat higher inflation (and thus, lower real borrowing rates) and, at least temporarily, faster GDP growth. We expect the Abe government to counteract at least part of the sales tax increase with new fiscal measures, and ultimately to abandon plans for further fiscal tightening over the next few years. In the EM space, Brazil, Turkey, and South Africa are among a handful of economies with vulnerable fiscal positions. They all have borrowing rates that exceed the growth rate of the economy, cyclically-adjusted primary budget deficits, and above-average levels of sovereign debt (Chart 9).   In contrast, China stands out as having the biggest positive gap between projected GDP growth and sovereign borrowing rates of any major economy. The problem is that the main borrowers have been state-owned companies and local governments, neither of which are backstopped by the state. Not officially, anyway. Unofficially, the government has been extremely reluctant to allow large-scale defaults anywhere in the economy. Despite all the rhetoric about market-based reforms, they are unlikely to start now. Historically, the Chinese government has allowed credit growth to reaccelerate whenever it has fallen towards nominal GDP growth. As we recently argued in a report entitled “China’s Savings Problem,” China needs more debt to sustain aggregate demand.7 Historically, the government has allowed credit growth to reaccelerate whenever it has fallen towards nominal GDP growth (Chart 10). The stronger-than-expected jump in credit origination in January suggests that we are approaching such an inflection point. Chart 10Historically, China Has Scaled Back On Deleveraging When Credit Growth Has Fallen Close To Nominal GDP Growth Investment Conclusions The consensus economic view is that deflation is a much harder problem to overcome than inflation. When dealing with inflation, all you have to do is raise interest rates and eventually the economy will cool down. With deflation, however, a central bank could very quickly find itself up against the zero lower bound constraint on interest rates, unable to ease policy any further via conventional means. While this standard argument is correct, it takes a very monetary policy-centric view of macroeconomic policy. When interest rates are low, fiscal policy becomes very potent. Indeed, the whole notion that deflation is a bigger problem than inflation is rather peculiar. Just as it is easier to consume resources than to produce them, it should be easier to get people to spend than to save. People like to spend. And even if they didn’t, governments could go out and buy goods and services directly. Looking out, our bet is that policymakers will increasingly lean towards the ever-more fiscal stimulus. If structural trends end up causing the so-called neutral rate of interest to rise – the rate of interest that is necessary to avoid overheating – policymakers will have no choice but to eventually raise rates and tighten fiscal policy (Box 2). However, they will only do so begrudgingly. The result, at least temporarily, will be higher inflation. Fixed-income investors should maintain below benchmark duration exposure over both a cyclical and structural horizon. Reflationary policies that increase nominal GDP growth will help support equities, at least over the next 12 months. Chart 11 shows that corporate earnings tend to accelerate whenever nominal GDP growth rises. We upgraded global equities to overweight following the December FOMC meeting selloff. While our enthusiasm for stocks has waned with the year-to-date rally, we are sticking with our bullish bias. Chart 11Earnings And Nominal GDP Growth Tend To Move In Lock-Step A reacceleration in Chinese credit growth will put a bottom under both Chinese and global growth by the middle of this year. As a countercyclical currency, the dollar will likely come under pressure in the second half of this year. Until then, we expect the greenback to be flat-to-modestly stronger. The combination of faster global growth and a weaker dollar later this year will be manna from heaven for emerging markets. We closed our put on the EEM ETF for a gain of 104% on Jan 3rd, and are now outright long EM equities. I do not have a strong view on the relative performance of EM versus DM at the moment, but expect to shift EM equities to overweight by this summer.8 Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Box 1 The Arithmetic Of Debt Sustainability   Box 2 Debt Sustainability And Full Employment: The Role Of Fiscal And Monetary Policy Policymakers should strive to stabilize the ratio of debt-to-GDP over the long haul, while also ensuring that the economy stays near full employment. The accompanying chart shows the tradeoffs involved. The DD schedule depicts the combination of the primary fiscal balance and the gap between the borrowing rate and GDP growth (r minus g) that is consistent with a stable debt-to-GDP ratio. In line with the debt sustainability equation derived in Box 1, the slope of the DD schedule is simply equal to the debt/GDP ratio. Any point below the DD schedule is one where the debt-to-GDP ratio is rising, while any point above is one where the ratio is falling. The EE schedule depicts the combination of the primary fiscal balance and r - g that keeps the economy at full employment. The schedule is downward-sloping because an increase in the primary fiscal balance implies a tightening of fiscal policy, and hence requires an offsetting decline in interest rates. Any point above the EE schedule is one where the economy is operating at less than full employment. Any point below the EE schedule is one where the economy is operating beyond full employment and hence overheating. Suppose there is a structural shift in the economy that causes the neutral rate of interest – the rate of interest consistent with full employment and stable inflation – to increase. In that case, the EE schedule would shift to the right: For any level of the fiscal primary balance, the economy would need a higher interest rate to avoid overheating. The arrows show three possible “transition paths” to a new equilibrium. Scenario #1 is one where policymakers raise rates quickly but are slow to tighten fiscal policy. This results in a higher debt-to-GDP ratio. Scenario #2 is one where policymakers tighten fiscal policy quickly but are slow to raise rates. This results in a lower debt-to-GDP ratio. Scenario #3 is one where the government drags its feet in both raising rates and tightening fiscal policy. As the economy overheats, real rates actually decline, sending the arrow initially to the left. This effectively allows policymakers to inflate away the debt, leading to a lower debt-to-GDP ratio. Note: In Scenario #2, and especially in Scenario #3, the DD line will become flatter (not shown on the chart to avoid clutter). Consequently, the final equilibrium will be one where real rates are somewhat higher, but the primary fiscal balance is somewhat lower, than in Scenario #1.   Footnotes 1          One can equally define the interest rate and GDP growth rate in nominal terms (see Box 1 for details).  2       Japan is a good example of this point. The primary budget deficit averaged 5% of GDP between 1993 and 2010, a period when government net debt rose from 20% of GDP to 142% of GDP. Since then, Japan’s primary deficit has averaged 5.1% of GDP, but net debt has risen to only 156% of GDP (and has been largely stable for the past two years). 