$3.5 trillion reconciliation package could spike deficits and inflation

$3.5 trillion reconciliation package could spike deficits and inflation
© The Hill Illustration

The $3.5 trillion reconciliation measure recently launched by Congressional Democrats would likely raise federal deficits — despite their assurances to the contrary. At a time of rising inflation and near record federal red ink, more deficit spending poses many risks we cannot afford.

For the first nine months of fiscal year 2021, the federal government’s deficits totaled $2.2 trillion, which is actually down from the same period of the last year of the Trump administration. The Congressional Budget Office recently projected a 2021 deficit of $3 trillion, also slightly below last year’s record $3.1 trillion deficit. Under its current 10-year projection, CBO sees deficits declining through 2025 before rising later in the decade as the last Baby Boomers reach retirement age and access more federal benefits, including Social Security and Medicare. Annual federal budget deficits never fall below 3 percent of Gross Domestic Product during the forecast period.

Because CBO forecasts are based on current law, they do not reflect the impacts of the bipartisan infrastructure package or the reconciliation budget measure under consideration. Although President Joe BidenJoe BidenHaiti prime minister warns inequality will cause migration to continue Pelosi: House must pass 3 major pieces of spending legislation this week Erdoğan says Turkey plans to buy another Russian defense system MORE’s American Recovery Plan and American Families Plan contained “pay-fors,” which Democratic leadership intends to include in its reconciliation package, there is no assurance that the new revenue will offset the new spending. One way to get such assurance is to ask the Congressional Budget Office to thoroughly score the final package before final votes are taken. But given political pressures, packages are often rushed through before all their provisions are fully evaluated.

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Senate Democrats will need all 50 members of their caucus to vote for the reconciliation package. Lobbyists seeking to shield clients from portions of any tax hikes included in the final bill will be shopping legislative language to any Senator willing to listen. Cumulatively, such loopholes can drain hundreds of billions of revenues from tax hikes in the package. Meanwhile, House Democrats representing areas with high state and local income taxes want to repeal the cap on state and local tax (SALT) deductions, which would further reduce the bill’s revenues.

On the spending side, Democrats are cramming numerous programs that would cumulatively cost more than $350 billion annually (or $3.5 trillion over the 10-year budget window) into the reconciliation bill. To make it all fit, lawmakers may phase in programs, thereby reducing their incremental costs in the near term.

In other cases, Congress can cut the long-term price tag by claiming it will terminate programs in later years while expecting a future Congress to extend them. This tactic was famously used by President George W. Bush’s administration, which phased out its tax cuts late in the 10-year budget window. Income tax rate reductions for all but the highest brackets later became permanent. Similarly, the Tax Cuts and Jobs Act of 2017 contains individual income tax cuts set to expire between 2025 and 2027. Since many of these tax cuts also benefit middle-class Americans, they have good prospects of being extended.

If the reconciliation package does increase the deficit, the consequences could be quite negative. As fiscal hawks have been warning for years, the federal government is headed for a long-term fiscal crisis due to the rapid growth of entitlement spending. CBO has been projecting for years that the nation’s debt-to-GDP ratio would reach record territory in the 2030s and 2040s. The COVID-19 pandemic, recession and massive government spending in response have accelerated the rising debt trajectory. The reconciliation bill would further exacerbate the debt.  

While many correctly note that deficit hawks’ dire predictions haven’t come about — yet — the fact is that no one knows what level of federal debt is sustainable. Evidence from Japan suggests a modern, first-world economy can support much higher debt burdens than the United States has accumulated. On the other hand, Japan may be able to sustain more government debt than the U.S. because its consumers and businesses save a higher proportion of national income than we do.

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Because U.S. Treasury securities offer negative real returns, there is a limit to the amount that can be sold to private players. Unless debt issuance is controlled, the Federal Reserve will eventually be obliged to purchase more Treasury securities with newly printed money, which risks higher inflation.

We do not know whether the country’s currently rising inflation figures represent a transient spike or the beginnings of a long-term trend toward more rapid consumer price escalation. Those arguing that the impact is transient rightly highlight that recent price increases have been concentrated in a few sectors, such as used cars and rental cars that are facing specific issues.

But if consumers have limited money to spend, supply driven price shocks in one sector should reduce demand for other goods and services, placing downward pressure on their prices. Right now, however, there appears to be so much money in the system that price spikes in specific sectors can be absorbed without reducing demand and pushing down prices elsewhere. And with the Fed adding money by making $120 billion in new bond purchases each month, there is reason to believe that price hikes could rotate around the economy later in 2021 and 2022.

Although 1970s-vintage double-digit inflation may not be in our immediate future, persistent annual price increases of 4 percent or 5 percent can seriously erode savings and impoverish those relying on fixed incomes in just a few short years. Similarly worrying, as the U.S. saw in 1968, inflation at this level combined with other factors such as intergenerational tensions, can, in some circumstances, also contribute to larger economic and social instability.

Rather than take these risks, Democrats should reduce their spending plans to align with the tax revenue they can confidently expect to raise. And both major political parties should start to grapple with the debt and deficits they’ve been laying on the shoulders of future taxpayers.

Marc Joffe is a policy analyst at Reason Foundation, former senior director at Moody's Analytics, and author of the study "Unfinished Business: Despite Dodd-Frank, Credit Rating Agencies Remain the Financial System’s Weakest Link."