Ted Wieseman | New York
After a flood of revenue growth that offset continued elevated spending led to a sharp narrowing in the budget gap in the past two fiscal years, we look for stabilization in FY2007, with revenue growth normalizing back towards GDP growth and spending growth decelerating to its slowest growth of the Bush Administration as tight budgets the past couple years take hold and gridlock rules in Washington. Net Treasury supply should rise relatively modestly this year, but with a compositional shift towards bills and away from coupons. Relative stability should rule through 2008, but the outcome of the 2008 elections and a sharp rise in maturing coupons in FY2009 create considerable uncertainty for the budget and Treasury financing beyond then.
Surging revenues drove another upside surprise in FY2006. With significant additional spending on tap for hurricane rebuilding and the beginning of the Medicare prescription drug plan and an expected moderation in tax revenue back towards the growth rate of the economy after the 14.6% spike in FY2005, we came into FY2006 expecting a significant temporary widening in the budget deficit to over $400 billion from the $319 billion recorded in FY2005. And boy were we wrong — revenues continued to surge, spending proved a bit more restrained than expected, with little growth on an underlying basis in nondefense discretionary outlays, and the deficit surprisingly narrowed significantly further to $248 billion, or 1.9% of GDP versus 2.6% in FY2005.
Total revenue jumped another 11.8% in FY2006, making for the strongest two-year rise since FY1980-81 (and with inflation running in double digits back then, the real rise the past two years was much stronger). Upside was seen across all categories. Individual income taxes rose 12.6%, with withheld taxes up 7.9% and nonwithheld 20.7%, the latter apparently reflecting in part the surge in options and bonuses that so sharply boosted Q1 wage and salary income in the national accounts. Corporate taxes jumped 27.2% and have now nearly tripled since the FY2003 trough. Social insurance taxes gained 5.5%. And driven by sharply higher remittances from the Fed, miscellaneous other revenues even spiked 17.6%. Meanwhile spending rose 7.4%. While this was in line with the elevated gains during the prior four years, on an underlying basis the results pointed to improvement. In particular, excluding defense, Social Security, Medicare (which was boosted by about $25 billion by the beginning of the prescription drug plan), Medicaid and other health programs, and net interest, spending rose 6.7% or $48 billion. Almost all of this reflected two special items — a $29 billion increase in spending by FEMA for flood insurance and other hurricane cleanup related spending, and about $15 billion in noncash accounting adjustments to revalue subsidies on student and housing loans made in prior years. Stripping these out clearly indicated that the tight lids on nondiscretionary budget authority passed in FY2005 and FY2006 finally started to take hold in a major way to restrain nondefense discretionary outlays — an underlying improvement that should be much more evident in FY2007 without the one-off boosts to spending.
Stabilization in 2007. We look for the deficit to widen modestly in FY2007 to $265 billion, which would keep it steady as a share of GDP at a relatively low 1.9%, with both revenue (+4.6%) and outlays (+4.8%) growth expected to moderate significantly. Relative to GDP, revenues plunged from a peak of 20.9% in FY2000 to a low of 16.3% in FY2003 before recovering to 18.4% in FY2006 — very close to the long-term average. We look for revenue to hold close to this share in FY2007, with growth expected to be just slightly less than our estimate for nominal GDP growth. This slightly slower expected revenue growth compared to GDP is largely from two sources. First, individual tax refund growth should be unusually strong relative to recent history in 2007 as a result of consumers’ ability to claim a refund of previously paid long distance telephone excise taxes that were overturned by the courts on their 2006 tax returns. This should boost refunds in 2007 by about $10 billion. Second, we are looking for a sharp slowing in corporate profits over the course of 2007. After rising at about 25% a year the past four years, we expect pre-tax corporate book profit growth to moderate to less than 5% in FY2007, and we also expect the effective tax rate to moderate slightly after a sharp surge in recent years. Taken together, we expect net corporate taxes to be up 4.0%. Otherwise, we expect withheld income (+5.4%), nonwithheld income (+5.9%), and social insurance (+5.2%) taxes together to run in line with our estimated growth in personal income, which we recently scaled back somewhat as we marked down our 2007 GDP forecast and incorporated the downward revisions to income in the last GDP revision.
The significant slowing in underlying nondefense discretionary spending growth that was seen in FY2006 should become more apparent in FY2007. This underlying restraint, the absence of special items that boosted outlays last year, and some continuing moderation in defense spending growth should help to offset upside in nondiscretionary spending — particularly Medicare and interest — to keep overall spending growth at +4.8%, which would be the smallest rise since FY2001 and a major improvement from average rises of 7.3% in the first five full years of the Bush Administration. On the upside, Medicare spending growth is likely to accelerate significantly further in FY2007 with the first full year of the prescription drug plan and a legislative change that shifted some payments out of 2006 and into 2007. Since the Medicare prescription plan picks up some costs that were previously covered by Medicaid, it makes more sense to look at them together — we expect overall spending in Medicare, Medicaid, and other health programs to rise 11.3% this year after rising 6.0% last year, accounting for more than half of the overall spending rise we project. Interest expense growth should moderate somewhat from the sharp surge seen last year as rates flatten out, but still see significant growth.
