For some still unknown reason, Goldman Sachs, the bank that single-handedly accounts for the bulk of Trump's closest economic and financial advisors, and whose former COO has been reportedly tasked with hatching Trump's "phenomenal" tax plan, has been on a tear in the past month to discredit his proposed political agenda. Just last week Goldman slammed Trump's proposed economic plan, warning that unlike its earlier optimism, "one month into the year, the balance of risks is somewhat less positive in our view." Goldman's Jan Hatzius then gave three reasons why his outlook had soured substantially in just a few months:
- First, the recent difficulty congressional Republicans have had in moving forward on Obamacare repeal does not bode well for reaching a quick agreement on tax reform or infrastructure funding, and reinforces our view that a fiscal boost, if it happens, is mostly a 2018 story.
- Second, while bipartisan cooperation looked possible on some issues following the election, the political environment appears to be as polarized as ever, suggesting that issues that require bipartisan support may be difficult to address.
- Third, some of the recent administrative actions by the Trump Administration serve as a reminder that the president is likely to follow through on campaign promises
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Now, in yet another note from Goldman over the weekend, the bank's Washington analyst Alec Phillips breaks down the "Fiscal Constraints on the Political Agenda" and lays out why, despite Trump's intention to announce "something phenomenal on taxes in the next 2-3 weeks", a statement which promptly boosted stocks to new all time highs, the reality is far different, and that between Trump's tax plans and various other aspects of the president's fiscal agenda, the most likely outcome will be imminent disappointment as the plan begins to move through Congress where it is about to hit major roadblocks.
The reason for the latest dour outlook on Trump's fiscal overhaul is that, as Phillips explains, in recent years, congressional Republicans have offered annual budget resolutions that aim to eliminate the federal budget deficit within ten years by reducing spending growth. This has been a politically necessary goal, as some fiscally conservative lawmakers have opposed a budget plan that does not reach balance.
And while in the past such discussions between Democrats and Republicans have been the source of much consternation, infamously leading to the US government shutdown of 2011 and subsequent US downgrade, this year's budget plans will be even more difficult to put together.
He gives the following three reasons why:
- First, the projected deficit at the end of the ten-year period that Congress uses for fiscal plans is slightly larger.
- Second, Republican leaders will need to make room in the budget for tax reform and increased infrastructure spending, unlike previous budget proposals.
- Third, more of the budget appears to be politically off-limits to proposed cuts than in the past.
As Phillips summarizes, over the next few months, the Trump Administration and congressional Republicans will need to demonstrate how they will piece this puzzle together; the President may submit an abbreviated budget to Congress within the next several weeks. More importantly, Congress will need to pass a budget resolution in order to lay the procedural groundwork for tax reform, which will require that they lay out a fiscal plan for the next ten years.
Goldman takes a middle path, concluding that it expects an eventual agreement that accommodates some of these new priorities while still achieving balance. "However, reaching this eventual agreement is likely to be a political challenge and is likely to be an early indication to financial markets that a large fiscal stimulus will be difficult to achieve in light of fiscal constraints."
This, incidentally, is what JPMorgan's trading desk has been warning for nearly two months, cautioning that "the market’s focus will likely turn back to the precise scope, timing, and structure of the Trump/Ryan fiscal/regulatory agenda."
Considering the S&P closed on Friday at new all time highs, this moment has yet to pass, and Goldman and JPM's warnings have yet to be heeded by traders.
In any case, for those wondering why Goldman continues to temper expectations for a major fiscal breakthrough from Trump, here is the full report.
From Goldman's Alec Phillips
Fiscal Constraints on the Political Agenda
Spring marks the start of budget season in Washington, and the upcoming process looks likely to be more difficult than usual, as congressional Republicans try to accommodate new policy priorities while facing greater political constraints. Over the last several years, Republicans in Congress have supported significant spending cuts in the annual budget resolution that Congress traditionally uses to guide fiscal decisions for the coming fiscal year. These spending cuts have been used to demonstrate a balanced budget by the tenth and final year of the projection. Doing so has become politically necessary as some conservative lawmakers are likely to oppose a budget plan that does not reach balance.
While the annual budget resolution is often seen as symbolic, this year’s will be more significant as it will lay the institutional groundwork for tax reform and potentially infrastructure legislation, which cannot pass until after the budget resolution does. Exhibit 1 contrasts the Congressional Budget Office’s (CBO) recently released baseline deficit projection with the FY17 budget resolution that passed the House Budget Committee last year.
Exhibit 1: A wide gap between projections and plans
Source: Congressional Budget Office, House Budget Committee
In recent budget resolutions, spending cuts have done essentially all of the work in achieving projected balance by the end of the ten-year period. While this strategy looks likely again this year, Republican leaders will face three new challenges.
- First, the baseline budget deficit they will be trying to eliminate is slightly larger than last year, mainly because the 10-year budget window has rolled one year forward in a period of widening budget deficits. The CBO projects a deficit at the end of the current 10-year projection period of 5% of GDP.
