Congress Girds for Another Debt Fight as Deficit Shrinks

Indeed, Lieber agrees that while some type of "small compromise" will be worked out that likely "provides a face-saving move for both Democrats and Republicans," Republicans will "not get a dollar in spending cuts for every dollar increase in the debt limit, but some small deal that might even include minor entitlement changes is likely." While these economic policy debates in Washington have "important ramifications for investors," the PIMCO analysts say, "and could drive market volatility higher in coming months," the markets now expect "very little out of Washington and have become accustomed to politicians taking us to the brink of fiscal catastrophe."

But John Canally (left), economist for LPL Financial, writes in an economic commentary released Tuesday that the federal deficit, at $725 billion, is currently at its lowest level since late 2008. But the budget picture could take a turn for the worse depending on how Congress tackles the aforementioned economic issues, he says.

An improving economy, stronger labor market, spending cuts from sequestration and tax increases are all contributing factors to the shrinking deficit, Canally says.

The Congressional Budget Office continues to project that the budget deficit in FY 2013 will total $642 billion, which amounts to about 4% of GDP, he says.

A number of factors are driving the improving deficit, Canally says.

• First is that year to date, federal revenues are up 14%, while spending is down nearly 4%.
• Also, personal income taxes account for roughly 50% of federal revenues while taxes withheld for Social Security and Medicare account for 35% of federal revenues.
• A better labor market — with 2.3 million net new jobs created over the past 12 months — and rising wages (wage and salary income, as measured by the monthly report on personal income and spending, is up 4% year over year), account for some of the gain.
• The expiration of the Social Security payroll tax cut in January and the increase in tax rates for incomes above certain thresholds have boosted revenues.
• The rising equity market has also accounted for some of the gain in individual tax revenues: equity markets hit new all-time highs in the first half of 2013 and investors may set aside tax payments after exercising stock options or selling stocks.
• Corporate profits are at record levels and corporate tax receipts are up 17% in the first 10 months of FY 2013 versus the similar period in FY 2012. Corporate tax receipts account for 10%-15% of federal tax revenues.

Canally warns, however, that an "otherwise positive budget picture" thus far could be cut short if policymakers continue to ignore the following "warning signs."

The "risk," he says, "is that Congress and the general public will be distracted by the rapidly improving near-term budget outlook, and will not address the longer-term structural budget problem quickly enough to head off a worsening, long-term budget deficit."

The first warning sign, he says, is that FY 2013 to date, federal spending on mandatory programs (payments set by formula written into the law) like Social Security, Medicare and Medicaid "is running above the pace of nominal GDP growth."

Also, federal spending on Social Security benefits is up 5.4%, "nearly twice the rate of nominal GDP growth over the past year (2.9%)," he says. "Similarly, spending on Medicare is up 3.0% in the first 10 months of FY 2013, while Medicaid spending is up 5.7%, also about twice the rate of nominal GDP growth."

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