Mandatory spending outpaces discretionary spending
The below graph reflects the trend in mandatory spending of the US government. Total spending (the black line) reflects an ongoing rise in total spending levels, and reflects current spending levels that are well above historical levels, standing at 13% of gross domestic product (or GDP) versus a historical average of closer to 10% of GDP. These mandatory spending items consist of “entitlements”—the specific target of the Republican Party, led by Republican Speaker of the House John Boehner. The Obama Administration’s Affordable Care Act’s growing expenses will be reflected under the Medicaid line item (the green line) as of 2013. (The data below is through 2012.) This article will examine the trends in entitlement-related spending in relation to the growing US government deficit, and consider the implications for US equity investors.
Growth in mandatory spending
In the 1960s, mandatory spending accounted for roughly 30% of all government spending. By 2004, this level of spending had doubled—reaching 60% of overall government spending. Mandatory spending stands at just over 62% of the US budget today, though it’s expected to reach 70% of the federal budget in ten years. These numbers are based on the “conservative estimate,” based on the “baseline projections” of allowing the Bush Tax cuts discussed in the third article in this series to expire (Congressional Budget Office estimates). If the Bush Tax cuts don’t expire, or at least don’t expire in their entirety (which they probably won’t), then we can expect discretionary spending to exceed the estimates by a considerable degree. This is what’s scaring the conservatives. But the Republicans can’t have their cake (the Bush Tax Cuts) and eat it too (the declining debt levels,) unless they eat their cake in conjunction with fiscal Hydroxycut (cuts in entitlements).
Composition of mandatory spending
Social security comprises 33.9% of mandatory spending, Medicare—24.7%, and Medicaid—11.5%. Income security, including unemployment compensation, comprises 15.2% of mandatory spending. During the recent economic crisis, unemployment compensation reached 2% of GDP, though it currently stands closer to 1% of GDP, and is expected to decline to its historical average of closer to 0.60% of GDP within a few years.
Ending the 2001 and 2003 Bush Tax Cuts: The baseline scenario
Extending the 2001 and 2003 Bush Tax Cuts: The alternative fiscal scenario
The focus of the current budget debate in Washington is very much on the items in the above graph—the components of discretionary spending, and their respective growth rates. The Bush Tax cuts of 2001 and 2003 were set to expire at the end of 2011, though they were extended two more years under Obama. While the Republican Party feels these tax cuts were intended to have been permanent in nature, the Democratic Party doesn’t seem to be in full agreement. These tax cuts were achieved through the arcane budget process known as “reconciliation,” which is the same process that was used to allow the Affordable Health Care Act to become law. The issue that the US faces going forward is whether or not it will allow these changes to the tax code to persist, or end as originally documented. In fact, the Obama Administration has already rolled back some of these Bush Tax Cuts. The “fiscal cliff deal” of the Obama Administration last year allowed some of those Bush tax cuts to expire—namely, the change in capital gains tax rates from 15% back to 20%. The issue remains. Will the Obama Administration allow the top tax bracket rates to go up 3% or more—essentially back to the 1993 Clinton levels or higher?
Estimated debt growth with Obamacare: The baseline scenario
Currently, in 2013, the Congressional Budget office estimates that the total debt held by the public is 75.1% of US GDP, at roughly $12 trillion. Should the rest of the Bush Tax cuts expire per the “baseline scenario,” the US would revert back to a higher tax rate environment, and debt growth would not be an issue—estimated to decline slightly from the current 75% of GDP to 73.6% of GDP in ten years.
Estimated debt growth with Obamacare: The alternative scenario
However, should the remainder of Bush Tax cuts remain in place, US tax revenues would be smaller than originally planned (“the alternative fiscal scenario”) and publicly held debt to GDP would gradually rise to 83% of GDP. This is why the Republicans feel that additional discretionary spending needs to decrease, as opposed to increase, and that Obamacare is simply too expensive, as US debt levels should come down and not go up. This is also why the Democrats would like to increase the taxes on wealthy Americans, and feel that the Bush Tax cuts (not to mention Bill Clinton’s 1997 cut of capital gains from 27% to 20%) went too far. The Democrats seem to be reaching for the Clinton tax regime of 1993, which raised taxes on the wealthy and incensed the Republicans.
