News & Analysis » US

The Federal Budget Outlook and the Election

Contributed by Raymond James

With one month remaining in the fiscal year, the federal government appears to be on track to record a deficit of about $1.130 trillion, down from $1.296 trillion in FY11 and $1.294 trillion in FY10. Such large deficits can’t continue indefinitely and this year’s election should, in part, be about how, and how fast, the deficit will be trimmed in the years ahead. However, it’s important to look at where the deficit came from.

Everyone “knows” that large deficits are due to runaway government spending right? Let’s see. We’ll set the Way-Back Machine to September 2008 – Lehman implodes, Freddie and Fannie have been taken into government conservatorship, we have a global financial panic. The nonpartisan Congressional Budget Office releases its Economic and Budget Outlook Update. The CBO’s projections, as usual, are based on current law. The deficit was higher than expected in FY09-11, largely related to recession-related spending (the fiscal stimulus, extended unemployment insurance benefits, etc.). Now here’s the interesting thing. The 2008 projection of federal outlays for FY12 is very close to being spot on. Moreover, due to last year’s budget deal, the CBO currently projects that federal spending for the next two years will be lower than was projected in 2008. That’s not to say that federal spending isn’t “too high” or “ill spent.” It’s merely pointing out that spending is currently not any higher than one would have anticipated back in 2008.

What stands out in the graph of the CBO’s 2008 budget projections is the shortfall (more than $1 trillion) in forecasted tax revenues. The biggest part of this difference is due to the severe recession and gradual economic recovery. Tax revenues sank in the recession. They have improved as the economy has recovered, but the pace has been moderate. Revenues also differ from the 2008 CBO projections due to the 2% payroll tax reduction and the two-year extension of the Bush-era tax cuts.

If, as demonstrated, the bulk of the deficit is due to weak tax revenues, that doesn’t mean that we should necessarily raise tax rates. Raising tax rates in the current environment, as is set to happen in the fiscal cliff, would slow the recovery. Instead, the revenue shortfall should be decreased largely by policies to bring the level of the economy back to its potential. Accommodative Federal Reserve policy would help. Note that spending cuts set for 2013 spare Social Security and Medicare and are expected to fall mostly on defense.

This year’s presidential election should be about how we will reduce the deficit in the years ahead. This isn’t an easy problem. With substantial entitlement burdens and strong resistance to tax increases, compromise will be painful.

Election campaigns that include an incumbent president are largely driven by the economy. However, it’s typically not just the strength of the economy that counts, but whether conditions are improving. As is well known, this election is expected to depend on the outcomes in eight or ten key states. Currently, states in which Obama is leading account for 201 electoral votes and states in which Romney is leading account for 206 electoral votes. The following ten toss-up states account for 131 electoral votes (note that Obama is currently leading in Michigan and Pennsylvania, but I have added them to the mix because they are seen as “flip-able”). A candidate needs at least 270 electoral votes for a victory. At this point, Romney can win if he simply takes Florida, Pennsylvania, and Ohio.

The unemployment rate is down from a year ago in all but one of these states, which suggests that Obama may have a reasonable chance of winning. Note that we’ll get three more employment reports before the November 6 election.

There are three presidential debates set for October 3, 16, and 22. In recent years, these have degenerated into competing “commercials” without much substance. Voters shouldn’t settle for that. We need a long-term plan to reduce the deficit. It would be nice to hear details about how we can get there.