Taxing Times: Tipping Point? Why August 2nd matters in the Debt Debate and how it affects you

Hourglass

As the deadline approaches to lift the U.S. debt ceiling, lawmakers debate competing proposals linking future tax policy and spending increases. Differing budget proposals range from $1-4 trillion in spending cuts over the next ten to twelve years in exchange for an agreement to lift the debt ceiling.1 Each alternative purports to narrow the large operating deficits accrued in recent years and devise a credible strategy to manage the steadily rising $14.29 trillion debt.

Previous “Taxing Times” discuss challenges posed by both long term debt and wide deficits. Here we focus on what comprises upcoming obligations due in August.

What is at stake on August 2nd?

Decision-makers, including congress, Obama, and Bernanke concede that August 2nd is the “x date” after which the U.S. Treasury can no longer pay its bills.2 While the Bipartisan Policy Center estimates that the “x date” falls between August 2nd and 9th, Congress goes on recess as of August 3rd. What’s more, on May 16th the U.S. reached its statutory debt limit. Since then, the Treasury has resorted to “extraordinary measures” which include delaying investment into the Federal Employees’ retirement system and suspending issuing State and Local Government Series Treasury Securities. With these short-term solutions, the U.S. has been able to meet its financial obligations without breaching the debt limit.3

Why this deadline is real and could affect you

The U.S. Treasury has run out of room to maneuver. According to financial estimates by the Bipartisan Policy Center, anticipated revenues of $172.4 billion in August will be dwarfed by mandatory expected payments of $306.7 billion.4 If the debt ceiling is not raised, this shortfall of more than $134 billion would require the Treasury to prioritize its payments. This is analogous to a household juggling its credit card bills. The Bipartisan Policy Center indicates how payments might be prioritized:

Interest on Treasury Securities $29.0 billion

Social Security Benefits $49.2

Medicare/Medicaid $50.0

Defense Vendors $31.7

Unemployment Insurance $12.8

Total $172 billion

With a $134 billion deficit, what might remain unpaid? Some of the notable creditors to the U.S. government would be: active military personnel, Federal workers, taxpayers expecting IRS refunds, and agencies such as the Department of Justice. Under an alternative scenario, payments to Defense vendors might be held in favor of housing and nutrition assistance to the poor, tuition and education grants, and veterans’ affairs programs.5

Short term consequences could inflict irrevocable pain

Among the financial community, most analysts believe that raising the debt ceiling is inevitable and regard the theatrics in Washington as political theater.6 However, the absence of additional borrowing authority for the U.S. – even for a short period – could have dire consequences. S&P rating agency warns that “if the government is forced to undergo a sudden, unplanned fiscal contraction – as a result of Treasury efforts to conserve cash and avoid default absent an agreement to raise the debt ceiling – we think that the effect on consumer sentiment, market confidence, and thus economic growth will likely be detrimental and long lasting.”7 The rating agency goes on to advise that “If the government misses a scheduled debt payment, we believe the effect would be even more significant and, under our criteria, would result in Standard & Poor’s lowering the long-term and short-term ratings on the U.S.”8

Pedal to the metal – facing the debt

Economic analysis of the long-term effects of excessive debt to economic growth concludes that debt “burdens above 90% are associated with 1 percent lower median growth.”9 Currently, the US general government debt to GDP ratio is nearing 75% but could reach 84% in 2013 assuming moderate economic growth and the expiration of Bush Tax cuts.10 While the US is currently below the critical threshold of 90% debt to GDP, law makers need to signal to the public and to markets a willingness to grapple with the debt and budgetary issues facing the country.

At Russell, we will be watching for a resolution by August 2nd that communicates the ability by the US government to manage its affairs – even if that means raising taxes – rather than a stop-gap fix that could cause revisiting these same issues when the consequences are more severe.

Abigail Huffman, CFA, is the director of research for Russell Investments’ investment strategies group.

1 “Obama Warns of Default Risk”, July 26th, 2011, Wall Street Journal, page A4.

2 Refer to the “Debt Limit Analysis”, July 2011, by the Bipartisan Policy Center.

3 Refer to the “Debt Limit Analysis”, July 2011, by the Bipartisan Policy Center.

4 Members of the Bipartisan Policy Center endorse findings published in “The Moment of Truth” Obama’s appointed Commission on Fiscal Responsibility and Reform which proposed an overhaul of the federal tax system on December 1st, 2010. Their detailed plan “Restoring America’s Future” demonstrates the potential for compromise and solutions – elements that seem to be lacking in today’s current debate.

5 Refer to the “Debt Limit Analysis”, July 2011, by the Bipartisan Policy Center.

6 “Downgrade threat is Looming Larger”, July 26, 2011, Wall Street Journal, page A4.

7 “United States of America ‘AAA/A-1+’ Ratings Placed on credit watch negative on rising risk of policy stalemate”, by Standard & Poor’s, July 14, 2011, page 3. Emphasis added.

8 “United States of America ‘AAA/A-1+’ Ratings Placed on credit watch negative on rising risk of policy stalemate”, by Standard & Poor’s, July 14, 2011, page 3.

9 “Too Much Debt means the economy can’t grow: Reinhart and Rogoff”, July 14, 2011, Bloomberg news.

10 Today the United States has the highest credit rating of AAA. “United States of America ‘AAA/A-1+’ Ratings Placed on credit watch negative on rising risk of policy stalemate”, by Standard & Poor’s, July 14, 2011, page 4.

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  1. avatar
    M Taylor
    July 27th, 2011 at 10:30 | #1

    I appreciate this very much: simple and to the point, it answers all of my questions. Its by far the clearest article I have read on the matter.

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