3      Please see Global Investment Strategy Special Report, “The Most Important Trend In The World Has Reversed And Nobody Knows Why,” dated February 1, 2019. 4      Olivier Blanchard, “Public Debt And Low Interest Rates,” Peterson Institute for International Economics and MIT American Economic Association (AEA) Presidential Address, (January 2019). 5      Paolo Mauro, Rafael Romeu, Ariel Binder, and Asad Zaman, “A Modern History Of Fiscal Prudence And Profligacy,” IMF Working Paper, (January 2013). 6      The Italian 10-year bond yield is 2.83% while nominal GDP growth is 2.64%. Multiplying the difference by net debt of 118% of GDP results in a required primary surplus of .22% of GDP that is necessary to stabilize the debt-to-GDP ratio. This is lower than the IMF’s 2018 estimate of cyclically-adjusted government primary surplus of 2.14%. 7      Please see Global Investment Strategy Weekly Report, “China’s Savings Problem,” dated January 25, 2019. 8      Please note that my colleague, Arthur Budaghyan, BCA’s Chief EM strategist, remains bearish on both EM and DM equities and expects EM to underperform DM over the coming months. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades        

Special Report

Congress is conducting a major economic experiment that has never been attempted in the U.S. outside of wartime; substantial fiscal stimulus when the economy is already at full employment. The budget deficit is on track to surpass 6% of GDP in a few years. It would likely peak above 8% in the case of a recession. The alarming long-term U.S. fiscal outlook is well known, but it has just become far worse. The combination of rising life expectancy and a decline in the ratio of taxpayers to retirees will place growing financial strains on the Social Security and Medicare systems. The federal government will be spilling far more red ink over the next decade than during any economic expansion phase since the 1940s. The debt/GDP ratio could surpass the previous peak set during WWII within 12 years. Shockingly large budget deficits in the past have sparked some attempt in Congress to limit the damage. Unfortunately, there will be little appetite to tighten the fiscal purse strings for the next decade. Voters have shifted to the left and politicians are following along. Factors that explain the political shift include disappointing income growth, income inequality, and rising political clout for Millennials, Hispanics and the elderly. Fiscal conservatism is out of fashion and this is unlikely to change over the next decade, no matter which party is in power. This means that a market riot will be required to shake voters and the political establishment into making the tough decisions necessary. While the U.S. is not at imminent risk of a market riot over the deteriorating fiscal trends, there are costs: in the long-term, the dollar will be weaker, borrowing rates will be higher and living standards will be lower than otherwise would be the case. Profligacy: (Noun) Unconstrained by convention or morality. Congress is conducting a major economic experiment that has never been attempted before in the U.S. outside of wartime; substantial fiscal stimulus at a time when the economy is already at full employment. Investors are celebrating the growth-positive aspects of the new fiscal tailwind at the moment, but it may wind up generating a party that is followed by a hangover as the Fed is forced to lean hard against the resulting inflationary pressures. Moreover, even in the absence of a recession, the federal government will likely be spilling far more red ink than during any economic expansion since the 1940s (Chart II-1). What are the long-term implications of this macro experiment? Will the U.S. continue to easily fund large and sustained budget deficits? Chart II-1U.S. Deficits Will Be Extremely Large For A Non-Recessionary Period Historically, shockingly large budget deficits sparked some attempt by Congress to limit the damage. Unfortunately, we argue in this Special Report that there will be little appetite to tighten the fiscal purse strings for the next decade. Voters have shifted to the left and politicians are following along. While the U.S. is not at imminent risk of a market riot over the deteriorating fiscal trends, the dollar will be weaker, borrowing rates will be higher and living standards will be lower than otherwise would be the case. On The Bright Side The Trump tax cuts, the immediate expensing of capital spending and a lighter regulatory touch have stirred animal spirits in the U.S. The Administration's trade policies are a source of concern, but CEO confidence is generally high. The NFIB survey highlights that small business owners are almost euphoric regarding the outlook. The IMF estimates that the tax cuts and less restrictive spending caps will provide a direct fiscal thrust of 0.8% in 2018 and 0.9% in 2019 (Chart II-2). The overall impact on the economy over the next 12-18 months could be larger to the extent that business leaders follow through on their newfound bullishness and ramp up capital spending. Chart II-2Lots Of Fiscal Stimulus In 2018 And 2019 Fiscal policy is a clear positive for stocks and other risk assets in the near term, as long as inflation is slow to respond. In addition to the near-term boost, there will be longer-term benefits from the 2017 tax act. Various provisions of the act affect the long-run productive potential of the U.S. economy, by promoting increases in investment and labor supply. Corporate tax cuts and the full expensing of business capital outlays should permanently increase the nation's capital stock relative to what it otherwise would be, leading to a slightly faster trend pace of productivity growth. Similarly, lower income taxes are projected to encourage more people to enter the workforce or to work longer hours. The CBO estimates that the tax act will boost the level of potential real GDP by 0.9% by the middle of the next decade. This may not sound like much, but it translates into almost a million extra jobs. The supply-side benefits of the 2017 tax act are therefore meaningful. Unfortunately, given the lack of offsetting spending cuts, it comes at the cost of a dramatically worse medium- and long-term outlook for government debt. The CBO estimates that the recent changes in fiscal policy will cumulatively add $1.7 trillion to the federal government's debt pile, relative to the previous baseline (Chart II-3). The annual deficit is projected to surpass $1 trillion in 2020, and peak as a share of GDP at 5.4% in 2022. Federal government debt held by the private sector will rise from 76% this year to 96% in 2028 in this scenario. Chart II-3Comparing To The Reagan Era The budget situation begins to look better after 2020 in the CBO's baseline forecast because a raft of "temporary provisions" are assumed to sunset as per current law, including some of the personal tax cuts and deductions included in the 2017 tax package. As is usually the case, the vast majority of these provisions are likely to be extended. The CBO performed an alternative scenario in which it extends the temporary provisions and grows the spending caps at the rate of inflation after 2020. In this more realistic scenario, the deficit reaches 7% of GDP by 2028 and the federal debt-to-GDP ratio