Deficits Matter Now Even If You Pretend Not to See Them

Republicans are exploring a budget gimmick to make tax cuts politically easier, but gimmicks won't save them from inflation.

Dear readers,

I have a few updates on the fiscal timeline I wrote last month. Since then, we’ve learned a few interesting things about the way Republicans plan to make tax and spending policy as they move into a new Congressional session — developments that reflect how challenging it’s going to be to work with the bare majority they have in the House of Representatives.

The first development is one that surprises me. According to Punchbowl News, incoming Senate Majority Leader John Thune has told his caucus that he wants to try to move two reconciliation bills next year, but he’s not proposing to have the tax bill go first — he wants, within the first 30 days of the new Congress, to pass a bill through budget reconciliation pursuing Republican priorities “like border security, defense and energy.”

I see two main problems with this plan:

• Budget reconciliation can only be used for fiscal (tax and spending) measures. Per Punchbowl, Thune noted that Democrats successfully stretched the policymaking boundaries of the reconciliation process with the Inflation Reduction Act, and he believes Republicans can do the same toward their own ends. But the way Democrats did that through the IRA was by finding fiscal ways to pursue non-budgetary policy ends, like using tax credits to pursue carbon emissions goals. There are key aspects of the Republican policy wish list in these areas that I don’t believe can be made fiscal, like changing the rules around asylum applications and loosening permitting requirements for energy projects.

• House Republicans would need to achieve unanimity on this approach. After Trump is inaugurated, Republicans are likely to have just a 217-215 majority in the House of Representatives. So for Thune’s plan to work, every House Republican will have to agree twice — first on a budget resolution that says how much this bill can increase the deficit, and then on the bill itself. That’s going to be difficult. On the other hand, it’s probably not as difficult as getting unanimous agreement on a tax bill. So I can see why Republicans might want to move this package first and wait a few months to do the tax package, until after special elections that fill vacant Republican seats and take their majority up to a slightly more comfortable 220.

I’d note that this is just an idea coming from the Senate Majority Leader — House Republicans will have to have their own say on the approach and the order they’d like to go in. So far, Majority Leader Steve Scalise has been saying he wants to include the tax plan in the first reconciliation bill — a bill that could also have other non-tax policies rolled into it — and pass it in the first 100 days, rather than waiting to do tax in a second reconciliation package.

I also suspect that, even if Republicans make fiscal moves related to the border and energy through the reconciliation process, they will still try to move some legislation about immigration policy and energy policy through the Senate under regular order, seeking a 60-vote majority that would have to include at least seven Democrats, so they can make changes that are not eligible for reconciliation. And there’s reason to think they might succeed: Republicans’ pledge to crack down on the asylum-seeking surge is popular, and Democrats have significant openness to permitting reforms to promote energy investment, so there should be room for bipartisan cooperation on these issues. But they should probably try to get that done before Trump poisons the well too much with whatever else he does upon taking office.

Besides Thune’s stated plan and its looming challenges, the second development affecting Republicans’ early 2025 plans is one that hasn’t quite happened yet. There’s still no agreement about what to do about the fact that the federal government is only funded through December 20, 17 days from now. (Republicans have been waiting for Trump to weigh in and tell them what he wants done, but he hasn’t obliged.) As Politico notes, internal House GOP conference politics are likely to lead Speaker Mike Johnson to seek another stopgap spending bill that creates a new funding deadline in the first quarter of next year. That means, if Thune gets his way, Republicans in Congress will have to resolve two big negotiations — one over the border/defense/energy bill, and one over spending levels for the current fiscal year — before they can even get to tax policy. I wrote last month that passing full-year funding bills before the end of this year could give Republicans a good amount of momentum for the tax negotiations, but it’s looking unlikely at this point.

And then the third development regards the tax policy fight itself. Much of the 2017 tax cut law is scheduled to expire at the end of 2025, and Republicans will have to decide how much of the law should be extended, which other new tax cuts should be enacted, and how (and how much) of the resulting deficit increase should be offset. Pushing the tax cuts out another ten years will add about $4 trillion to the federal budget deficit. But some Republicans have a big idea about how to deal with that: what if we just say it doesn’t cost anything?

ChatGPT image generation for “hidden budget deficit”

The New York Times reported last month:

Senator Michael D. Crapo, an Idaho Republican who is expected to lead the Senate Finance Committee next year, took to Fox Business this week to make that argument.

“If you’re just extending current law, we’re not raising taxes or lowering taxes, that is a $4 trillion deficit. That’s ridiculous,” he said in an interview with Larry Kudlow, who helps advise President-elect Donald J. Trump. Mr. Crapo said later, “We’re going to have to take the bold steps of saying to the American people that we are not going to let $4 trillion of tax hikes happen and that it’s not going to increase the deficit.”

