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By Robert Johnson, CFA and Jeremy Glaser | 05-10-2017 11:00 AM

Budget Data Shows Hints of What's to Come

Bob Johnson says there's good news with payroll taxes, but individual income and corporate taxes showed no growth while interest expense rose.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. With federal budget data through April, I'm here with Bob Johnson, he is our director of economic analysis, who thinks that it's giving us a preview of what the budget could look like in the years to come.

Bob, thanks for joining me.

Bob Johnson: It's great to be here today.

Glaser: So, let's take a look at what we've seen so far this year. Through April is the data that we have. What's happening with both expenditures and the amount of money that the federal government is bringing in?

Johnson: Yeah. First of all, on the receipts side of the house, the growth was relatively modest through the first seven months of the year, and again, they are on a September fiscal year. It grew about 0.7% and remember, this isn't inflation-adjusted. This is just the flat number and we've had some inflation this year. So, that's a pretty disappointing number at 0.7%. There was a mechanism where the Federal Reserve had to pay back some money in that calculation. But even if you add that and receipts were still only just under 2% growth year-over-year, seven months over seven months. So, clearly, a number that's a bit disappointing. When employment is growing faster, you hear things are getting better. It just wasn't a great number.

Then you look at the expenditures side, and the growth was like 4%. So, clearly, a bigger number. The Social Security, Medicare, and so forth, some of the big social programs, those numbers continue to grow at about 3% or so, which is probably not as bad as it has been, but still a hefty number that's driving that 4% overall growth.

Glaser: Let's look at those receipts first. You said that we're having better employment. Why is that not turning into higher taxes?

Johnson: Yeah. Well, you know, the one category that is doing well is overall payroll taxes. That's the most directly measured, people that have a daily job and those payroll taxes are up about 5% year-over-year and that's a very, very big portion of the total tax take is those payroll taxes. And that's tied pretty much to how fast the payrolls and payroll dollar grows. And so, we saw that 5% level there. So, that's the good news and unfortunately, that's about the end of the good news.

The other part of it is, is individual income taxes that aren't withheld. Maybe the retirees send in cash every quarter; small businesses that send in their quarterly tax payments. Those other items showed no growth whatsoever. And so, that was clearly disappointing. And then we turn to corporate taxes, again, they had been a major league of hurt. At least now, they've stopped declining, but there was no growth in that category. And then the other receipts also didn't do much. So, the only category with any significant growth at all was the payroll tax number, and that's why the overall number was as low as it was, depending on which metric you use, the 0.7% or the just under 2% growth.

Glaser: That corporate tax number comes as we're beginning to talk more about corporate tax reform. Is that a sign that the system is kind of broken, and it does very much need this reform? How do you, kind of, square that with the political realities?

Johnson: Yeah. A very interesting question. I mean, of the total government take of 1.4 million or so that we've so far, a couple of hundred million of that's from--or less than that--is from corporate. And so, it's not a very big piece of the tax puzzle. It's been more at times, but now there's been a couple of things where corporations have become better at managing their taxes. So, they pay less on a worldwide basis by where they recognize income. And certainly, that's hurt the corporate tax number some. And then you've got some of the big hefty profit-makers, the oil companies, banks, and so forth, and a number of other businesses running into a bit of a profit slump last year. And certainly, that's hurt the number just a little bit, too. But clearly, it looks like we're in need of some reform here with no growth in that category.

Glaser: Let's look to the expense side now, the expenditures side. Medicare, Social Security--these are kind of known programs, but you said that interest expense is also becoming a bigger problem as rates rise.

Johnson: Absolutely is. I mean it's, overall, in terms of expenditures it's a big number, but it's grown like a weed. The interest-rate expense was up 20% for the first seven months, and that was the biggest, fastest-growing expenditure in the federal budget. We had all thought it might take a little bit longer for that to work through because they obviously have a big book of things that they pay interest on and some of it's one year, some of it's five years, some of it's as much as 30 years. So, it takes a while for that to roll through. And we didn't think the numbers would get this bad this quickly. But what's happened is inflation is moved higher. And there are a number of inflation-adjusted securities and portfolio and that's begun to impact the data. And that's why we've seen such a dramatic increase.

And I think, unfortunately, it's a little bit of a preview of what could happen going forward. Now, this is just on the inflation adjustment part of the equation, and now as we have people pay off some of the older debt--the government pays off some of the older debt and now it has to be finance it again--now the rates are going to start moving up. You're going to have this situation where rates move higher and create this problem where every year you run a deficit, so the amount of debt gets bigger and not only does the amount of the debt get bigger, but the interest rates move up just because the natural aging of the portfolio and you get this situation where you get a rising deficit. So, those that are thinking we've got a ton of free money to expand and stimulate all we want at no expense to the rest of the world, they are sadly mistaken.

Glaser: Is there anything that could be done to try to mitigate the risk of higher rates in the portfolio? Could they change the maturities? Have less short-term debt? Is there any talk of moves there?

Johnson: Yeah. I mean, there is some talk of issuing some longer-term debt as many countries do to take advantage of the low rates that we have right now. The only problem is, in the short run, short interest rates, which we're mildly addicted to right now, are so much lower than, say, even the 10-year rate that if you suddenly moved everything from being in a one to five-year category to the 10-year category, you're looking at rates that go from less than 1% to well over 2%. So, you automatically double your interest expense on that portion that you shift. So, it's great for the long term, because obviously the Federal Reserve is clearly signaling that rates aren't going to be low forever, and they are targeting a 3% Fed funds rate over time. If they are clearly thinking that number, those short-term rates won't be around forever. But if we bite the bullet and go those longer maturities right now, it immediately kicks a giant hole in the deficit.

Glaser: No easy answer then, but it seems like there are some hints of what needs to get done to bring the picture back into balance?

Johnson: Yeah, absolutely.

Glaser: Bob, thanks for joining me today.

Johnson: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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