Yesterday, the Joint Select Committee on Deficit Reduction (“Super Committee”) announced that it was not able to come to an agreement to cut at least $1.2 trillion from the budget deficit. Bill Longbrake, Executive-in-Residence at the Center for Financial Policy, addressed some questions about the implications of the committee’s failure, potential effects on the U.S. economy, and the possibility for further Congressional action.
Q: What are the most significant implications of the automatic, across-the-board spending cuts that will result from the Super Committee’s (Joint Select Committee on Deficit Reduction) failure to reach an agreement? Are there any other options left to avoid this?
A: The annual sequester, as it is officially called, would amount to $109 billion, divided equally between domestic spending (approximately half discretionary and half Medicare) and security spending (mostly defense). The cut to defense spending would equal about 8% of the current defense budget and does not include Iraq and Afghanistan war expenditures. Entitlement programs, such as Social Security and Medicaid, are specifically exempted and reductions in Medicare are capped at 2%.
Congress could repeal or revise the sequester during 2012. This seems unlikely and President Obama has promised to veto any legislation that weakens the sequester. There is a small chance of very modest deficit reduction legislation prior to 2013, which could be tied to extension of the payroll tax reduction or extension of extended unemployment tax benefits.
Q: The Super Committee’s failure has built up uncertainties about a range of tax benefits, including the payroll tax cut and extended unemployment benefits, that are set to expire at the end of the year. If these benefits are eliminated, are we likely to see a significant effect on the U.S. economy?
A: The 2% payroll tax cut and extended unemployment benefits expire at the end of 2011. Unless both are extend, expiration will result in substantial fiscal drag in 2012 – $110 billion for the payroll tax (0.7% of GDP) and $49 billion for extended unemployment benefits (0.3% of GDP).
GDP growth during 2012 generally is expected to range between 2.0% and 2.5%, assuming extension of both tax breaks. Without either, GDP growth would fall to 1.0% to 1.5% and could be even lower, with a good chance of recession, if the sovereign debt crisis in Europe worsens materially.
The stage is set for fiscal policy to have a potentially very significant adverse impact on GDP in 2013. Under current law, government spending and tax revenues are set to reduce the deficit by $535 billion, or approximately 3.5% of GDP, in 2013. This includes $109 billion in spending cuts (the sequester), $255 billion from the expiration of the Bush tax cuts, $112 billion in the expiration of the payroll tax reduction (assuming Congress extends this tax cut for 2012), $21 billion from Medicare tax increases mandated by the Health Care Reform Act, and $38 billion from expiration of the alternative minimum tax reduction.
Depending upon the outcome of the 2012 election, it seems likely that Congress will enact significant tax reform in 2013 which will have the impact of reducing the budget deficit and stabilizing the public debt to GDP ratio, or even put that ratio on a declining trajectory.
Q: After a long, drawn out process to raise the debt ceiling, S&P downgraded the US’s rating to AA+ in August. How likely is another downgrade due to the committee’s inability to reach a deal?
A: There are three credit rating agencies – S&P, Moody’s and Fitch. All three have indicated that an immediate rating downgrade is unlikely in the wake of the Super Committee’s failure. However, both S&P and Moody’s have stated that a rating downgrade is likely in 2013, if significant long-term deficit reduction does not occur. Previously published rating agency statements provide the following guidance:
- S&P – AA+: Rating downgrade to AA possible within next two years, if there is less spending reduction than $1.2 to $1.5 trillion, higher interest rates, or the long-term trajectory of the public debt to GDP ratio worsens.
- Moody’s – AAA: Downgrade will occur if fiscal discipline weakens in 2012, deficit reduction is not adopted in 2013, the economic outlook deteriorates, or government funding costs rise appreciably above current expectations. Because of the automatic sequester provision, failure of the Super Committee will not, by itself, lead to a rating downgrade.
- Fitch – AAA: Failure of the Super Committee and a worsening of the U.S. economic outlook will most likely result in a “Negative Outlook”, which means there would be a 50% chance of downgrade within the next two years. Fitch committed to review the rating if the Super Committee failed, which could result in a change in the outlook to “negative”.
Q: Are we likely to see a return of the “Gang of Six” to try to come up with a bipartisan proposal to reduce the budget deficit?
A: Failure of the Super Committee and President Obama’s decision not to attempt to intervene means that both Republicans and Democrats have decided to let the issues of tax policy and deficit reduction be a 2012 election issue. This means that it is unlikely that there will be serious attempts to consider tax reform during 2012. However, because this is now an election issue, there will be considerable debate in coming months. It is possible, perhaps even likely, that there will be limited bipartisan proposals, such as the “Gang of Six’s” 2011 proposal, but it is unlikely that Congress will do anything during 2012.