- Second and more importantly, budget plans will need to accommodate new political priorities, particularly tax reform. The Urban/Brookings Tax Policy Center estimates the revenue effect of the House Republican Blueprint on tax reform at roughly $2.5 trillion over ten years, including their most generous estimate of macroeconomic feedback on revenues (“dynamic scoring”). This is equal to nearly half of the primary spending cuts that House Republicans proposed last year to reach a balanced budget by 2026, and would increase the deficit by 0.9% of GDP by the end of the 10-year budget window. Since the border-adjusted tax (BAT) proposal in the House Republican plan raises an estimated $1.2 trillion over ten years in revenue, the low probability in our view that eventual tax reform legislation will include it suggest that fitting a substantial corporate tax rate reduction could be even greater. President Trump has yet to make a specific proposal on infrastructure, but the proposal released by his advisors shortly before the election would authorize another $140bn in tax credits, and would add another 0.1% of GDP to the deficit in ten years.
- Third, it is difficult to see how congressional Republicans can propose the same spending cuts they did last year in certain areas of the budget, in light of changed political circumstances. Last year’s budget resolution proposed reducing Medicare spending by $450bn over ten years (0.4% of GDP by the end of the budget window), but President Trump campaigned on a position that Medicare and Social Security should be left largely unchanged.
A more substantial source of previously proposed savings is the repeal of benefits under the Affordable Care Act (ACA). However, President Trump has insisted that he intends to replace it with a new program that maintains or increases coverage levels, as have some congressional Republicans. Last year’s Republican budget assumed the savings from repealing (but not replacing) ACA benefits, a difference of around $2 trillion over the next ten years, or around 1.2% of GDP by the end of the 10-year budget window. Exhibit 2 shows how the spending cuts proposed last year would reduce the baseline budget deficit in FY2027 and how much might be offset by new policy considerations.
Source: Congressional Budget Office, House Budget Committee, Goldman Sachs Global Investment Research
In theory, these additional costs could be offset with savings elsewhere in the budget. However, these cuts would be very deep as a share of projected spending in those categories. Exhibit 3 presents a scenario in which Medicare is considered off limits, savings from the ACA are not counted because they would need to be redirected into new benefits for those currently covered, and defense spending is kept at the same slightly increased level as last year’s proposal, and cuts in the remaining areas are scaled up proportionately to achieve balance while covering the cost of the tax cuts and infrastructure spending.
The upshot is that Medicaid, non-defense “discretionary” spending (funds appropriated by Congress for purposes other than defense) and other “mandatory” spending (income support programs, federal and military pensions, and veterans’ benefits) would need to be cut by between 50-80% to achieve a balanced budget within the next ten years. We are skeptical that a budget resolution that proposes cuts of this size could win the 51 votes necessary to pass in the Senate.
Exhibit 3: Large concentrated cuts are improbable but would be necessary to reach balance within political constraints
Source: Congressional Budget Office, House Budget Committee, Goldman Sachs Global Investment Research
This dilemma might be resolved by a combination of three things.
- First, it is possible though unlikely that congressional Republicans might abandon their goal of a balanced budget within ten years. Fiscal conservatives are likely to vote against a budget proposal that does not eventually achieve balance, which could sink the effort since no Democrats are likely to vote for it.
- Second, entitlement reform might be on the table after all, at least as far as the congressional budget process is concerned. While we expect changes to be made to the Affordable Care Act, we are skeptical that Congress will make meaningful changes to other social benefit programs like Medicare this year or next. That said, it is difficult to see how congressional Republicans will put together a credible budget proposal that achieves balance within ten years without proposing changes in this area.
- Third, tax cut plans might be scaled back. Compared to the roughly $3 trillion “static” cost of the House Republican plan, our expectation is that Congress will ultimately enact a tax cut of around $1.75 trillion over ten years, which would probably show up in official projections as well under $1 trillion once “dynamic scoring” is applied and various adjustments to the budget baseline are taken into account.
We note that the budget resolution that congressional Republicans will release in the next couple of months—the normal timing is early March but this looks likely to be delayed due to the ongoing debate over ACA reforms—does not become law, so congressional leaders will have some flexibility to propose policies that have a low probability of actually taking effect. That said, some aspects of the budget resolution will be quite important since the levels set in the budget outline that Congress adopts this spring will govern consideration of tax reform and potentially infrastructure legislation. If those bills exceed the limits in the resolution, they could lose procedural protections and could require 60 votes (and therefore Democratic support) in the Senate to pass.
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Finally, here are the clues to look for over the next several weeks to see how Trump's agenda is progressing.
- February 28 – State of the Union Address: President Trump seems unlikely to go into much detail, but his comments on the broad aspects of some of the issues discussed above could shed light on the administration’s general approach.
- March – President’s Budget? White House officials continue to indicate that some type of budget proposal will be released in the next few weeks. This looks likely to touch on tax reform and infrastructure, but it is unclear whether it will constitute an abbreviated budget that presents a summary across all areas of the budget, similar to what other new presidents have proposed, or whether it will include proposals in just a few areas.
- April – Congressional budget resolutions: As discussed above, Congress traditionally approves (or tries to approve) a budget resolution by April that includes spending and revenue levels for each of the next ten fiscal years. This resolution is also likely to include “reconciliation instructions” for tax reform, which is the only way that legislation can pass with 51 votes in the Senate. While the resolution itself does not have the force of law—the President never signs it—it must pass before tax reform legislation can begin to move forward.
Normally the first iteration of the budget resolution is released in the first or second week in March, but this year’s process might begin slightly later due to delays in considering ACA repeal legislation, which for procedural reasons needs to be largely concluded before the budget process can begin.