The fiscal handbook: Reconciliation bill endgame

Summary

While trade policy has dominated the world in recent weeks, Republicans in Congress are attempting to thread the needle on a budget reconciliation bill that would make sweeping changes to federal fiscal policy.

Reconciliation details: This week, Congress came to an agreement on a budget resolution, an important first step toward eventually passing a reconciliation bill.

• The reconciliation instructions permit an extension of the expiring 2017 tax cuts plus $1.5 trillion in net new tax cuts over 10 years. The plan also calls for several hundred billion dollars of new spending on certain policy priorities, such as the military and border security. On spending cuts, there is a $4 billion minimum, but no maximum. This setup affords lawmakers the flexibility to dial up or dial back spending cuts depending on political and economic realities.

• Taken at face value, the plan would increase federal budget deficits by a net $5.8 trillion over the next 10 years on a static basis, excluding interest costs and when scored using a current law baseline. Using a current policy baseline, the plan would increase deficits by about $2 trillion over that period.

• Thus far, negotiations have centered on high level targets for revenues and outlays. When Congress returns from recess on April 28, the next step in the process will involve making difficult trade-offs and specific policy decisions.

Policy expectations: We expect the 2017 tax cuts to be extended, and our economic forecast also assumes that $150 billion per year of net new tax cuts take effect in 2026. We project that federal spending growth largely will remain unchanged as new spending in areas like the military is offset by spending cuts elsewhere.

• We expect the new tax cuts to be mostly focused on lower and middle-income households. Examples of tax cuts that might be enacted are no taxation of tip income, reduced or zero taxation of Social Security benefits and a larger Child Tax Credit.

• We do not expect changes to most of the corporate income tax code, but we do expect some of the more generous 2017 corporate tax law provisions to be revived (e.g., full expensing of capital investment).

Economic impact: Our expectation for more accommodative fiscal policy in 2026 is one factor underpinning our projection for a rebound in economic growth next year. The tax and spend policy changes we expect are adding about 0.25-0.50 percentage points to our forecast for real GDP growth in the United States in 2026.

• Critically, the reconciliation process is flexible enough that, should lawmakers choose to front-load the tax cuts to provide the economy more stimulus, they are able to do so. Similarly, there is a possibility that Congress cuts spending by more than we expect, and it offsets the near-term bump to economic growth from tax cuts.

• We think it will be the summer at the earliest before a reconciliation bill becomes law, with the impact on the U.S. economy probably not felt until next year.

• Higher tariffs help reduce the federal budget deficit, all else equal, but extending the 2017 tax cuts and adopting new tax cuts will wipe away much of this belt tightening. Our forecast for the federal budget deficit is roughly 6% of GDP in FY 2025 and 2026, more or less unchanged from the end of the Biden administration.

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