The Mother of All Fiscal Cliffs

By Dominic Pino

Thursday, September 28, 2023

 

The current argument over government funding and the risk of a shutdown is small potatoes. The debt-limit fight over the summer was small potatoes. Even the great “fiscal cliff” of 2012–13 was small potatoes. The mother of all fiscal cliffs is coming in 2025, and we’re not ready for it.

 

Paul Winfree has worked on budget issues in the White House and in Congress. An economic historian, he has written a book on the history of the U.S. budget process. He’s the president and CEO of the Economic Policy Innovation Center, a new think tank founded to help guide lawmakers on economic issues. And he’s alarmed by what’s coming in 2025 and how nonchalant most in Washington are about it.

 

“When I talk to members of Congress, one of the responses I get from folks is, ‘Thank you for thinking about this because we don’t have the bandwidth right now to get into this issue,’” Winfree says. The issue? About $5 trillion in new debt that’s expected to hit in 2025. That’s five times the level of the 2009 stimulus bill responding to the worst economic crisis since the Great Depression, and it’s expected to come in a time of no wars, low unemployment, and a growing economy.

 

Brian Riedl studies the federal budget all day, every day, as a senior fellow at the Manhattan Institute. He says of his future research, “All of 2024 is going to be prepping for this stuff in 2025.” He also talks to lawmakers and is also not confident they are taking this issue seriously. “There is just no appetite in Washington to make the hard decisions right now to rein in the deficits.”

 

***

 

All of the individual-taxpayer provisions of the Tax Cuts and Jobs Act expire on December 31, 2025. That means if Congress does nothing, tax rates will increase, the standard deduction will decrease, and the tax burden will increase for most taxpayers. Some of the business provisions of the TCJA will also expire, such as the treatment of cross-border income and payments, bonus depreciation of investments, and opportunity-zone tax credits. The child tax credit will also decrease from a maximum of $2,000 per child to a maximum of $1,000 per child.

 

“These were all built-in tax increases that were designed essentially to meet the ten-year-budget-window rules that allow for reconciliation,” says Will McBride, vice president of federal tax policy at the Tax Foundation. Republicans used the budget-reconciliation process to pass the TCJA in 2017 so they would need only 50 votes in the Senate to pass it rather than the 60 that would have been required to break a Democratic filibuster.

 

Expiring on the same day is a set of health-care subsidies. The Affordable Care Act, a.k.a. Obamacare, offered subsidies to households making up to 400 percent of the federal poverty line. President Biden’s American Rescue Plan Act (ARPA) temporarily removed that cap. Then the so-called Inflation Reduction Act extended that suspension through the end of 2025.

 

Democrats planned for the cap to come back at the same time TCJA provisions expired. The idea was that no matter who was in office at the end of 2025, each party would have something important it wanted extended. Republicans get to keep their tax cuts, Democrats get to keep their Obamacare subsidies, everyone’s happy.

 

That would be fine if the parties each had some budgetary offsets in mind that they would use to pay for the extensions. But that’s unlikely to happen. In fact, we should expect 2025 to be a time of high pressure to increase spending even further.

 

“You typically don’t see a lot of fiscal consolidations and benefits being taken away shortly after a new presidential term begins,” Riedl says. “It typically goes in the other direction.” A new administration will begin in January 2025, and the first year is usually a time to reward the people who helped get you elected, not to cut the deficit.

 

On top of that general rule, there are more factors specific to 2025 that will make things difficult. The ARPA’s State and Local Recovery Fund gave $350 billion in federal money to state and local governments. According to the Treasury rules governing the fund, states have until the end of 2024 to obligate spending from it and until the end of 2026 to actually make the expenditures. So state and local officials, from both parties, are going to be descending on Washington in 2025 and begging for more money.

 

“Since the beginning of Covid, $190 billion has gone to schools alone,” Winfree says. “If school districts have been using that money to hire teachers or provide extra activities, there’s not going to be money for that anymore.” For-the-sake-of-the-children arguments will abound, and no politician wants to say no to the children.

 

Also expiring at the end of 2026 is nearly $400 billion in contract authority under the bipartisan infrastructure law. Difficult as it may be to believe, a lot of contractors can be expected to argue that the $1.1 trillion law didn’t spend enough.

 

The reason, paradoxically, is that it spent too much. By flooding the market for infrastructure construction with so much cash, the law, combined with other federal spending and overall economic trends, spurred price inflation within the industry. “If the government is telling you you have to build now to receive the money, you’ll move resources to that, and it will increase costs,” Winfree says.

 

For example, the government has allocated tens of billions of dollars for broadband-internet infrastructure in the past few years. That much cash for just one relatively small industry has caused the costs of materials to increase, and firms have struggled to find enough workers for the sudden influx of new projects, which has caused labor costs to increase as well. Additionally, as a Government Accountability Office report from May found, broadband spending is spread over at least 133 programs in 15 different agencies, and there is little national strategy guiding it.

 

A lot of infrastructure projects that started under one set of cost assumptions will have much higher costs in reality, which means a lot of projects that will have already begun by 2025 will need more money to be completed. Contractors from around the country will swarm Washington to explain why they need additional funding for those new bridges the politicians promised.