Meanwhile, on the positive side, discretionary spending growth, particularly nondefense, looks set to decelerate significantly. Since surging 16.3% in FY2003, defense spending growth has moderated each year since to +6.8% in FY2006, and we expect further slowing in FY2007 to +4.9%. After having surged 73% from FY2001 through FY2006, defense spending appears to moving towards gradually topping out at a high level. Meanwhile, after the spending spree of the early years of the Bush Administration, the White House requested and Congress passed tight limits on regular nondefense discretionary budget authority in both FY2005 and FY2006 of only about +2% in each year. And after a bit of a lag, this restraint clearly became apparent on an underlying basis in FY2006, even as overall spending was boosted by unusual items. Clearly, after the recent election the outlook here is somewhat cloudy for FY2007. With the outgoing Congress having passed only two of the eleven appropriations bills, the bulk of the budget is operating under a continuing resolution through February 15 that holds spending at last year’s levels. Our baseline case is that the likely gridlock next year keeps discretionary spending growth on a tight leash, as happened for an extended period during the Clinton Administration, which along with the continuing impact of the tight budgets passed the prior couple years should keep overall nondefense discretionary spending growth slow in FY2007. Adding in the impact of the absence of the special factors that boosted outlays in FY2006, we expect spending outside of defense, Social Security, Medicare, Medicaid and health, and interest to fall 2% this year.
Treasury financing implications. We expect overall net Treasury issuance to rise to $249 billion in FY2007 from $213 billion in FY2006. The $17 billion increase we expect in the budget deficit explains only about half of this. The rest should result from a smaller contribution from nonmarketable debt issuance and “other means of financing.” The combination of these two items reached a record +$103 billion in FY2005, and, while moderating significantly, remained very elevated at +$61 billion in FY2006. We look for some normalization to +$5 billion in FY2007. Nonmarketable debt issuance — which is primarily State and Local Government Series (SLGS) debt that municipal governments use as a means to invest proceeds from pre-refundings without running afoul of laws against their arbitraging the tax advantaged status of their debt — has already slowed sharply from a record $64 billion in FY2005 to $13 billion in FY2006. We look for a modest further slowing to $8 billion this year. The much bigger swing factor we estimate to be other means, which ran extremely strong relative to typical levels in each of the prior two years, as various off budget sources or uses of money turned significantly more positive. Our base case at this early stage is that these positive swings have run their course and other means will swing from a $48 billion source of cash in FY2006 to a slight use of money this year.
At current coupon sizes, we estimate Treasury faces a financing gap — the amount of increased market issuance through higher coupon sizes and net bill issuance needed to fund the budget gap plus nonmarketable funding sources or uses — in FY2007 of $97 billion. This — and any reasonably likely deviation from it — can be easily met within the current financing structure. The main shift we project in the current fiscal year is some rebalancing between bills and coupons. In FY2007 the first full year of revived 3-year notes will mature, leading to a $50 billion increase in overall coupon maturities. We expect coupon sizes to move somewhat higher starting with the 2-year and 5-year issues at the end of January and continuing with the February refunding and for these slightly levels to be maintained through year-end. We project a $2 billion boost in the 2-year size to $22 billion, a $1 billion increase in the 5-year to $15 billion, a $1 billion increase in the 3-year to $20 billion, and a $1 billion increase in the 10-year to $14 billion new/$9 billion reopening. Starting in February, 30-year issuance will shift to quarterly from semi-annual, with new issues in February and August and reopenings in May and November. We expect the run rate for 30-year issuance to rise from $24 billion to $30 billion ($9 billion new/$6 billion reopening), but since there was no bond in November, actual bond issuance would be unchanged at $24 billion in FY2007 under this pattern. Combined with an expected $70 billion in TIPS issuance, we see overall gross coupon issuance rising $20 billion to $698 billion, but net issuance falling to $190 billion from $217 billion. Offsetting this should be a pickup in net issuance of bills. The recent budget surprises led to net bill paydowns in each of the last two fiscal years and a sharp decline in the bill share of the outstanding publicly held debt from 22.4% at the end of FY2004 to 18.0% at the end of FY2006. The debt managers have suggested that the recent paydowns were neither intended nor particularly desirable and have seemingly driven the bill share below where Treasury would like it to be. The swing to about $60 billion in net bill issuance we project for FY2007, would start to rectify this, lifting the bill share about a half percentage point.
Medium-term issues. The Democratic takeover of Congress clearly presents significant uncertainties for the medium-term budget outlook. Our assumption is that not much of anything will happen for the remaining two years of the Bush Administration, keeping spending relatively restrained and the deficit near current levels as the trend like GDP growth we anticipate keeps revenue growth reasonably healthy. The key uncertainties will not be decided until the 2008 elections. The major Bush tax cuts begin to expire at the end of 2010, and unless Republicans hold the White House and retake Congress most of them likely will be allowed to expire. A Democratic sweep in 2008 would probably mean that the increased revenues this would bring in would be spent on programs the Democrats feel were neglected under the Republicans. A continuation of split government, in which tax cuts expired and not much in the way of new spending was able to get past the White House, could put the budget on a significantly improving path. As far as more medium-term funding issues, assuming the deficit stays reasonably close to current levels, the existing financing calendar is fine through FY2008. In FY2009, however, the first full year of monthly 5-year issues mature, leading to a sharp rise in coupon maturities and a large resulting financing gap that could possibly call for more substantive adjustments to the current auction schedule than the relatively small swings in coupon sizes and net bill issuance we expect for the next couple years