Is the US Seeing a Sustainable Fiscal Improvement?
US fiscal performance witnessed one of the largest deteriorations among AAA-rated sovereigns in the first half of the current decade. This trend was closely associated with the emergence of record imbalances in global savings and investment, which continue to present a major concern for the world economy and financial markets. Against this backdrop, and with the impact of ageing on public spending looming ever closer, Fitch Ratings has taken a closer look at recent trends in US public finances and the medium-term outlook.
US fiscal performance improved sharply in 2006. The general government deficit fell to 2.3% of GDP from a peak of nearly 5% in 2003, the primary (non-interest) balance was in surplus for the first time since 2001, and the ratio of government debt to GDP fell by nearly 2pp of GDP.
Most of the recent recovery in fiscal health can be attributed to a revival in revenue as wage income growth and capital gains boosted individual income tax collections over the past two years while strong profit growth boosted corporate taxes. However, the revenue/GDP ratio is likely to remain below its late 1990s average over 2007-2009, because the 2001-2003 tax cuts are still in place, relief on the Alternative Minimum Tax (AMT) is likely to be extended, and recent cyclical improvements in revenue are partly unwound.
Nevertheless, Fitch expects ongoing expenditure restraint to keep the deficit broadly stable in 2007 and 2008. Expenditure as a share of GDP remained below historical averages in the past five years despite a rapid build-up in military spending and accelerating healthcare spending. Congressional disagreements over discretionary spending priorities are likely to result in overall spending growth remaining subdued in the short to medium term.
Despite the recent fiscal improvement, general government debt remains nearly 4% higher than in 2000. At 54.6% of GDP, public debt was above the AAA median, and was the highest among all AAA sovereigns as a share of revenue. Moreover, the increasing reliance on foreign financing – foreigners held 44% of government debt, up from 18% in the 1980s and early 1990s – has raised the government’s exposure to international capital flows. Interest payments as a share of revenue were also high at 9.4% in 2006.
High elderly labour force participation rates and less severe demographics leave the US less exposed than some AAA European peers to the direct impacts of ageing on public pension spending. However, the historically high pace of growth of public health spending per beneficiary raises the risk of alarming rises in Medicare and Medicaid spending in the long term unless growth in health costs per beneficiary can be contained.
US government finances have seen historically large variations over the past 10 years or so – with a 7.4% of GDP improvement over 1993-2000 followed by a 6.5% deterioration over 2000-2003. The latter was among the sharpest declines of any AAA-rated sovereign and larger than those witnessed in the large European countries that breached the EU’s Stability and Growth Pact. The widening of the fiscal deficit in the early part of this decade contributed to the record expansion in the US current account deficit, which continues to present risks for the global economy.
The outturn for the federal government deficit in the year to end-September 2006 (FY06) was 1.9% of GDP, down from 2.6% in FY05 and a peak of 3.6% in FY04. On the broader general government basis used by Fitch – which includes the balances of the federal, state and local governments combined – the balance for 2006 is estimated to have fallen to 2.3% of GDP from 3.7% in 2005 and a peak of 4.8% in 2003. As the chart below shows, the latest fiscal recovery, if sustained, would imply a markedly better fiscal performance over the past 10 years than through the 1980s and first half of the 1990s. To assess whether this recent improvement is sustainable, it is worth taking a closer look at trends in revenue and expenditure over the past few years. General government revenue was on an upward trend throughout the 1990s and surged to an all-time high in 2000, fuelled by buoyant corporate and personal income taxes amid the technology boom in the second half of the decade. After reaching a record 32.2% of GDP in 2000, revenue collections fell sharply to 28% in 2003 – their lowest level since 1967 – and stayed at that level in 2004. This historically unprecedented 4pp decline in the revenue/GDP ratio in the space of just three years reflected not only weak economic growth and an ailing business sector but also tax cuts. The Bush administration enacted major tax cuts over 2001-2003, which are estimated to have reduced revenue by US$160bn by 2004, or 1.4% of 2004 GDP according to the Congressional Budget Office (CBO).
However, the recovery in growth since 2003 and the pick-up in corporate sector earnings have caused a resurgence in individual income tax and corporate tax collections over the past two years. As a result, receipts grew by a better-than-expected 10.4% in 2005 and an estimated 10.8% last year, taking revenue to 30.2% of GDP in 2006, which is higher than their 40-year average, though still noticeably below that in the late 1990s.