 

Winfree notes the negative economic effects of much of this spending as well. In a September blog post, he found that since the ARPA passed in 2021, private fixed investment has fallen by 1.3 percent but manufacturing construction has increased by 55 percent. That suggests the entire boom in manufacturing construction celebrated by the Biden administration is driven by government subsidies and that they’re crowding out private investment.

 

A look at the labor market makes the crowding out more apparent. The unemployment rate is below 4 percent, and labor-market slack is near historic lows. That means construction firms have to move existing workers from private projects to fulfill government-supported projects. There aren’t more workers to hire.

 

***

 

Simply extending all these provisions would add about $5 trillion to the debt over the ten-year budget window, with about $3 trillion of that coming from extending the tax cuts. But it’s even worse than that.

 

The discretionary-spending caps from the debt-limit deal also expire in 2025, and the debt limit will need to be raised again. The government will still need to fund all the normal stuff it always funds, such as the military, anti-poverty programs, education, and transportation. And we haven’t even touched on the biggest budgetary problem of all: entitlements.

 

Politicians have been largely keeping the bipartisan promise to pretend there’s no need for entitlement reform, but the facts haven’t changed. Medicare and Social Security this year will spend $649 billion more than they take in. Cumulatively, over the next 30 years, they’ll spend $69 trillion more than they take in, according to the CBO. That will require more borrowing, which will create $47 trillion in interest costs, bringing the grand total of the cost of Social Security and Medicare to $116 trillion in new debt over the next 30 years.

 

Riedl was sounding the alarm on the danger of higher interest rates when they were still low and spending advocates were saying the government would be stupid not to spend. “Every point that interest rates rise costs about $30 trillion over 30 years in higher interest costs,” Riedl says. “That’s like adding another Defense Department to the budget.”

 

The rate on a ten-year Treasury bond is about 4.4 percent right now. Those CBO projections on interest-rate costs assume that rates will never rise above 4 percent over the next 30 years, Riedl says. Scary as they may seem, they’re based on a very rosy scenario, and the actual picture will likely be much worse.

 

Planning the fiscal future of the country around the assumption that interest rates would remain the lowest they’ve been in 4,000 years, as bond-market researcher Jim Grant has described the interest-rate policies of the 2010s, was not a great idea. Interest on the debt has doubled in just the past two years. “The average maturity on the federal debt is about 70 months, and the vast majority of it will roll over in about a decade,” Riedl says. The low rates of the past were not “locked in.”

 

All this anticipated deficit spending will only increase the upward pressure on interest rates, as investors will demand higher payment for the increased risk of the federal government’s fiscal irresponsibility. And it will make conditions ripe for bursts of inflation, which will spur the Federal Reserve to raise interest rates in response.

 

***

 

McBride, of the Tax Foundation, notes that despite the tax cuts and massive deficits, federal tax collections in fiscal year 2022 were higher than ever and are expected to be above average again this year. The federal government collected the equivalent of 20 percent of GDP in 2022, well above the 50-year average of 17 percent. “Even absurd tax increases of several trillion dollars don’t put a dent in the debt-to-GDP ratio in the long run,” McBride says. “The only way to do that is to rein in the spending.”

 

Of all of the TCJA’s tax cuts, it’s the depreciation rules for business investments that deliver the best bang for the buck in economic growth, according to McBride. Lawmakers should prioritize keeping those rules, but the individual-taxpayer provisions will take up much more of their attention, and no president is going to raise taxes on millions of households right after being elected. (It will be fun to watch Democrats, who for years have said falsely that the TCJA cut taxes only for the rich, suddenly talk about how letting the TCJA expire would be a middle-class tax increase.)

 

Congress is going to face pressure from voters, state and local governments, and lobbyists from countless industries to continue spending here, there, and everywhere. “Congress will fight tooth and nail over creating new tax cuts or spending programs, but extending existing programs and tax policies is usually seen as likely to sail through,” Riedl says.

 

Perhaps most stunningly, we still haven’t reached a crisis point. Based on his research of the history of the budget process, Winfree thinks that reforms come only after a major fiscal event. And despite trillions in emergency spending spurring 9 percent inflation and still causing a $2 trillion deficit three years later, the Covid pandemic wasn’t enough to qualify as one.

 

Political pressure for spending reform could rise if inflation remains persistent and voters connect it to the deficit, Winfree says. He also notes that “when the economy has been juiced for so long, there’s going to be a crash coming off of it.” A possible bubble in manufacturing investment, caused by government subsidies, could do some damage.

 

Riedl, in his research, specifies three conditions for major budgetary reforms: a penalty default, public support, and healthy congressional negotiations. But “we’re really not close to meeting those standards.” He says that a successful reform would “have to be done with both sides together holding hands, with tax hikes and spending cuts.”

 

Appetite for such a broad reform package is low, with politicians essentially promising the opposite and voters not demanding any better. We may not be ready for 2025, but it will be here soon. And at our current pace, the mother of all fiscal cliffs will look like small potatoes by 2035, which will look like small potatoes by 2045 . . .