Tax reform, infrastructure spending and the national debt are topics likely to take center stage in Washington in the spring of 2017. The debt ceiling returns as a potentially potent political factor after being temporarily suspended in late 2015 to avoid any Congressional vote during the 2016 election year. This time around, Beware the Ides of March!
The need to raise the debt ceiling will be reactivated at $20.1 trillion somewhere in the second quarter as the U.S. national debt will be at its maximum allowed level, even with emergency measures. There is no doubt that with Republicans controlling the White House, Senate and House of Representatives, the challenge of the debt ceiling will be overcome. The burden of governing is on Republicans and they will ensure that there will be no government shutdowns on their watch. Nevertheless, how the debt ceiling issue is resolved will provide a very strong signal to the equity and bond markets as to the principles and assumptions that will guide fiscal policy over the next four years or more.
U.S. Treasury markets have moved in the direction of preparing for a massive issuance of new debt, rising inflation, and for the Federal Reserve to raise short-term rates. By contrast, U.S. equity markets have embraced the possibility of corporate tax cuts, lighter touch regulations, and eventual government-sponsored infrastructure spending. So, a lot is at stake in the markets as the debt ceiling is confronted.
The Four Choices
There are at least four choices on how to manage the debt ceiling. Two of them are to (a) just abolish it, or (b) just raise it.
The debt ceiling goes back to 1917 when the law was enacted to make it easier to finance U.S. entry into World War I. At the time, the Constitution was interpreted such that Congress was required to authorize each and every issuance of U.S. government debt. The debt ceiling put a hard limit on the amount of money the U.S. government could borrow, while giving the U.S. Treasury full discretion as to how to raise the money to pay the nation’s bills, so long as the total debt remains below the ceiling. We doubt Congress would want to return to the WWI approach of voting on each and every new debt issue. So, abolishing the debt ceiling is probably a non-starter.
Equally, just raising the debt ceiling may also be politically unpopular, given the symbolism of the debt ceiling as a constraint on government excess. There is the possibility that the usual rancor over raising the debt ceiling could be a thing of the past now that Republicans control the executive and legislative branches of government. The rub might lie in the fact that the Republican Party is not a monolithic entity when it comes to policy positions on fiscal discipline, with some of its elected representatives consistently voting against raising the debt ceiling to reflect the conservative aspirations of their constituencies. That thread of conservatism was perhaps most evident in the rural populism that was the core of the Republican victory in the 2016 elections and which embeds a strong theme of smaller government. This means that navigating the debt ceiling may be the first real challenge of the Republican-led Congress. So, perhaps, we should explore some more creative alternatives that link fiscal policy to the debt ceiling.
A third option could be to adopt a rule to make raising the debt ceiling automatic when the budget is passed and then signed into law. The debt ceiling gets its political potency from the fact that Congress has to separately authorize spending and then provide the legal basis for raising the debt to pay the bills. This can create an inconsistency in fiscal policy when the budget requires more debt than allowed by the debt ceiling. Once upon a time, this inconsistency was resolved by the “Gephardt Rule” – named for former House Majority leader Richard Gephardt (Democrat, Missouri) – which automatically raised the debt ceiling as soon as Congress passed a new budget for the coming fiscal year. The Gephardt Rule meant that lawmakers did not have to cast a direct vote to raise the debt ceiling. This procedure was, however, repealed by Republicans in 1995 when they took over control of the House of Representatives. Since 1995, especially when the Republicans have controlled the House of Representatives, there have been several contentious battles over raising the debt ceiling, including some disruptive albeit temporary government shutdowns. Going back to a “Democratic” solution is probably a non-starter this time around.
A fourth and, perhaps, even more intriguing choice would be to link the debt ceiling to nominal GDP. The debt ceiling could be set as a percentage of nominal GDP, and then have that percentage decline in future years. Given that the national debt is around 105% of nominal GDP now, one could set the ceiling through 2020 at, say, 120% of GDP, to accommodate a budget deficit of 5% of GDP for a few years. After that, the Republicans could signal their intention to reduce the debt-to-GDP ratio by having the percentage progressively fall back toward some long-term target, say 80% by 2030.