Buoyant corporate taxes reflect the rise in the profit share in national income which reached 14.1% in Q306, its highest level since Q450. Corporate income tax collections doubled as a proportion of GDP from 1.7% in 2002, the lowest level since 1939, to an estimated 3.4% in 2006, or the highest since 1979. Income tax receipts, which make up the biggest chunk of current receipts at about one-third, grew by a similarly impressive 14.6% in 2005 and 13.3% in 2006. They were buoyed by non-wage income growth, particularly in the form of asset-market-related capital gains, which caused the non-withheld part of individual tax receipts to surge by over 20% during the year. With personal incomes recently on an upward trend and the shift in political power to a labour-leaning Democratic Party, Fitch expects some recovery in the share of wages in national income going forward as real wage growth picks up relative to productivity. This will likely depress corporate tax revenues relative to their recent multi-year highs. In addition, slower economic growth in 2007 would be expected to reduce revenues. For example, the CBO estimates that a 1% decline in economic growth (which Fitch is forecasting for 2007) would lessen revenues by roughly 0.4% of GDP.
After rising throughout the 1980s and peaking during the first Gulf War, general government expenditure as a percentage of GDP declined throughout the 1990s before picking up at the turn of the century. However, following a rise of 2.2% of GDP between 2000 and 2003, spending has been flat at around 32.5% in the past three years, a level lower than that seen through most of the 1980s and first half of the 1990s and much lower than the 35.1% peak reached in 1992. Moreover, spending growth fell slightly to 6% in 2006.
The stability of overall spending trends does, however, obscure concerns about pressures on health spending. These are borne out more clearly by a decomposition of federal spending, (while federal spending is much lower than overall spending, the trends are similar to those seen at the general government level). The federal budget comprises two elements. Mandatory spending is governed by legal criteria and is not usually inhibited by the annual appropriation process, and includes Social Security (pensions), Medicare (the federal health insurance programme for the aged) and Medicaid (the federal healthcare programme for the poor). In contrast, discretionary spending must be sanctioned through the annual appropriations process and includes outlays for national defence, highways, national parks, education, research and the federal workforce. While both categories have risen as a share of GDP since 2000, mandatory spending has been a far greater source of pressure on spending over the past 10 years and will remain so over the longer term.
Even before ageing-related pressures to pensions and healthcare have begun to bite, mandatory outlays have consumed an ever greater proportion of budgetary resources, thanks to rising medical spending. Indeed, most of the 6.6% average annual rise in mandatory outlays over FY00-FY06 can be attributed to medical services inflation, which caused Medicare costs to rise at an average rate of 10.6% and total health spending (including Medicaid and other mandatory health programmes) at 9.8%. Medical expenditure inflation is likely to remain persistently high due to the addition of an expensive new prescription drug benefit; the continued rise in the number and quality of medical services available; and the consistent underestimation of their costs. It is indeed striking that the US spends the most on health in the world: 15.3% of GDP in 2004, according to the OECD. Despite the public sector accounting for only 45% of total health spending in the US against an average 73% in the other OECD countries, the US public sector spent 6.8% of GDP on health, more than its counterparts in the Netherlands, Spain, Finland and Ireland.
Social Security outlays rose by a more modest 5% per annum, owing partly to the fact that the number of beneficiaries has risen by only 0.7% per year on average over FY00-FY05, which is slightly lower than during the 1990s and much lower than in the 1980s, when the number of beneficiaries grew at 1.6% per annum.
Discretionary spending, by contrast, has fallen steadily since 1962. During FY91-FY00 discretionary spending growth was regulated by the use of statutory caps that mandated that spending grow at approximately 2% per year – much slower than the 5% annual rate of the 1980s. Congress generally obeyed these caps and the growth rate of discretionary spending fell (except, unavoidably, during the Gulf War). Discretionary spending has turned upwards since FY01, rising by 12.3% per year on average to reach 7.8% of GDP in FY06, up from 6.5% in FY01. This is largely explained by higher defence spending. Defence constitutes the bulk of discretionary spending and has risen to 4% of GDP in FY06 from 3% in FY00.
Nevertheless it remains much lower than levels seen through the prior three decades. Non-defence discretionary spending has also edged upwards to 3.8% of GDP in FY06 compared with 3.5% in the 1990s, due to larger outlays for education, health, transport and, more recently, spending related to reconstruction in Iraq and hurricane relief. As a result in FY06 and again in FY07 the White House requested that Congress limit non-defence discretionary programme spending growth to below inflation. As before, this measure proved effective in curtailing non-defence spending growth: outlays excluding hurricane-related expenditure grew only 5.6% in FY06.
According to the draft FY08 budget submitted to Congress in February 2007, official projections envisage a federal deficit of 1.8% of GDP for FY07 and 1.6% for FY08, with further reductions through to FY12, when the deficit is expected to turn into a surplus of 0.3% of GDP. Most of the expected savings over FY08-FY12 come from discretionary spending, which is projected to rise by a mere 2.2% over this period (in total) on the back of a (frontloaded) 5% increase in the defence budget and a 0.8% fall in non-defence discretionary spending. As regards the latter, the FY08 budget has also reinstated statutory caps that limit non-defence discretionary expenditure to below 1%. Mandatory spending, by contrast, is expected to grow by 36% between FY07 and FY12.