Kudlow and the Laffer Curve: The strong do what they will
Larry Kudlow would likely point to the Reagan Era tax cuts, as well as Clinton Capital gains tax cuts in 1997, as the key driver for the recovery of the US economy post–oil shock and post–inflation shock of the early 1970s to the early 1980s. As capital gains tax rates declined through 1997, there was significant growth in investment in the US, including technological innovation, which led to the robust economic data that followed until 2001. So Kudlow would argue, as did Ronald Reagan, that the top tax bracket of 50% or higher for the wealthiest Americans was far too high, and that capital investment was being overtaxed. In fact, Arthur Laffer acolyte Larry Kudlow might even argue that Clinton’s tax cuts of 1997 were an admission that the Clinton tax hikes of 1993 were a big economic mistake. However, the reality is more likely that Clinton simply needed to regain control of the House, which had turned against him and gone Republican, and get the right-wing Newt Gingrich monkey off his back. Politics likely triumphed over economics on that tax reform waffle job—not the other way around. Though Larry Kudlow, like most Republicans, will take tax breaks any way he can get them.
Reich and academics: The weak suffer what they must
Robert Reich would likely cite both US and academic studies that demonstrate that the post–Reagan Era tax rates are far too low, and suboptimal in generating tax revenue. The Congressional Budget Office of research performed in 2005 suggested that reducing tax rates by 10% from current levels resulted in a recovery of only 28% of such foregone revenue. In other words, 72% of the loss in tax revenue went straight to the federal debt. Plus, the CBO concluded that the tax revenue shortfalls, which primarily benefitted the wealthy, would be made up for by future taxes borne relatively evenly by all tax payers. Other academic studies estimate optimal tax rates in the US at closer to 65%—perhaps more consistent with the pre-Reagan levels. As Franklin D. Roosevelt had pointed out, “No American citizen ought to have a net income, after he has paid his taxes, of more than $25,000 per year.” That would approximate $350,000 in 2013 dollars. FDR has suggested that the top tax bracket might be 100%.
As such, academic research seems to suggest that trickle-down economics may in fact function like a process of leeching soil, in which the wealthy capture the lion’s share of the gains from the leeching process in the near term, while the broader tax base is left with a less fertile soil to till in the long term. In short, research has suggested that the post–Reagan Era tax levels can be characterized as a short-term slash-and-burn tactic that engenders negative long-term economic consequences. However, the global economy has changed dramatically since the fall of the Berlin Wall, and the utility of high-tax regimes could be fading, as the international competition for capital has intensified. More than ever, countries must be careful of pricing themselves out of the global capital markets in terms of tax policy—especially if their labor pool has productivity issues.
Do with their death bury their Congressional strife…
Putting an end to the debt debate through the development of some form of consensus on the marginal effects of taxation on economic growth in the post-modern global economy would be a step in the right direction. However, given the large number of economic variables that change under differing economic circumstances, and continually changing regulatory regimes (think Basel III and global banking), such a task remains difficult—if not impossible. Republicans will remain convinced that low taxes and small government are the best means to achieve economic growth, regardless of ambient economic or regulatory conditions, while the Democrats will cling to their views that investing in the middle class, despite the near-term deficit growth involved, will likely lead to a more sustainable path of financial growth. It’s the current debate that will decide the prevailing ideology until the next election.
Shutdown investing: Outlook
Should Congress and the President fail to make progress on budget discussions, investors may wish to consider limiting excessive exposure to the US domestic economy, as reflected more completely in the iShares Russell 2000 Index (IWM). Alternatively, investors may wish to consider shifting equity exposure to more defensive consumer staples–related shares, as reflected in the iShares Russell 1000 Value Index (IWD). Plus, even the global blue chip shares in the S&P 500 or Dow Jones could come under pressure in a rising interest rate environment accompanied by sequester-driven declines in consumption, investment, and economic growth. So investors may exercise greater caution when investing in the State Street Global Advisors S&P 500 SPDR (SPY), Blackrock iShares S&P 500 Index (IVV), or the State Street Global Advisors Dow Jones SPDR (DIA) ETFs. Until consumption, investment, and GDP start to show greater signs of self-sustained growth, investors may wish to exercise caution, and consider value and defensive sectors for investment.
© 2013 Market Realist, Inc.