hits 105% (Chart II-3). Moreover, there will undoubtedly be a recession sometime in the next five years. Even a mild downturn, on par with the early 1990s, could inflate the budget deficit to 8% or more of GDP. The Demographic Time Bomb Chart II-4The Withering Support Ratio The pressure that the aging population will place on federal coffers over the medium term is well known, but it is worth reviewing in light of Washington's new attitude toward deficit financing. The combination of rising life expectancy and a decline in the ratio of taxpayers to retirees will place growing financial strains on the Social Security and Medicare systems. In 1970, there were 5.4 people between the ages of 20 and 64 for every person 65 or older. That ratio has since dropped to 4 and will be down to 2.6 within the next 20 years (Chart II-4). Spending on entitlements (Social Security, Medicare, Medicaid, Income Security and government pensions) is on an unsustainable trajectory (Charts II-5 and II-6). In fiscal 2017, these programs absorbed 76% of federal revenues and the CBO estimates that this will rise to almost 100% by 2028, absent any change in law. If we also include net interest costs, total mandatory spending1 is projected to exceed total federal government revenues as early as next year, meaning that deficit financing will be required for all discretionary spending. Chart II-5Entitlements Will Explode ##br##Mandatory Spending Chart II-6All Discretionary Spending ##br##To Be Deficit Financed? The CBO last published a multi-decade outlook in 2017 (Chart II-7). The Federal debt/GDP ratio was projected to reach 150% by 2047. If we adjust this for the new (higher) starting point in 2028 provided by the CBO's alternative scenario, the debt/GDP ratio would top 164% in 2047. Chart II-7An Unsustainable Debt Accumulation To put this into perspective, the demands of WWII swelled the federal debt/GDP ratio to 106% in 1946, the highest on record going back to the early 1700s (Chart II-8). The debt ratio could rocket past that level before 2030, even in the absence of a recession. Chart II-8U.S. Debt In Historical Context These extremely long-term projections are only meant to be suggestive. A lot of things can happen in the coming years that could make the trajectory better or even worse. But the point is that current levels of taxation are insufficient to fund entitlements in their current form in the long run. Chart II-9 shows that outlays as a share of GDP have persistently exceeded revenues since the mid-1970s, except for a brief period during the Clinton Administration. The gap is set to widen over the coming decade. Something will have to give. Chart II-9U.S. Outlays And Revenues Forget Starving The Beast "Starve the Beast" refers to the idea that the size of government can be restrained through a low-tax regime that spurs growth and pressures Congress to cut spending and control the budget deficit. It has been the mantra of Republicans since the Reagan era. The 1981 Reagan tax cuts included an across-the-board reduction in marginal tax rates, taking the top rate down from 70% to 50%. Corporate taxes were slashed by $150 billion over a 5-year period and tax rates were indexed for inflation, among other changes. It was not surprising that the budget deficit subsequently ballooned. Outrage grew among fiscal conservatives, but Congress spent the next few years passing laws to reverse the loss of revenues, rather than aggressively attacking the spending side. Today, Congressional fiscal hawks are in retreat and the Republican Party under President Donald Trump is not as fiscally conservative as it once was. This trend reflects the pull toward the center of the economic policy spectrum in response to a shift to the left among voters. BCA's political strategists have highlighted that this is the "median voter theory" (MVT) in action.2 The MVT posits that parties and politicians will approximate the policy choices of the median voter in order to win an election or stay in power. Every U.S. presidential election involves candidates making a mad dash to the most popularly appealing positions. President Trump exhibited this process when he ran in the Republican primary on a platform of increased infrastructure spending and zero cuts to "entitlement" spending. The Great Financial Crisis, disappointingly slow growth, stagnating middle class incomes and the widening income distribution have resulted in a leftward shift among voters on economic issues. Adding to the shift is the rising political clout of the Millennial generation, which generally favors more government involvement in the economy and will become the major voting block as it ages in the 2020s. There also are important changes underway in the ethnic composition of the electorate. The rising proportion of Hispanic voters will on balance favor the Democrats, according to voting trends (Chart II-10). A previous Special Report by Peter Berezin, BCA's Chief Global Strategist, predicted that Texas will become a swing state in as little as a decade and a solid Democrat state by 2030.3 Chart II-10The Proportion Of Minority Voters Set To Grow President Trump's shift to the left on economic policy helped him to out-flank Clinton in the election, particularly in the Rust Belt, where his protectionist and anti-austerity message resonated. Even his anti-immigration appeal is mostly based on economic reasoning - i.e. jobs, rather than cultural factors. Trump has admitted that he is not all that concerned about taking the country deeper into hock. The Republican rank-and-file has generally gone along with Trump's agenda because he has delivered traditional Republican tax cuts and continues to rate highly among his supporters (his approval is around 90% among Republicans). Fiscal hawks within the GOP have been forced to the sidelines while Trump and moderate Republicans have passed bipartisan spending increases with Democratic assistance. Where's The Outrage? Chart II-11Entitlements Are Popular* The implication is that, unlike the Reagan years, we do not expect there will be a strong political force capable of leading a fight against budget deficits. After a decade of disappointing income growth, voters are in no mood for tax hikes. On the spending side, health care and pensions are still politically untouchable. A recent study by the Pew Research Center confirms that only a very small percentage of Americans of either political stripe would agree with cuts to spending on education, Medicare, Social Security, defense, infrastructure, veterans or anti-terrorism efforts (Chart II-11). It is therefore no surprise that a populist such as Trump has promised to defend entitlement programs. Moreover, the graying of America will make it increasingly difficult for politicians to tame the entitlement beast. An aging population might generally favor the GOP, but it will also solidify opposition towards cutting Medicare and Social Security. As for defense, U.S. military spending was 3.3% of GDP and almost 15% of total spending in 2017 (Chart II-12). Congress recently lifted the spending cap for defense expenditures, but it is still projected to fall as a share of total government spending and GDP in the coming years. It is conceivable that Congress could eventually trim the defense budget even faster, but spending is already low by historical standards and it is hard to see any future