The fiscal handbook: A reconciliation bill is born

Summary

• The House of Representatives is weighing a Republican-backed plan to make sweeping changes to U.S. fiscal policy. In short, the bill extends the expiring portions of the 2017 tax cut bill and provides a shot of near-term fiscal stimulus in the form of additional, temporary individual and business income tax cuts, such as no tax on tips or overtime income. The bill also includes some new spending on certain Trump administration priorities, such as more funding for the military and border security.

• These tax cuts and spending increases are partially offset by some tax increases and spending cuts for Medicaid, food assistance for lower income individuals, student loans and green energy tax credits, among other budget offsets.

• On a current law baseline (i.e. assuming the 2017 tax cuts expire as scheduled), the bill increases the federal budget deficit by very roughly $2.3 trillion over the next 10 years. However, since the 2017 tax cuts extension costs a bit less than $4 trillion over that time period, the new tax and spend changes are deficit-reducing over the next decade relative to current policy.

• However, there is a catch. Many of the tax cuts and spending increases are temporary and slated to expire after a few years, while many of the tax increases and spending cuts are phased-in slowly over time. Thus, the fiscal accommodation in the bill is generally front-loaded, while the fiscal tightening is generally back-loaded.

• In the near term, the bill would generate new fiscal stimulus and increase the federal budget deficit by 0.5-1.0 percentage point of GDP per year over the next few years. Over the medium to longer term, the deficit impact is highly conditional on the decisions made by future policymakers.

• If we include a 15% average effective tariff rate in this analysis, higher tariffs generate roughly 0.8% of GDP in new tax revenue per year, largely nullifying the near-term fiscal impulse from the reconciliation bill. That said, there is an important timing mismatch, with fiscal tightening from higher tariffs occurring today in real-time, and the peak fiscal easing from tax cuts still a year away.

• Pulling it all together, we are forecasting neither a fiscal blowout nor a fiscal consolidation in the near term. Our base case forecast for the federal budget deficit as a share of GDP is in the 6.0%-6.5% range over the next few years, more or less in line with the current status quo but still well in excess of the 3% that the U.S. averaged over the half century preceding the pandemic.

• The tailwinds from tax cuts and headwinds from tariffs are already largely baked into our U.S. economic forecast. On the margin, the House bill generates modest upside risk to our forecasts for U.S. economic growth, inflation and interest rates in 2026.

• It is important to note that even if the House of Representatives passes this bill, the process is not complete. The Senate has yet to weigh in, and we expect alterations are coming from the upper chamber of Congress. That said, we think this bill lays the foundation for the final product.

• Our sense is that August 1 is a key date by which the White House and Republican Congressional leaders aim to have the entire process completed. The bill includes an increase in the debt ceiling, and passing it by August 1 would ensure Treasury can meet its borrowing needs during the month-long recess Congress has scheduled for August.

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