Will the US Fiscal Deficit Undershoot?

Investors across all markets should pay close attention to US tax receipts in coming months, because if the economy is truly at an inflection point in the current quarter, it should swiftly translate into monthly revenue increases of 4-5% for the Federal coffers. Anything less would signal that the much lauded recovery has been postponed, or is so anaemic as to be inconsequential for personal and corporate income and hence taxes. If that recovery is as rapid as risk assets are currently discounting, then investors who have been fast to discount the implications for corporate earnings should reflect that this scenario also implies a smaller than expected deficit. It's increasingly possible the deficit will undershoot the forecast $1.3trn in the fiscal year beginning in September by about $150-200bn, which has implications for the dollar and Treasuries as a 'positive' surprise. It's even conceivable that the Obama stimulus plans may be scaled back in order to save the cherished healthcare project, which is foundering on cost as much as principle. The chart below indicates a slowing in the rate of decline in tax receipts since the Spring, to a 3-mth annualized decline of 10% in July.

The original Treasury and CBO estimate was for a $1.8trn deficit for this fiscal year, and we're up to $1.3trn as of end July. Key factors have been tax revenues plunging 17%, adding $353 billion to the deficit. That decline has been particularly sharp for corporate incomes taxes (down 57%) and individual income taxes (down 20%). The CBO estimates that spending to date on TARP will have net cost to taxpayers of $169 billion (the government has injected $83 billion into Fannie Mae and Freddie Mac, the two housing GSEs making a total of $252 billion to the deficit). Spending on other programs has increased 14%, adding $325 billion to the deficit. These increases are spread across many program areas; for example, defense spending is up 8% as the commitment to Afghanistan increases and Medicare spending is up 15%. The most striking increases, however, are for benefit programs like unemployment up more than 160% and Medicaid up almost 24%, which have been boosted by the weak economy and expanded Federal programs.

The one positive is on interest payments (for the moment at least), which are down despite the explosion of federal debt. Payments have fallen on conventional bonds because of low interest rates and on TIPS because of low inflation. If a surprise emerges over the next few months in either direction for markets, a key category to watch for a pointer is US tax revenues. Spending will decline as we get past the irregular stimulus package spending period, while revenues will be highly geared to economic activity. Even a positive outcome leaves the US with about a 10% deficit to fund on an ongoing basis based on spending at over 25% of GDP, which is simply unsustainable, but at least near-term, worries over a funding and associated dollar crisis may prove misplaced.

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