Congress gutting the military at a time when the global challenge from China and Russia is rising. Indeed, given the geopolitical atmosphere of great power competition, defense spending is more likely to rise. Chart II-12What's Left To Cut? So, what is left to cut? If entitlements and defense are off the table, that leaves non-defense discretionary spending as the sacrificial lamb. This category includes spending by the Departments of Agriculture, Education, Energy, Homeland Security, Health and Human Services, Justice, State and Veteran Affairs. Such spending has already declined sharply during the past several decades (Chart II-12). Non-defense discretionary spending amounted to $610 billion in 2017, which is only 15.3% of total federal spending. To put this into perspective, cutting every last cent of non-defense discretionary spending by 2022 would still leave a budget deficit of about 2½% of GDP. And it would be political suicide. The Departments of Education, Health and Human Services, Homeland Security, Justice and Veterans Affairs account for more than half of non-defense discretionary spending. But these programs are very popular among voters. And, at only 1.3% of total spending, eliminating all foreign aid won't make much difference. Either President Trump or Vice-President Mike Pence will be the GOP presidential candidate in 2020. Pence could be more fiscally conservative than Trump, but Congress is unlikely to remain GOP-controlled through 2024. Similarly, it is difficult to see the Democrats making more than a token effort to rein in the deficit if the party is in charge after 2020. Perhaps they will raise taxes on the rich and push the corporate rate back up a bit, but voters will probably not favor a full reversal of the Trump tax cuts. Democrats will not tackle entitlements either. In other words, we can forget about "starving the beast" as a viable option no matter which party is in power. There will be little appetite for fiscal austerity in the U.S. through to the mid-2020s at a minimum. International Comparison This all places the U.S. out of sync with other major industrialized countries, where structural budget deficits have been tamed in most cases and are expected to remain so according to the IMF's latest projections (Chart II-13). The U.S. cyclically-adjusted budget deficit is projected to be almost 7% of GDP in 2019, by far the highest among other industrialized countries except for Norway. Spain and Italy are expected to have relatively small structural deficits of 2½% and 0.8%, respectively, next year. Greece is running a small structural surplus! Including all levels of government, the IMF estimates that the U.S. general government gross debt/GDP ratio is projected to be well above that of the U.K., France, Germany, Spain and Portugal in 2023 (Chart II-14). It is expected to be on par with Italy at that time, although the newly-installed populist government there is likely to negotiate a loosening of the fiscal rules with Brussels, leading to higher debt levels than the IMF currently expects. The implication is that the U.S. government appears destined to become one of the most indebted in the developed world. Chart II-13U.S. Budget Deficit Stands Out Chart II-14International Debt Comparison The Fiscal Tipping Point Investors are not yet worried about the path of U.S. fiscal policy; the yield curve is quite flat, CDS spreads on U.S. Treasurys have not moved and the dollar is still overvalued by most traditional measures. The challenge is timing when a fiscally-induced crisis might occur. A warning bell does not ring when government debt or deficits reach certain levels. Fiscal trends generally do not suddenly spiral out of control - it is a gradual and insidious process reflected in multi-year deficits and slowly accumulating debt burdens. Eventually, a tipping point is reached where the only solution is drastic policy shifts or in extreme cases, default. Along the way, there are a number of signs that fiscal trends are entering dangerous territory. The relevance of the various signs will be different for each country, reflecting, among other things, the depth and structure of the financial system, the soundness of the economy, the dependence on foreign capital, and the asset preferences of domestic investors. Some key signs of building fiscal stress are given in Box II-1. None of the factors in Box II-1 appear to be a threat at the moment for the U.S. Moreover, comparisons with other countries that have hit the debt wall in the past are not that helpful because the U.S. is a special case. It has a huge economy and has political and military clout. The dollar is the world's main reserve currency and the country is able to borrow in its own currency. This suggests that the U.S. will be able to "get away with" its borrowing habit for longer than other countries have in the past. At the same time, financial markets are fickle and, even with hindsight, it not always clear why investors switch from acceptance to bearishness about a particular state of affairs. BOX II-1 Traditional Signs Of An Approaching Debt Crisis Government deficits absorb a rising share of net private savings, leaving little for new investment. Interest payments account for an increasingly large share of government revenues, squeezing out discretionary spending and requiring tough budget action merely to stop the deficit from rising. The government exhausts its ability to raise tax burdens. Traditional sources of debt finance dry up, requiring alternative funding strategies. Fears of inflation and/or default lead to a rising risk premium on interest rates and/ or a falling exchange rate. Political shifts occur as governments get blamed for eroding living standards, high taxes, and continued pressure to cut spending. The Costs Of Fiscal Profligacy Even if the U.S. is not near a fiscal tipping point, this does not mean that massive debt accumulation is costless: Interest Costs: Spending 3% of GDP on servicing the federal government's debt load over the next decade is not a disaster. Nonetheless, it does reduce the tax dollars available to fund entitlements or investing in infrastructure. Counter-Cyclical Fiscal Policy: Lawmakers would have less flexibility to use tax and spending policies to respond to unexpected events, such as natural disasters or recessions. As noted above, a recession in 2020 could generate a federal deficit of more than 8% of GDP. In that case, Congress may feel constrained in supporting the economy with even temporary fiscal stimulus. National Savings: Because government borrowing reduces national savings, then either capital spending must assume a smaller share of the economy or the U.S. must borrow more from abroad. Most likely it will be some combination of both. Crowding Out: If global savings are not in plentiful supply, then the additional U.S. debt issuance will place upward pressure on domestic interest rates and thereby "crowd out" business capital spending. This would reduce the nation's capital stock, leading to lower growth in productivity and living standards than would otherwise be the case. The CBO estimates that the positive impact on the capital stock from the changes to the corporate tax structure will overwhelm the negative impact from higher interest rates over the next decade. Nonetheless, the crowding out effect may dominate over a longer-time