With major tax increases unlikely in the near term, and with both parties in agreement on the need to return the budget to balance and aware of the pressures on mandatory spending, intense debate will be taking place on discretionary spending priorities. The FY08 budget proposal implies real cuts to education, agriculture, environment and energy spending in order to make room for higher military expenditure. However, these cuts will be unpalatable to the Democrats, making it improbable that the budget will pass in its current form. Moreover, unlike in parliamentary regimes where government budgets are the drafts upon which final legislation is based, in America the budgetary process allows for protracted negotiations.
Interestingly, after much criticism about the supplementary nature of military spending in the past few years, the proposed FY08 budget incorporates an upfront estimate for defence costs for the first time. This estimate foresees a substantial 10% rise in military spending in FY08 over FY07, to 4.4% of GDP, but, unrealistically, no additional funding for defence beyond FY09. The growing reluctance in Congress to increase war funding will make it difficult for the original request to be sanctioned in full. Fitch expects that disagreements over discretionary spending priorities will contain total spending in this category. This should see overall spending growth moderating from the high levels seen over 2003-2006.
This is further highlighted by the fact that, in the more immediate future, discretionary federal spending growth will be checked by a congressional stalemate. Disagreements between Republicans in the House and the Senate over nine of the 11 appropriations bills in the president’s FY07 funding proposal and an inconclusive budget process mean that the government is currently running on a stopgap ‘continuing resolution’, which sets funding levels for programmes at the lower of the FY06 budget or the FY07 House-passed appropriation bills. In February 2007 the succeeding Democratic Congress extended the auto-pilot resolution to FYE07, keeping spending for most agencies at FY06 levels and increasing total discretionary authority by 3.8%.
On the mandatory spending front, the federal FY08 budget proposes to curtail long-term spending by: introducing individual savings accounts for Social Security in 2012; progressive indexation of Social Security benefits; greater means-testing of Medicare payments; clipping payments to medical providers by reducing the automatic annual inflation adjustment; imposing payment rate cuts when Medicare funding from general revenue exceeds 45% (expected in 2011); and higher premium payments from corporations for pension insurance. Again, Democrats are likely to oppose the estimated US$96bn (1% of mandatory spending) in net savings from these reforms budgeted over 2008-2012, especially on healthcare, and the savings might yet be subsumed by a rapid unforeseen rise in medical costs. Moreover, some of the measures, like the introduction of individual accounts, will only translate into substantial savings in the longer term, i.e. beyond this five-year window. Fitch expects mandatory spending growth to slow briefly in 2007 before picking up slightly in 2008, at which time it will begin to rise steadily for the foreseeable future.
On the revenue front, the federal budget incorporates an average annual growth rate of 5.4% over 2008-2012, resting on optimistic assumptions of continued strong GDP growth. It also envisages extending AMT exemptions 1 for FY07 and FY08 and permanently extending the two biggest tax cuts in 2010. By remaining silent on the AMT extension in FY09 and beyond, the budget assumes a default increase in taxation from the continued fiscal drag: AMT relief cost about US$50bn in FY06. Were the relief to be indexed for inflation, it would cost US$50bn-60bn in revenue over 2008-2012, or 0.35% of GDP a year on average. Moreover, the CBO estimates that extending the tax cuts in 2010 would worsen the budget balance by 1% of GDP by FY12. However, Fitch believes that the Democrats in Congress will allow most of the tax cuts to lapse, with the exception of certain specific cuts like college tuition deductibles, which are a Democratic priority – a positive for the medium-term revenue outlook.
Fitch estimates that a cyclical slowdown in GDP growth in 2007, followed by a slight pick-up in 2008, will result in general government revenue moderating to 29.6% of GDP in 2007 and 2008. This would leave the revenue/GDP ratio some way below its late 1990s average, reflecting the continuing effect of the tax cuts, an extension of the AMT relief, and steady receipts at the sub-national level. Fitch expects total general government spending to dip to 32.1% of GDP in 2007 and 31.9% in 2008 from 32.5% in 2006. This expectation of expenditure restraint reflects budgetary rules limiting non-defence spending, congressional gridlock, resistance to further inflating war expenditure, smaller increases in mandatory spending relative to 2006 and continuing moderation in sub-national expenditure.
As a result Fitch expects the general government fiscal deficit to widen slightly to 2.6% of GDP in 2007 from 2.3% in 2006 before recovering to 2.4% in 2008. This would, however, remain below the average deficit seen over 1960-2000. Medium-term prospects are harder to predict given the presidential elections in 2008. However, Fitch believes that given the bi-partisan commitment to balancing the budget by 2012, total spending would not increase substantially over the medium term, irrespective of the outcome of the 2008 elections. The mix of spending could, however, differ with the budgetary priorities of the party in power.
This article is an extract from the report ‘US – A Sustainable Fiscal Improvement?’ by Fitch Ratings.