S&P credit rating analysis values spending cuts more than tax revenue

The decision by Standard & Poor's to downgrade the U.S. credit rating to "AA+" at once laments the possibility that cuts to entitlement programs will not materialize and the decreasing likelihood of new tax revenues. But it appears to give more weight to the need for more spending cuts, as it warns that a further credit rating downgrade is in the cards if the U.S. does not trim spending.

In contrast, while the report indicates that new tax revenues would help mitigate the debt crisis, failing to find these revenues does not immediately put the U.S. at risk of another downgrade.

Specifically, the report warns directly that a further downgrade to "AA" status could occur within the next two years if there is "less reduction in spending" than what was agreed in the debt ceiling agreement. S&P said one factor that could lead to this second downgrade is if the minimum $1.2 trillion in spending cuts under the debt ceiling agreement does not occur.

But S&P sees the continuation of the Bush tax cuts in 2001 and 2003 as something that could still allow the U.S. to maintain its new "AA+" rating.

While this difference would seem to put a greater emphasis on spending cuts, the report more broadly seems to value both spending cuts and tax revenues as a way out of the debt crisis. S&P said it takes no position on the "mix of spending and revenue measures" needed to put the U.S. back on a path to its historic "AAA" rating, a sign that it believes both are needed in some measure.

It also laments Congress's failure to find a way forward on either prescription as part of the debt ceiling agreement.

"It appears that for now, new revenues have dropped down on the menu of policy options," the report said. "In addition, the plan envisions only minor policy changes on Medicare and little change in other entitlements, the containment of which we and most other independent observers regard as key to long-term fiscal sustainability."

While Democrat and Republican leaders on Friday night argued that the S&P report shows the need for more taxes and more cuts, respectively, the report pointed out the benefits of both. The report's "base case scenario" assumes that a minimum of $2.1 trillion in spending cuts are made as part of the debt ceiling agreement, and assumes that the Bush tax cuts do not expire.

Under this base case scenario, net general government debt would rise from 74 percent of GDP in 2011 to 79 percent in 2015, and 85 percent in 2021.

But the S&P's revised "upside scenario" assumes that the Bush tax cuts expire in 2013, which it said would slow these increases. If the tax cuts expire, S&P expects the debt-to-GDP ratio to increase more slowly, to 77 percent by 2015 and 78 percent in 2021.

S&P's revised "downside scenario" shows the cost of not following through on spending cuts. In this case, the debt-to-GDP ratio would increase to 90 percent in 2015 and 101 percent by 2021.

The report does not say these increases would be due to the lack of spending cuts alone -- also part of this downside scenario is an assumption that interest rates rise, and the presence of other less favorable economic conditions.

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