horizon. Academic studies suggest that every percentage point rise in the government's debt-to-GDP ratio adds 2-3 basis points to the equilibrium level of bond yields. If this is correct, then a rise in the U.S. ratio of 25 percentage points over the next decade in the CBO's baseline would lift equilibrium long-term bond yields by a meaningful 50-75 basis points. Much depends, however, on global savings backdrop at the time. External Trade Gap: If global savings are plentiful, then it may not take much of a rise in U.S. interest rates to attract the necessary foreign inflows to fund both the higher U.S. federal deficit and the private sector's borrowing requirements. Of course, this implies a larger current account deficit and a faster accumulation of foreign IO Us. Twin Deficits The U.S. has run a current account deficit for most of the past 40 years, which has cumulated into a rising stock of foreign-owned debt. The Net International Investment Position (NIIP) is the difference between the stock of foreign assets held by U.S. residents and the stock of U.S. assets held by foreign investors. The NIIP has fallen increasingly into the red over the past few decades, reaching 40% of GDP today (Chart II-15). The current account deficit was 2.4% at the end of 2017, matching the post-Lehman average. Nonetheless, this deficit is set to worsen as increased domestic demand related to the fiscal stimulus is partly satisfied via higher imports. Chart II-15Scenarios For The U.S. Net International Investment Position We estimate that a two percentage point rise in the budget deficit relative to the baseline could add a percentage point or more to the current account deficit, taking it up close to 4% of GDP. Upward pressure on the external deficit will also be accentuated in the next few years to the extent that the U.S. business sector ramps up capital spending. The implication is that the NIIP will fall deeper into negative territory at an even faster pace. A 2% current account deficit would be roughly consistent with stabilization in the NIIP/GDP ratio. But a 4% deficit would cause the NIIP to deteriorate to almost 80% of GDP by 2040 (Chart II-15). The sustainability of the U.S. twin deficits has been an area of intense debate among academics and market practitioners for many years. The U.S. has been able to get away with the twin deficits for so long in part because of the dollar's status as the world's premier reserve currency. The critical role of the dollar in international transactions underpins global demand for the currency. This has allowed the U.S. to issue most of its debt obligations in U.S. dollars, forcing the currency risk onto foreign investors. The worry is that foreign investors will at some point begin to question the desirability of an oversized exposure to U.S. assets within their global portfolios. We argued in our April 2018 Special Report 4 that the U.S. situation is not that dire that the U.S. dollar and Treasury bond prices are about to fall off a cliff because of sudden concerns about the unsustainability of the current account deficit. Even though the NIIP/GDP ratio will continue to deteriorate in the coming years, it does not appear that the U.S. is close to the point where foreign investors would begin to seriously question America's ability or willingness to service its debt. That said, the "twin deficits" and the downward trend in U.S. productivity relative to the rest of the world will ensure that the underlying long-term trend in the dollar will remain down (Chart II-16).5 Chart II-16Structural Drivers Of The U.S. Dollar Conclusions The long-term U.S. fiscal outlook was dire even before the Great Recession and the associated shift to the political left in America. Fiscal conservatism is out of fashion and this is unlikely to change before the mid-2020s, no matter which party is in power. This means that a market riot will be required to shake voters and the political establishment into making the tough decisions. Given demographic trends, it appears more likely that taxes will rise than entitlements cut. We do not foresee a crisis occurring in the next few years. Nonetheless, arguing that the U.S. fiscal situation is sustainable for the foreseeable future does not mean that it is desirable. There will be costs associated with current fiscal trends, even on a relatively short 5-10 year horizon. Interest costs will mushroom, potentially crowding out government spending in other areas. U.S. government debt has already been downgraded by S&P to AA+ in 2013, and the other two main rating agencies are likely to follow suit during the next recession as the deficit balloons to 8% or more. Investors may begin to demand a risk premium in order to entice them to continually raise their exposure to U.S. government bonds in their portfolios. Taxes will eventually have to rise to service the government debt, and some capital spending will be crowded out, both of which will undermine the economy's growth potential. Finally, the dollar will also be weaker than it otherwise would be in the long-term, representing an erosion in America's standard of living because everything imported is more expensive. Could Japan offer a roadmap for the U.S.? The Bank of Japan has effectively monetized 43% of the JGB market and has control over yields, at least out to the 10-year maturity. Moreover, Japan has enjoyed a "free lunch" so far because monetization has not resulted in inflation. The reason that Japan has enjoyed a free lunch is that it has suffered from a chronic lack of demand and excess savings in the private sector. The government has persistently run a deficit and fiscally stimulated the economy in order to offset insufficient demand in the private sector. The Bank of Japan purchased bonds and drove short-term interest rates down to zero. These policies have made very slow progress in eradicating lingering deflationary economic forces. However, if animal spirits in the business sector perk up, then inflation could make a comeback unless the policy stimulus is dialed down in a timely manner. In other words, the BoJ-financed fiscal "free lunch" should disappear at some point. The U.S. is in a very different situation. There is no lack of aggregate demand or excessive savings in the private sector. The economy is at full employment, and thus persistent budget deficits should turn into inflation much more quickly than was the case in Japan. In other words, the U.S. is unlikely to enjoy much of a "free lunch", whether the Fed monetizes the debt or not. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Mandatory spending refers to entitlements; that is, government expenditure programs that are required by current law. These include Social Security, Medicare, Medicaid, government pensions and other smaller programs. 2 Please see Geopolitical Strategy Monthly Report, "Introducing The Median Voter Theory," June 8, 2016, available at gps.bcaresearch.com. 3 Please see The Bank Credit Analyst, "America's Fiscal Fortune: Leave Your Wallet On The Way Out," June 2011, available at bca.bcaresearch.com. 4 Please see The Bank Credit Analyst Special Report, "U.S. Twin Deficits: Is The Dollar Doomed?," April, 2018, available at bca.bcaresearch.com. 5 In the near term, fiscal stimulus and increased business capital spending will likely boost the dollar. But this effect on the dollar will reverse in the long-term.

