U.S. Fiscal Issues: The Debt Limit Debate
On April 8, 2013, Goldman Sachs Research published an updated report on the U.S. debt limit entitled, “The Next Debt Limit Increase: Harder Than the Last One but Easier Than 2011.”
Full Text of the Report
- The debt limit will need to be raised again this year, probably by August. The deadline is still a few months away, but over the next few weeks the direction the debate takes may become clearer. At this point it appears likely that the next debt limit increase will need to be accompanied by more significant policy concessions than the increase enacted in February. That said, we don't expect the upcoming debate to be as disruptive as the debt limit increase in 2011 was.
- The White House has indicated that the budget the President submits to Congress on April 10 will include deficit reduction measures in line with the offer he made to House Republicans in late 2012. The main difference between those proposals and prior budgets is a proposal to index benefit programs, including Social Security, and aspects of the tax code to a slower-growing inflation measure known as "chained CPI."
- Congressional Republicans may begin to formulate a strategy for the upcoming debt limit increase over the next few weeks. Initial comments from Republican leaders imply they will seek major spending reductions, making the next increase difficult. However, we suspect that Republicans will eventually allow the debt limit to increase with more incremental policy changes in return. This could include more targeted entitlement changes (like the chained CPI proposal in the President's budget), some type of commitment on tax reform, or other budget process reforms.
The fiscal debate thus far this year has turned out to be less disruptive than expected. After the "fiscal cliff" agreement at the start of the year, Congress faced a series of fiscal deadlines: the debt limit was expected to be reached in late February, sequestration was set to take effect March 1, and government funding was scheduled to expire March 27, leading to a government shutdown if not extended. However, the debt limit was raised well ahead of the deadline with no spending cuts attached; Republican lawmakers sought only to force the Senate to pass a non-binding budget resolution, which it did. The possibility of a government shutdown faded in March as the House and Senate agreed to bipartisan legislation to extend spending authority. Although we still believe sequestration will weigh on growth in Q2 and Q3, markets have so far taken the onset of the cuts on March 1 in stride.
With those deadlines having passed, the next issue on the agenda will be competing budget proposals and the need to increase the debt limit once again, after it is reinstated next month.
The President's Budget
The President will submit his budget to Congress on Wednesday, April 10. Like the congressional budget resolutions the House and Senate passed last month, the President's budget is mainly a political document and does not become law. That said, it represents the President's current position on fiscal reforms, and the White House has indicated that the forthcoming budget will track the proposal to congressional Republicans late last year, which included $680bn in new revenue and $930bn in spending reductions, plus interest savings.
The most important change from last year's budget is expected to be the "chained CPI" proposal, which would index benefit programs and the tax code using a slower-increasing measure. Traditional CPIs track the prices of a representative "market basket" of goods based on spending patterns that are updated once every two years. (CPI-U tracks prices of goods consumed by "all urban consumers" while CPI-W tracks "urban wage earners and clerical workers.") In contrast to the traditional measures, chained CPI tracks a basket of goods that changes each month based on estimated changes in consumer spending patterns, to reflect the shift in consumption from higher priced goods to similar lower priced goods. As a result, chained CPI rises more slowly than traditional CPI: since the start of the index in 2000 it has grown by an average of 27bps per year more slowly than CPI-U; the gap since 2008 has been narrower, at around 16bps. Chained CPI would be used to index three general areas of the budget (note that it would have no effect on Treasury Inflation Protected Securities):
1. Social Security: Benefits are currently indexed to CPI-W. The Congressional Budget Office (CBO) estimates that using chained CPI (assuming a 25bps slower annual growth than CPI-W) would reduce Social Security benefit spending by $127bn from 2014 through 2023. In 2023, benefit spending would be 1.7% lower under chained CPI than under CPI-W.
2. Other benefit programs: Several other benefit programs are tied to CPI-U, either directly through indexation of benefits or indirectly through indexation of income-related eligibility levels. CBO estimates that switching to chained CPI would reduce spending by $88bn in those programs over ten years.
3. Tax code: Tax brackets and some other parameters of the tax code are indexed to CPI-U. Slowing the rate at which they increase would generally result in more income to be taxed in higher brackets, resulting in $124bn more revenue over ten years according to CBO.
The President's proposal would provide offsetting benefits to protect some beneficiaries of affected programs. As a result, the White House estimated the President's chained CPI proposal would reduce spending by $130bn over ten years, rather than the $216bn in spending reduction CBO estimates from the change.
The Upcoming Debt Limit Debate
On February 5 the President signed legislation that suspended the $16.4 trillion debt limit through May 18, when the limit takes effect again, adjusted for debt issued in the interim (probably around $400bn, resulting in a $16.8 trillion limit). Once reinstated, the Treasury will be forced to use accounting maneuvers to continue borrowing, which it will probably be able to do until sometime in August. Congress will need to pass another debt limit increase by then.
