Chief Economist, Invesco Ltd.
Sequestration – the mandatory reduction of federal government spending – arises from the Budget Control Act of 2011, which was the closing event in the struggle over the debt ceiling between the two parties in Congress and the administration. In exchange for agreeing to raise the debt ceiling, Congress created the Joint Select Committee on Deficit Reduction, or the "supercommittee," to lay out a plan to reduce the deficit by $1.5 trillion over the next decade. If the supercommittee failed to agree on legislation to implement the cuts, automatic spending cuts would become effective.
Given the wide divisions between the Republicans and the Democrats, no agreement was reached. The automatic spending reductions were due become effective from Jan. 2, 2013, but the fiscal-cliff settlement postponed the start of sequestration for two months until March 1.
The Congressional Budget Office (CBO) estimates that sequestration reduces the federal budget authority – the amount government departments may receive – by $85 billion in the remainder of the current fiscal year ending Sept. 30, 2013, and by a further $108 billion in each of the eight fiscal years from 2014 through 2021.
Federal outlays outpace revenues
Ever since the 1960s, federal outlays have tended to run ahead of federal revenues. Following the step-up in both outlays and revenues during the late 1960s — associated with President Lyndon Johnson's Great Society programs and the Vietnam War — outlays remained on a consistently higher trajectory than revenues, with the brief exception of the tech-bubble years during 1999 through 2001. Two major contributing elements to the enlarged persistent deficits were:
- President Ronald Reagan's tax cuts and increased defense expenditures in the 1980s.
- Tax cuts and the war in Afghanistan under President George W. Bush in the 2000s.
From 1960 through 2010, federal outlays have averaged 19.8% of gross domestic product (GDP), while federal revenues have averaged just 17.5%. However, the Great Recession of 2008 and 2009 has had by far the greatest impact on both outlays and expenditures, temporarily driving outlays up to 25.2% of GDP and revenues down to 14.6% of GDP, both in 2009. Since these respective peaks and troughs, the gap between outlays and revenues has narrowed significantly from a maximum of 10.2% (cyclically adjusted) to 7% in 2012, as outlays have declined to 22.8% of GDP, and revenues have risen to 15.8%. According to CBO projections, the deficit is expected to narrow even further in the next three years to 2015.1
The CBO expects economic growth will remain slow this year at 1.4%, as gradual cyclical and structural improvements in the economy are offset by the "fiscal drag" from the narrowing budget deficit scheduled to occur under current law. From 2014, the CBO expects economic growth will pick up, causing the unemployment rate to decline and inflation and interest rates eventually to rise from their current low levels. Nevertheless, the unemployment rate is expected to remain above 7.5% through next year. If that happens, 2014 will be the sixth consecutive year with unemployment exceeding 7.5% of the labor force – the longest such period in the past 70 years.
If the current laws that govern federal taxes and spending do not change in the interim, federal revenues will rise to 19.1% of GDP by 2015, and federal outlays will decline gradually to 21.6% of GDP. From then onward, both revenues and outlays will broadly stabilize as a percentage of GDP until the early 2020s, when the deficit will widen again due to:
- Pressures of an aging population.
- Rising health care costs.
- Expansion of federal subsidies for health insurance.
- Growing interest payments on federal debt.
Deficits become the norm
Budget deficits became the norm during the 1970s, 1980s and until the late 1990s. The budget briefly moved into surplus during the years of the tech bubble from 1998 through 2001 but then reverted back to deficits. The deficits of the early 2000s resulted from the recession of 2001 through 2002. There was then a brief recovery and a narrowing of the deficits until 2007 before the unprecedented deficits of the next two years, 2008 and 2009.
However, the US budget deficit has already narrowed by about one-third from its peak of 10.6% in 2009 to 7.0% in 2012. The three factors contributing to the speedy reduction in the deficit are increased revenues and reduced outlays, as well as the recovery in real and nominal GDP.
The continuing improvement in revenues and the restraint on outlays mean that even without the fiscal cliff or sequestration, the budget deficit would have narrowed in 2013. However, the additional measures being taken — the tax hikes of early January and the expenditure reductions that will occur as a result of sequestration — imply that the budget deficit will shrink this year to $845 billion, or 5.3% of GDP, its smallest size since 2008. In the CBO's baseline projections, deficits continue to shrink over the next few years, falling to 2.4% of GDP by 2015.
As previously stated, deficits are projected to increase later in the coming decade for the four reasons listed above. As a result, federal debt held by the public is projected to remain historically high relative to the size of the economy for the next decade. By 2023, if current laws remain in place and there is no agreement to introduce either further spending cuts or additional revenue increases, the debt will grow to 77% of GDP and yet still be on an upward path.
Discretionary programs to take brunt of sequestration
Sequestration was first implemented under Ronald Reagan in 1985 to ensure legislated spending caps were observed. If expenditures exceeded those limits, cuts would be applied on a proportionate basis across the board to all federal programs to bring spending back within the overall ceiling. However, to prevent sudden changes to areas of spending that affected vulnerable parts of the population – the unemployed and elderly, for example – most of the big entitlement programs were exempted from cuts. The result is that the federal spending budget today can be split up into "mandatory" programs that are mainly exempt from any sequestration – with the exception of Medicare, which is subject to a maximum 2% cut – and "discretionary" programs such as defense and certain other nondefense programs.
Sequestration focuses mainly on these last categories of spending. This means that while the headline amounts are small as a share of total federal spending – the $64 billion cut this fiscal year is only 1.8% of total outlays – the cuts are actually applied to the much smaller base of discretionary programs and will amount to close to 5%. But within defense, President Obama has excluded military personnel, meaning cuts will focus on an even smaller base and amount to 8% of each subaccount. Finally, because five months of the fiscal year have already passed, the cuts must be even larger and will amount to 13% of most defense programs for the remaining seven months of the fiscal year.
How will sequestration affect real GDP?
The impact of sequestration on US real GDP growth in 2013 and beyond will depend broadly on three sets of factors:
- The size of the cuts and the respective fiscal multipliers applying to each tranche. The CBO estimates sequestration will reduce actual outlays in fiscal 2013 (to Sept. 30) by $44 billion, and by between $89 billion and $110 billion in the fiscal years 2014 through 2021. The $44 billion cut in 2013 will reduce defense spending by $22 billion, nondefense by $13 billion and other outlays (such as Medicare) by $9 billion. Extending the cuts to the calendar year takes the overall sequester to $60 billion, or 0.4% of GDP, in 2013.
Estimates of the short-run multiplier vary, but most economists use a multiplier of close to 1%, suggesting a 0.4% hit to GDP over the remainder of this calendar year and something like 0.6% annually thereafter.
- Favorable offsets to these factors coming from improving cyclical and structural forces, including monetary policy. At the same time, the fundamentals of the economy are gradually improving, and the Federal Open Market Committee seems likely to keep on an expansionary track all this year.
- Whether Congress will agree to make any changes to existing legislation to amend the scale of the cuts. Finally, Congress could amend current spending laws — for example, to allow the president more discretion to decide where the cuts will be concentrated or to authorize emergency appropriations for certain functions, such as defense or homeland security.
The CBO projects real GDP will increase by 1.4% in 2013. My forecast is 1.7%, after 2.2% in 2012.
Where John Greenwood has expressed opinions, they are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.