Special Report

Following the debacle of the failed attempt to repeal and replace Obamacare, the Trump Administration is focusing on another important part of its policy platform: reforming taxes and reshaping government spending. In theory, the legislative obstacles should be easier to overcome than with the controversial health care bill, but many challenges still lie ahead. Meanwhile, the assumptions underpinning many of the key measures are questionable. The Administration's fiscal proposals are based on the following assertions: The level of U.S. taxes puts the U.S. at a competitive disadvantage and is a hindrance to faster economic growth. Military and infrastructure spending needs to rise sharply after having been cut back too severely in recent years. The federal government, outside of defense, has become bloated and needs to be drastically pruned. Entitlement spending remains politically untouchable. Proposed tax changes will be broadly deficit neutral after allowing for the revenue boost from faster economic growth. The above assertions supporting the administration's policy platform are a mix of facts, fallacies and fantasies. A frustrating aspect of economic debates is that it often is relatively easy to cherry pick data to support any particular argument one wants to make. In other words, there are plenty of alternative facts to choose from. In this report, I will endeavor to illuminate the debate about fiscal policy with unvarnished official statistics, untainted by partisan biases. Are U.S. Taxes Too High? Taxes are a necessary evil if a country's residents want their government to provide some services such as defense, policing, schooling, and old-age benefits etc. In a democracy, the exact level of services provided by a government is a choice that can be voted on at election time. Sometimes, politicians campaign on a platform of increased government spending (and implicitly higher taxes) and at other times, the opposite is true. As a presidential candidate, Donald Trump campaigned on a promise to reduce the government's involvement in the economy and society in general, with a corresponding reduction in tax burdens. The government's revenue grab takes many forms beyond just taxing incomes and can occur at the federal, state or local level. There are taxes on spending, assets, imports and employment, and a multitude of fees ranging from park entrance charges to speeding tickets. Chart 1 shows total U.S. tax and fee revenues from all levels of government, expressed as a share of GDP since 1980.1 The most striking thing about the chart is how little the ratio has changed over the past quarter century. Government revenues have averaged around 27% of GDP over the period and the only years with a marked divergence from that level were the late 1990s when the tech-driven stock market boom triggered unusually strong capital gains tax receipts and in 2009/10 when the economic collapse and temporary tax cuts led to a plunge in revenues. The other interesting point to note is that, according to OECD data, the U.S. is the lowest taxed industrial country, except for Ireland. Taxes and social security contributions as a share of GDP are more than ten percentage points below the unweighted average of 21 other industrial countries. And this gap has been relatively constant over the years (Chart 2). The unweighted average for European countries is almost 39% of GDP. Chart 1U.S. Total Tax Burdens Chart 2U.S. Tax Burdens: An International Perspective As noted earlier, whether a country's overall tax burdens are high or low is largely a reflection of voter preference. In the majority of countries outside the U.S., the government is the main or even sole provider of health care and that often is used to explain the lower level of U.S. taxes. Yet, it is not widely realized that U.S. government spending on health care as a percent of GDP is higher than the industrial country average (Chart 3).2 The point is that the U.S.'s low ranking in terms of global tax burdens does not simply reflect the lack of a universal government-funded health care system. Low taxes are a very good thing if they are sufficient to finance the required level of government services and provide positive incentives for economic growth. However, there is a loose but positive correlation between the level of tax burdens and structural budget deficits. In other words, the countries with low tax burdens have tended to have higher average cyclically-adjusted budget deficits (Chart 4). Again, that is choice that voters can make: choosing lower taxes today at the expense of rising debt burdens that will have costs in the future. The U.S. has been at the extreme end of the spectrum so far this century with the combination of low taxes and large deficits. Chart 3Government Spending on Health Care Chart 4Lower Tax Burdens Generally Mean Larger Fiscal Deficits The data I have shown highlight that the U.S. is a low-tax country from an international perspective and that overall tax burdens have not changed dramatically over time. Nonetheless, there is plenty of scope for reforming taxes in order to improve economic incentives and efficiency. The Case For Tax Reform There is a disconnect between low overall U.S. tax burdens and the facts that the country has the highest marginal corporate tax rate in the industrial world and that so many people feel over-taxed. The principal explanation is the skewed nature of the U.S. tax system with its heavy dependence on taxes on income rather than consumption. The U.S. is the only industrial country in the world without a national value added tax (VAT), and state and local sales taxes are low by international standards. This means that taxes on goods and services account for less than 18% of general government tax revenues in the U.S. compared with an unweighted average of almost 33% for all OECD countries (Table 1). As a result, the U.S. is forced to rely more on taxes on income and profits. These account for almost 48% of tax revenues in the U.S., 14 percentage points higher than the OECD average. General perceptions about tax burdens probably are more affected by income tax rates than by taxes on goods and services, many of which are hidden from view. Table 1The Structure of Government Tax Receipts Problems are compounded by the skewed distribution of income tax payments. For example, although the marginal U.S. corporate tax rate is around 39%,3 many large companies with overseas subsidiaries pay a significantly lower rate. According to Internal Revenue Service (IRS) corporate tax return data, the largest businesses (annual receipts above $100 million) paid an average federal rate of 22.8% on their taxable income in 2013 (the latest year for which detailed corporate returns are available), compared with 32.2% for companies with sales between $10 million and $100 million and 27.5% for those with sales of less than $10 million. It is no wonder that many multinationals are keen to shelter income overseas. There is a case for reforming the corporate tax code to equalize the playing field between multinationals and those with domestic operations. When it comes to personal taxes, there also are distortions. As is well known, there are many hard-to-justify allowances including those on carried interest and on mortgages up to the value of $1 million. Even if the government wanted to use the tax system to subsidize home ownership (which many countries have stopped doing), it would make sense to cap the benefit at the mortgage required to finance a median-priced home. The national median price for a single-family home currently is $230,000. A key problem is the fact that many people do not earn enough to pay much income tax, so the burden falls heavily on a relatively narrow group. The average personal federal tax rate has not changed