Federal Budget Deficit Expands to 8.6% of GDP

The federal budget deficit has undergone significant fluctuations in recent years. With the latest data revealing a striking increase to 8.6% of GDP. But what’s driving this deficit expansion? We delve into the factors and their potential impact on the U.S. economy.

Tax Revenues and Receipts Decline

Tax revenues that were soaring at approximately 19.5% of GDP in FY 2022. In 1990s tech boom levels, have regressed to a long-run average of 17.4% of GDP. While worker paychecks and corporate profits contribute steadily, dwindling receipts from capital gains, surging business tax refunds, and reduced Federal Reserve remittances have precipitated a 10% drop in overall receipts.

Multiple spending categories, including Social Security, major healthcare programs, national defense, and veterans’ programs, have witnessed steady growth, contributing to the expanding deficit. Despite the pandemic’s end, government spending remains three percentage points higher than pre-pandemic levels.

Interest Spending Surges

Interest spending has surged due to higher interest rates. Although it currently stands at 2.3% of GDP, well below previous peaks, it is expected to rise further as maturing debt is reissued at higher rates.

The forecast suggests federal budget deficits of approximately $1.9 trillion in FY 2024 and FY 2025, equating to 6.5-7.0% of GDP, double the average deficit of the past 50 years. While the risks are balanced, the likelihood of substantial fiscal consolidation remains low, at least until 2025.

Impact on Treasury Yields and Borrowing Costs

Large budget deficits may exert upward pressure on Treasury yields, with estimates indicating a 15-30 basis point increase in yields for each percentage point rise in the structural budget deficit. Higher Treasury yields can elevate borrowing costs across the economy, potentially affecting private investment and output growth.

Long-Term Fiscal Imbalance

Looking beyond 2025, the fiscal outlook remains concerning, with projections indicating a debt-to-GDP ratio of 181% by 2053, even assuming tax increases scheduled for 2026 occur.

U.S. Economy’s Resilience On Federal Budget Deficit

Despite these challenges, the United States maintains its ability to finance deficits, supported by a robust economy, the U.S. dollar’s global dominance, and the deepest market for U.S. Treasuries. However, the long-term fiscal imbalance presents a structural headwind for the economy.

Red Ink Rising: Fiscal Policy in Focus

While monetary policy has garnered significant attention lately, fiscal policy has returned to the forefront. The debt ceiling debate, potential government shutdown, and Fitch Ratings’ downgrade of the U.S. sovereign credit rating have highlighted the challenges posed by fiscal issues. A closer look reveals a high and growing general government debt burden, expected fiscal deterioration, and larger-than-expected Treasury security issuance, all contributing to the evolving fiscal landscape.

Federal Budget Deficit Fluctuations

The federal budget deficit has experienced wild fluctuations, from 4.6% of GDP before the pandemic in FY 2019 to 15% in FY 2020 during the pandemic’s economic turmoil. It later receded to 5.5% of GDP by FY 2022. However, the deficit has surged to an astounding 8.6% of GDP today. This raises concerns about the medium- to longer-term fiscal outlook, given the already substantial deficit, an aging population, and rising interest rates.

Federal Tax Revenues Normalizing

Before the pandemic, federal tax receipts were around 16% of GDP, slightly below the 50-year average of 17%. The economic recovery in 2021 and 2022 pushed revenues to about 19.5% of GDP, surpassing pre-pandemic levels. However, recent data shows revenues returning to more typical levels, with a $400 billion decrease year-to-date.

Drivers Behind Revenue Decline

While paycheck withholdings and payroll taxes have remained stable, non-withheld taxes, especially capital gains, have dwindled. Business tax refunds have also surged, driven by delayed utilization of COVID-era tax credits like the Employee Retention Tax Credit (ERTC). Moreover, Federal Reserve remittances have plummeted.

Non-interest spending has risen across various sectors, including Social Security, major healthcare programs, national defense, and veterans’ programs. This growth persists, contributing to the deficit’s widening pre- and post-pandemic.

Interest Spending Challenge

Federal interest spending, though currently at 2.3% of GDP, presents a challenge as interest rates rise. Projections indicate interest costs could reach 2.50% to 2.75% of GDP by year-end 2023, with uncertainties beyond.

The forecast suggests persistent budget deficits, with the deficit as a share of GDP reaching 6.5-7.0% in FY 2024 and FY 2025. While there are potential mitigating factors, sizable deficits appear likely.

Impact on Treasury Yields

Large deficits may exert upward pressure on Treasury yields, influencing borrowing costs throughout the economy. Research indicates a one percentage point increase in the structural budget deficit may correlate with a 15-30 basis point rise in longer-term Treasury yields.

Long-term projections indicate a concerning debt-to-GDP ratio, potentially reaching 181% by 2053, even accounting for scheduled tax increases in 2026.

Resilience Amid Challenges

Despite these fiscal challenges, the United States’ capacity to finance deficits remains supported by its robust economy, global reserve currency status, and deep Treasury market. However, the long-term fiscal imbalance poses a structural challenge for the U.S. economy.

In summary, fiscal policy has re-emerged as a critical consideration amid fluctuating federal budget deficits and their potential implications for the U.S. economy.

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Disclaimer: Please note that this article serves solely for informational purposes and should not be construed as financial advice. We strongly advise readers to conduct thorough research and consult with financial professionals before making any investment decisions