The concept of linking the national debt to the level of nominal GDP may well have some intuitive appeal for those seeking large tax cuts. Cutting the highest tax rates for personal and corporate income is a key plank in the Republican Party platform. The argument for lower marginal tax rates hinges critically on the theory that lower taxes can, over time, pay for themselves by generating much higher real GDP growth. Indeed, one can expect the Republican budget for the new Congress to include estimates of real GDP growth of 3.5% or even higher in the 2018-2024 period so that the proposed tax cuts will appear to more than pay for themselves and lead to progressive declines in the debt-to-GDP ratio.
Tax Reform, GDP Growth, the National Debt: The Reagan Experiment
During President Ronald Reagan’s tenure in the 1980s, marginal tax rates were lowered twice, from 70% all the way down to 28%, and there was a reasonable degree of meaningful, bipartisan tax simplification as well. We can expect proponents of tax-cut plans in this Republican Administration to invoke parallels with the Reagan era.
Reagan embraced supply-side economics as made popular by Professor Art Laffer, who argued then (and now) that lower marginal tax rates can have a profound impact on raising economic growth leading to much higher tax revenues and lower budget deficits. This theory is known as the “Laffer Curve” and the intuition is extremely appealing.
Unfortunately, the theory embeds some rather heroic assumptions, which if they do not come true, could lead to much higher levels of national debt. The “Laffer Curve” depends critically on the embedded assumption of a very simple tax code without loopholes and special deductions. The more complex the tax code, the less likely marginal tax rates make much of a difference for economic growth. We have no details yet of what the tax cut might look like. However, special interest groups have historically shown that they are very good at defending their loopholes. Before we embrace ideas of stronger growth, we will need to see meaningful tax reform, not just cuts in tax rates.
A second item of concern about higher growth forecasts is the starting point. When Reagan took office in 1981, the marginal tax rate on personal income was 70%. As previously noted, it was cut to 28% in two steps by Regan. This was a really big cut in the marginal tax rate. The statistical evidence from the Reagan era is worth a look. In 1983, federal government receipts averaged 17.73% of GDP, and by 1998, the average had risen to 18.33%. So, the federal government did take in more money after cutting taxes, as a percentage of GDP. But the increased government receipts were woefully inadequate to stem the flow of red ink, and the national debt rose from 31% of GDP in 1981 to just under 50% when Reagan left office in 1989, even with healthy real GDP growth. We are skeptical of the claims for higher real GDP growth this time around. If the tax cuts are tilted toward the wealthy, then we may see more savings than additional consumption. And, the United States is not starting at 70% marginal tax rates, but closer to 40%, so the change is smaller than during the Reagan days. Lastly, it is not at all clear that significant tax simplification is in the cards.
There are more reasons to be worried about future growth, tax cuts or not. The Reagan years included a nice rebound in growth from the deep 1980-1982 recession period, which would have happened with or without tax cuts. This time around, the Republicans are inheriting a steadily, yet modestly, growing economy with headline unemployment under 5%, an aging population, sluggish labor force growth, and massive student loans constraining the spending habits of the millennial generation. Tax cuts may lead to a little higher growth, but the economic starting point and the demographic headwinds argue for caution in estimating how much additional economic growth is possible.
In our analysis, we come to the conclusion that any debt ceiling compromise among the different factions within the Republican Party could very well roil both equity and bond markets. Equities have had a very strong rally after the 2016 presidential elections, while bond yields rose sharply. And, equity volatility declined to very low levels while bond volatility increased. The market reactions are sustainable in the scenario that simultaneously involves (a) a big tax cut, (b) strong and sustained economic growth with no intervening recession, and (c) very strong discipline on federal government spending. If one cannot handle these assumptions, then one may want to consider the scenario in which equities may have a much more challenging year with much more volatility than observed since the November elections. Beware the Ides of March!