very much over the past 35 years (Chart 5), but Table 2 shows the remarkably skewed nature of personal tax payments by income level. In 2014 (the latest year for detailed IRS personal data), 148 million tax returns were filed, but more than one-third had no taxable income. Almost 45% of filers reported gross adjusted income of less than $30,000 and, overall, this group received net tax refunds. At the other end of the scale, those with incomes above $200,000 represented only 4.2% of filed returns yet accounted for almost 63% of total federal taxes paid. It is no surprise that many high-income earners feel over-taxed. It is harder to justify the fact that 55% of respondents to a recent Fox News poll said that taxes were too high. The message is that taxes can never be low enough! Chart 5The Average Federal Personal Tax Rate Table 2The Skewed Nature of Personal Income Taxes An obvious way to improve the tax structure would be to eliminate some deductions and use the savings to reduce marginal rates. An even more significant change would be to broaden the tax base by introducing a VAT, using the revenue to dramatically lower income tax rates. The regressive nature of a VAT can be countered by exempting certain items such as food, energy, and children's clothing. The main argument against a VAT is that, once introduced, it becomes an easy way to raise revenue and an initial rate of say 5% eventually could end up at European levels (20%). The proposal for a new Border Adjustment Tax would be a step toward rebalancing tax burdens toward consumption and away from incomes. However, there is considerable opposition to such a move and its future is in doubt. To conclude, the data do not support the notion that the U.S. is overly taxed - either compared to its own history or relative to other countries. But the system has many distortions and there is a strong case for increased taxes on consumption, using the revenues to reduce marginal income tax rates in both the corporate and personal sector. The Case For More Spending On Infrastructure And Defense Unlike tax reform, increased infrastructure spending is not a contentious issue. As Larry Summers likes to quip, anyone flying to New York and driving into Manhattan can see infrastructure spending needs all around, from dreary airports to dodgy bridges and pothole-filled roads. Real government spending on non-defense structures (a proxy for infrastructure) has risen by only 20% over the past 50 years, a drop of almost 30% in per capita terms (Chart 6). As a share of GDP, infrastructure spending has almost halved in the past half century. The administration has talked about boosting infrastructure spending by $1 trillion over the next ten years. If we assume a constant baseline of spending averaging 1.6% of GDP (the 2016 level), an additional $1 trillion would equate to an additional 30% rise in overall infrastructure expenditure over the decade. But even with this increase, spending would still only be 2% of GDP, a relatively modest level by historical standards. The administration's infrastructure proposal is quite reasonable in terms of its scale and desirability. Of course, there is no guarantee that it will materialize. The administration's plan to significantly increase defense spending is a more debatable issue. The number of military personnel has been in a sharp downtrend since the end of the Vietnam War. In the past 35 years or so, a key driver has been the impact of technology with machines replacing people, but defense spending as a share of GDP also has been in a structural downtrend (Chart 7). At the same time, real spending per military employee has been in a strong uptrend, reflecting the switch in strategy away from boots on the ground towards sophisticated equipment. From an international perspective, U.S. defense spending remains very high compared to other countries. According to the SIPRI Military Expenditure Database, in 2015, the U.S. spent as much as the next eight largest military spenders combined.4 Yet, the combined GDP of those eight countries was 55% above that of the U.S. Chart 6Government Infrastructure Spending Chart 7Trends In Defense Spending The Budget Control Act of 2011 put tough spending caps on discretionary spending and these have not been repealed. According to the Congressional Budget Office (CBO), under current law, defense outlays as a share of GDP would fall from 3.2% of GDP to 2.6% by fiscal 2027. The Trump Administration has proposed a $54 billion increase in defense spending authority for fiscal 2018, implying an increase of around 9% from the 2017 level. And while we do not have details, we can assume that the longer-term plan is to reverse the downtrend in spending as a share of GDP. What is the right level of defense spending? The world remains a dangerous place, but the U.S. already outspends other countries by a huge margin. At the end of the day, financial constraints mean it boils down to a choice between defense and other spending programs. Voters may state a preference for increased defense spending, but that likely would change if other programs were crowded out. Is The Federal Government Bloated? Chart 8Federal Non-Defense Discretionary Spending Spending on entitlements is widely regarded as untouchable from a political perspective and it is no surprise that Trump has promised to defend these programs. Given the administration's platform of tax cuts and increased military and infrastructure spending, containing budget deficits implies tough constraints on non-defense discretionary spending. This includes spending by the Departments of Agriculture, Education, Energy, Homeland Security, Health and Human Services, Justice, State and Veterans Affairs. Such spending has already declined sharply during the past several decades, both as a share of total government outlays and as a share of GDP (Chart 8). The administration seeks further drastic cuts in the years ahead. There is a general perception that much of government spending is wasteful, implying huge savings can be made. At the same time, surveys show that people do not want cuts in areas such as security, veterans affairs, education and health. The problem is that spending by the Departments of Education, Health and Human Services, Homeland Security, Justice and Veterans Affairs account for more than half of non-defense discretionary spending. Thus, pressures for spending cuts fall heavily on other areas. But this often is not practical given that many of these other programs are so small. For example, spending on foreign aid represents less than 0.2% of GDP and less than 5% of non-defense discretionary spending. As for federal employment being bloated, it should be noted that civilian federal employment has shown no net change over the past 50 years, despite the marked growth in the population and economy over the period. Federal employment currently accounts for less than 2% of total employment, down from 4% in 1970 (bottom panel of Chart 8). There inevitably are areas of wasteful government spending and it is appropriate to look for savings. However, it is not reasonable to believe that there can be tax cuts and increases in defense spending and domestic security, while protecting entitlements programs and preventing a massive rise in the budget deficit. And that is even without adding in the cost of the proposed border wall with Mexico. Entitlement Spending Is The Major Problem Social Security has been called the third rail of American politics - touch it and you are dead. No politician seeking election would dare campaign on a platform of major cuts to the program in the form of reduced benefits, higher contributions, means testing, or an increase in the age eligibility limit. And the same is broadly true for Medicare. Voter dislike of government involvement in the provision