Raising the debt limit will be more difficult than it was earlier this year. In January, Republicans made a tactical decision to focus the spending debate on sequestration rather than on the debt ceiling. At that point, using the debt limit for negotiating leverage looked like an increasingly risky strategy, and following the "fiscal cliff" just a few weeks earlier the public had grown weary of deadline-driven fiscal debates. Instead, Republican leaders committed to present a budget plan that balanced within ten years and to focus instead on sequestration. As a result, House Republicans managed to pass their legislation suspending the debt limit without any spending cuts attached.
Congressional Republican leaders now need to present their members with a new justification for raising the debt limit later this summer. House Speaker Boehner told reporters last month that the preliminary position of House Republicans would be to cut spending by the same amount (over ten years) as the increase in the debt ceiling. Senate Minority Leader McConnell has said Republicans will not agree to raise the debt ceiling without addressing entitlement spending in some way. While Republicans have said they will push for additional spending cuts, the likelihood of a repeat of the disruptive 2011 debate still seems fairly low to us. The most obvious argument against another disruptive debate is simply that most members of Congress acknowledge that once the debt limit is reached it must be raised, and as a result Republican leaders do not appear to be convinced the debt limit gives them very much leverage. For example, when asked in a press conference in a few weeks ago whether the debt limit provides Republicans political leverage, Speaker Boehner responded: "there might be some there, but I'm not going to risk the full faith and credit of the federal government."
While we expect the next debt limit debate to be less disruptive than the 2011 debate, congressional leaders will probably still need to agree on some policy concessions that can be attached to win enough support for the increase. It seems likely that discussions of a "grand bargain" on deficit reduction will take place for the third time, following failed attempts in 2011 and 2012. While there is always a possibility that Congress could adopt a broader package of fiscal reforms--including increases in tax revenue--this does not appear that likely to us. Still, there may be more incremental options:
1. Chained CPI. One option might be to attach the chained CPI proposal the President will include in his budget. The White House has made clear that it views its proposal as a whole, not a list from which Republicans can choose. However, it might be the type of change that allows a debt limit increase to move forward: the provision has symbolic political value to Republicans because it addresses entitlement spending; many congressional Democrats dislike benefit reductions but might dislike them less once vulnerable populations were addressed. Moreover, unlike most other fiscal policy changes, this single provision would cut spending and raise revenue without raising tax rates.
2. Tax reform. Leaders of the tax-writing committees--the House Ways and Means Committee and Senate Finance Committee--are working on legislation to simplify the tax code. The House committee has already released parts of its proposal as drafts for public comment, while the Senate committee is working toward a target of preparing legislation prior to the debt limit deadline in August. Beyond the difficulty of agreeing which tax preferences to limit or repeal, there is little agreement on whether the exercise should be revenue neutral, as most Republicans would prefer, or raise revenue, as some Democrats suggest. While tax reform that raises a substantial amount of revenue is probably feasible only in the context of a "grand bargain" that also involves entitlement reform, there might be more common ground on corporate tax reform, where the President has indicated that he supports revenue neutral reform.
3. Changes to sequestration. Neither party is happy with sequestration, and the desire to soften or rearrange the cuts might grow once the effects have been more broadly felt. Republicans are likely to press for a softening of the defense cuts, while Democrats would like to rework the domestic cuts as well.
Overall, the risks around the debt limit debate appear fairly balanced. There is the obvious risk that the political debate increases policy uncertainty over the summer, just as it did in mid-2011 and late 2012. However, markets seem to have gotten more accustomed to these fiscal debates, and may give lawmakers the benefit of the doubt. More importantly, while we don't believe a "grand bargain" has very high odds of enactment, the likelihood that Congress agrees on a package of spending cuts and tax increases is probably greater than the likelihood that the debt limit is breached forcing the Treasury to delay scheduled payments. Such an agreement, if it were to occur, would probably not meaningfully increase fiscal drag in the near term, since changes to entitlement programs typically take several years to phase in. And while we expect the cuts under sequestration to remain in place, it is at least possible that a broader budget compromise could soften some of those cuts in return for longer-term reforms. So while our base case remains a fairly modest agreement to accompany the next debt limit increase, there are risks to that assumption in both directions.
Jan Hatzius - Goldman, Sachs & Co.
Alec Phillips - Goldman, Sachs & Co.
Jari Stehn - Goldman, Sachs & Co.
Kris Dawsey - Goldman, Sachs & Co.
David Mericle - Goldman, Sachs & Co.
Shuyan Wu - Goldman, Sachs & Co.
Michael Cahill - Goldman, Sachs & Co.
Legal and Certification Disclosures
We, Jan Hatzius, Alec Phillips, Jari Stehn, Kris Dawsey, David Mericle, Shuyan Wu and Michael Cahill, hereby certify that all of the views expressed in this report accurately reflect our personal views, which have not been influenced by considerations of the firm's business or client relationships.
For Reg AC certification, see above. For other important disclosures, go to www.gs.com/research/hedge.html