As the Times notes, it wouldn’t be the first time lawmakers took this approach to an expiring tax law:

In 2012, Congress and President Barack Obama faced a situation very similar to what lawmakers are dealing with now. Sweeping tax cuts signed into law by President George W. Bush were set to expire at the end of 2012, creating an expensive fiscal cliff. The Obama White House made the same argument as Mr. Crapo: The cost of legislation should be measured against “current policy,” which assumed that the Bush tax cuts would continue, not “current law,” under which the cuts would expire.

The thinking allowed the Obama White House to claim that the deal it made to extend many of the Bush tax cuts reduced the deficit by more than $700 billion over 10 years. The budget office, using the current law base line, said it actually increased deficits by roughly $4 trillion over that time frame.

When I wrote my 2025 fiscal preview last month, I noted that there are three different ways the deficit effect of legislation can matter.

1. The deficit can matter legally: The rules that govern the budget reconciliation process prevent Congress from passing laws that are projected by the Congressional Budget Office to increase budget deficits in the long run (that is, in the period starting 10 years from now). Laws passed through the reconciliation process can raise budget deficits in the nearer term, but only to the extent that a budget resolution passed by both houses of Congress permits the increase.

2. The deficit can matter economically: Increased government borrowing can stimulate a slumbering economy to produce real economic growth, but when the economy is near its productive capacity, higher budget deficits are likely to push inflation and interest rates upward, while doing little or nothing to boost GDP.

3. And the deficit can matter politically: Lawmakers want to be able to say they’re being responsible about the deficit, so they can be reluctant to vote for bills that appear to have large fiscal costs. Sometimes, they set red lines: Sen. Bob Corker fought to ensure that the budget resolution enabling the 2017 tax law would restrict the bill from being “scored” as raising the deficit by more than $1.5 trillion over the ten-year budget window, and Sen. Joe Manchin insisted that Democrats’ 2022 tax-and-spending package, the Inflation Reduction Act, be scored as producing a modest deficit reduction.

Crapo’s plan is aimed at point (3): he is offering up a way for Republicans to extend the tax cuts and then go on television and say they didn’t raise the deficit. He might also think it aims at point (1) — the Times reports he’s interested in adopting the “current policy” baseline as an actual Senate rule, not just a talking point. But the Times also says he’s likely to face resistance from other Republicans on doing that, and it’s not obvious that doing so would actually give Congress any new flexibility on what can go in the reconciliation bill, since the restrictions on how reconciliation bills can affect the budget are set out in statute, not just Senate rules.

But the most important thing here is point (2) — how the Senate chooses to characterize the deficit effect of a bill has no impact on inflation or interest rates. Economic outcomes will be driven by what the bill actually does, not what lawmakers say it does.

In many of the recent cases when Congress has passed major laws to expand the budget deficit — most notably, in 2001 and 2003 and 2010 and 2013 and 2017 — the inflation environment was mild and there was substantial fiscal space to cut taxes and grow the deficit without putting significant upward pressure on prices or interest rates. The most important constraints on deficit expansion were political, not economic, and I think Republicans are operating with a certain amount of muscle memory from that experience: what they remember is that if you want to do something that grows the deficit, the main challenge you face is making the politics work.

But there have been more recent experiences with deficit expansion since 2017, and we’ve seen that the old rule no longer applies.

The COVID pandemic led to a combination of real negative supply shocks and aggressive government intervention to boost demand — this led to tight economic conditions with shortages of goods and labor, and the result was that fiscal expansion (deficit spending or tax cuts) tends to produce inflation rather than real economic growth. Democrats learned this the hard way — in 2021, they enacted an excessively large COVID relief package, the American Rescue Plan, which ballooned the deficit and contributed significantly to spiking inflation. In 2022, they passed a tax-and-spending package that was branded as the “Inflation Reduction Act,” but because its deficit-reducing effects were backloaded (no deficit cuts until 2027), it had little near-term effect on inflation.

Because budget deficits have been so excessively large in recent years, the primary responsibility for fighting inflation has fallen to the Fed, which sharply raised short-term interest rates to fight inflation. Long-term rates (including mortgage rates) are also elevated compared to recent years, and mortgage rates have continued to go up even as the Fed has started to cut short-term rates — this reflects market expectations that federal budget deficits will remain elevated and the Fed will continue to need to keep interest rates on the high side to stop those deficits from producing more inflation.

So while Republicans may well succeed in creating the political space that allows them to pass a deficit-busting tax cut — and part of the strategy for that might be using a “current policy” baseline to argue the deficit isn’t getting busted at all — they can’t message their way out of the fact that more government borrowing is likely to do for them what it did for Democrats: push prices up, and/or require the Fed to produce a painful interest rate environment so prices don’t go up. And those real economic limitations are likely to be the most important ones Republicans run up against as they seek to do more tax cutting next year.

Very seriously,

Josh