of health care does not seem to extend to those over the age of 65! The combination of rising life expectancy and a decline in the ratio of taxpayers to retirees will place growing financial strains on the Social Security and Medicare systems. In 1970, there were 5.4 people between the ages of 20 and 64 for every person 65 and older. That ratio has since dropped to 4 and will be down to 2.6 within the next 20 years (Chart 9). Spending on entitlements (Social Security, Medicare, Medicaid, income security, and government pensions) is on an unsustainable trajectory. In fiscal 2016, these programs equaled 74% of federal revenues and the CBO estimates that this will rise to 84% by 2027, absent any change to current law (Chart 10). If we also allow for net interest costs, total mandatory spending is projected to exceed revenues within the next 12 years or so, meaning that deficit financing will be required for all discretionary spending. Chart 9The Demographic Fiscal Headwind Chart 10The Entitlement Problem Politicians operating in a world of two-year election cycles have no incentive to support short-term pain for long-term gain. At some point, markets will force change, but it is hard to know exactly when that will happen. According to the CBO's latest estimates, current policies imply that the federal deficit will average 4% of GDP over the next decade, rising to 6.2% and 8.4% over the subsequent two 10-year periods. As a result, the debt-to-GDP ratio rises from 77% currently to 113% by 2037 and 150% by 2047.5 Of course, that is a long way in the future and much can happen to undermine these projections - for the better or for the worse. Long-run fiscal projections are subject to a wide margin of error because, in addition to legislative changes, they are very sensitive to assumptions about economic growth, inflation and interest rates. The CBO's baseline estimates published in mid-2009 had Medicare spending rising from 3.1% to 7.2% of GDP between 2010 and 2037. The latest CBO report has 2037 Medicare spending at a much lower 5.3% of GDP, representing massive savings from the 2009 estimate. Unfortunately, total federal revenues as a share of GDP were revised down by an even greater amount, with the result that expected deficits and debt levels have been revised up sharply since the 2009 report, despite the slower path of Medicare spending (Chart 11). Chart 11Long-Term Fiscal Projections: Prone to Revisions One can point to Japan as an example of how a high government debt-to-GDP ratio need not imply economic disaster. Japan's gross debt currently stands at 250% of GDP and there has not been any difficulty in financing its ongoing deficits. However, two qualifications are necessary. First, it is too soon for Japan to claim victory: its horrible demographic profile points to an ever-worsening fiscal position and there likely will be a crisis at some point. Secondly, Japan finances its deficits internally which protects it from the whims of foreign investors. Although the dollar's status as reserve currency also gives the U.S. protection, the country's ongoing large current account deficit creates vulnerability to financing problems if overseas investors lose confidence in the U.S. fiscal outlook. Concluding Thoughts Public discussions of fiscal policy invariably morph into partisan arguments about the appropriate size and role of the government in the economy. It quickly becomes frustrating when the warring factions then use misleading or outright wrong data to support their positions. In the spirit of the adage that "everyone is entitled to their own opinions, but there is only one set of facts," I have focused this paper on published and reputable data about government revenues and spending. Several points emerge: One may want taxes to come down, but it is a FACT that the U.S. is a low-tax country by international standards, and tax burdens have not noticeably risen over time. It is a FACT that the U.S. tax system has serious distortions and is crying out for some reform. But what these reforms should be is open to debate, and are a matter of opinion. There is a strong case for increased infrastructure because it is a FACT that spending has fallen sharply over the years. It is less obvious that a major rise in defense spending is warranted. It would be a matter of preference rather than incontrovertible need. It is a FALLACY to describe overall non-defense discretionary spending as massively bloated and out-of-control. Of course, there are many places where the government can make cuts and improve efficiency, but squeezing this category of spending will provide only limited savings. It is FANTASY to think that entitlement programs can be maintained over the long run in their current form. The longer that reforms are delayed, the bigger the cutbacks will have to be. Government deficits and debt do matter, but it is virtually impossible to predict when financing problems might occur. There is no particular level of the debt-to-GDP ratio that will trigger a crisis because much depends on the domestic and global economic and financial environment. But, to quote the late Herb Stein, "if something cannot go on forever, it will stop." The Trump administration's fiscal desires are a mix of sensible policies, wishful thinking and impracticalities. Hopefully, there will be progress with boosting infrastructure, and making some positive reforms to the tax code. However, there will be serious challenges to tax changes once special interests get involved. The end point may very well be outright tax cuts without reform, and that would be much less desirable. On the spending side, increased defense spending is a perfectly legitimate choice, but the planned severe cuts to non-defense discretionary spending are impractical. The good news is that the odds of such severe cuts being implemented are very low. It seems almost certain that federal deficits will head higher over the coming few years. Using dynamic scoring to suggest that the economy will improve by enough to make tax cuts and spending increases virtually self-financing will have little credibility outside of the administration and will be challenged by the calculations of the CBO and Joint Committee on Taxation. If the government is successful in implementing major fiscal stimulus then the biggest problem might be overheating the economy. As I discussed in a recent report, the U.S. economy already is operating close to full capacity and it will not take much to create a classic late-cycle build-up of inflationary pressures.6 That would set the scene for enough Fed tightening in 2018 to give high odds of a recession in 2019. Martin H. Barnes, Senior Vice President Economic Advisor mbarnes@bcaresearch.com 1 The totals exclude government interest receipts and transfers from the Federal Reserve to the Treasury as those largely represent transactions related to intra-government holdings of Treasury securities. 2 Overall the U.S. devotes a much larger share of its GDP to health care than other countries. According to OECD data, total health care spending represented 16.9% of U.S. GDP in 2015, compared to an unweighted average of 10% for other industrial countries. Within these totals, the government share was 8.4% in the U.S and 7.6% elsewhere, with the private sector making up the difference. 3 This comprises a top federal rate of 35% and state and local taxes of 6%, fully deductible against federal taxes. 4 SIPRI stands for the Stockholm International Peace Research Institute. Details available at https://www.sipri.org/databases/milex 5 For more information, please see The 2017 Long-Term Budget Outlook, Congressional Budget Office, March 2017. Available at www.cbo.gov 6 Please see BCA Special Report, "Beware the 2019 Trump Recession," dated March 7, 2017 available at bcaresearch.com