The US election is now less than seven weeks away. We have witnessed two quite memorable Presidential debates. The candidates have clashed on issues of character, fitness for office, U-turns on previous policy positions, etc. All important topics, to be sure. However, direct questions on how to address key policy issues are dodged repeatedly. Not too surprising, candidates don’t like to delivery hard news to an electorate that prefers to hear only rose-coloured messaging.

During the recent United Kingdom election, the esteemed Institute for Fiscal Studies suggested there was a “conspiracy of silence”, as all parties proved unwilling to address the unsustainable state of the country’s public finances. The same observation can be made about the United States. Reflecting the sharp rise in government spending following both the Global Financial Crisis and Covid pandemic and the Trump administration tax cuts, the USA has experienced annual budget deficits of roughly 7% of GDP during the past two decades.

As a result, Federal government debt as a percent of GDP has doubled, and now stands at 100% of GDP. More worrisome, perhaps, the situation is on an unsustainable path. The influential Congressional Budget Office (CBO) projects central government debt will reach 122% of GDP in the next decade, as yearly deficits remain near 7% of GDP. Using the OECD’s broader definition (including state and local goverments), overall public sector debt could reach 150% unless action is taken.

And yet, the candidates ignore the US debt crisis. What are they not telling us? What are the implications for the US public, economy, and global financial markets both if problem is eventually addressed after polling day…..and if it is not?

How Did We Get Here, What Needs to Be Done?

To be sure, the USA is not alone, as government liabilities have soared in most countries. However, US public debt is now higher than all other major economies, except Japan and Italy. Identifying how the problem emerged may give clues to the solution. The Chart below indicates that US fiscal problems reflect a combination of higher government spending along with tax reductions (much like China). In Europe and Canada, in contrast, the need for greater public sector outlays was offset partially by increased taxation. As a result, the surge in debt levels has been less significant.

Where are we now, what needs to be done? Economists suggest that reducing a country’s debt ratio requires the annual primary deficit (the overall shortfall excluding interest payments) be less than the gap between real interest rates and real GDP growth. The following Chart indicates the US must cut its primary deficit roughly 4.5% of GDP simply to stabilise the debt burden, let alone reduce it. The required adjustment exceeds all countries except Japan and Brazil.

What’s Needed: The Conspiracy of Silence

A look at how the US federal government raises revenue and allocates spending sheds light on the likelihood of a fiscal adjustment of this scale, and on whom the burden might fall.

Expenditures

Not surprisingly, both candidates are pledging higher — not lower — government spending. In promoting her still undefined “Opportunity Economy”, VP Harris is focused on supporting worthy targets, e.g. small businesses, housing costs, healthcare, etc. Former President Trump’s spending priorities are pretty unclear, but his attempt to distance himself from the Project 2025 draconian spending cuts indicates his preference for populist outlays.

However, cutting government spending is more difficult than most imagine. In particular, 61% of federal outlays are “mandatory”, e.g guaranteed by existing legislation, and not part of an annual budgetary assessment. These include very popular Social Security, Medicare and Medicaid programs. Both candidates support these plans. It’s hard to imagine either proposing legislation reneging on their pledge to protect these politically sensitive programs. Beyond political considerations, the population demographics point to greater spending pressure on these age-related outlays (Chart below).

Defense procurement represents another 16% of government expenditures. Given the current geopolitical climate, both political parties appear more likely to increase (not cut) defense spending from its current level of nearly 3.5% of GDP.

Similarly, interest payments on outstanding government debt currently account for another 16% of government spending, the same as national defense. As the level of public sector debt continues to rise, so to will servicing costs. Within a decade, interest payments will be the largest government expense aside from Social Security. By 2034, debt servicing will amount to over 4% of GDP compared to the 2% historical average.

That leaves only non-defense discretionary spending, which amounts to 3.3% of GDP at present. If the USA is required to make a fiscal adjustment of over 4% of GDP simply to stablise its debt level, ALL discretionary spending (every cent, and more) on these vital programs will need to be eliminated. I do not hear either candidate mentioning this fate awaits the American public after polling day.

Taxation

With security and demographic pressures limiting the scope for spending cuts, higher taxation should play a role in America’s needed fiscal adjustment. Indeed, lower tax revenues are one of the sources of the fiscal mess. Nevertheless, despite the CBO’s projection that under prevailing laws public sector revenues will rise 1% of GDP in the next decade, government deficits will remain near 7% of GDP. In the absence of meaningful spending reductions, taxes would need to rise even more than the CBO is forecasting. Again, neither candidate has outlined clear plans to comprehensively raise taxes on the American public.

The CBO’s estimate of higher revenues in the next few years reflects the expiration of the Trump era reductions in personal taxes (TCJA). If elected Donald Trump, would likely extend these tax cuts for several years. Likewise, if Kamala Harris becomes President, it’s hard to imagine her allowing higher taxes for low and middle-income families. Therefore, I would expect her to extend the TCJA tax cuts for all except the highest earners. As a result, tax revenues might fall short of the CBO’s projections in the next couple of years.

Nevertheless, higher taxation inevitably will play a key role in America’s fiscal adjustment. International experience suggests the most successful deficit reduction programs involve $2 of spending cuts for each $1 of greater revenues. In VP Harris’ case, the burden would primarily fall on higher earners, as well as corporations, whose share of the tax burden has declined consistently over the past decades (from nearly 3% of GDP in the 1970s to just over 1% now). Donald Trump’s ill-considered plan to rely on import tariffs is not a good start to a successful deficit-reduction plan. Indeed, the extreme version of replacing personal taxes with customs revenues would require levies of 40% on all imported goods, which would boost inflation 6%-8% and almost certainly tip the economy into recession.

Strategic Considerations: What They’re Not Saying

• A successful fiscal adjustment of 4-5% of GDP, of course, should not happen all at once — it may require 4 to 8 years. This would represent an economic headwind of roughly 0.5% of GDP per year.
• On the other hand, the lack of required belt-tightening would continue to crowd out private investment and curb productivity growth. This has been the experience of high-debt nations such as Japan and Italy where GDP per capita has declined in recent decades.
• Likewise, the UK experience of the short-lived Truss government last Autumn highlights the market and economic consequences of fiscal mismanagement.
• The most successful fiscal adjustments involve a combination of tax hikes and spending cuts. I believe the US tax burden will inevitably rise during the next 5-10 years. The burden will largely (and correctly) fall on high earners and corporations.
• Politically unpopular adjustments to entitlement programs appear inevitable, perhaps delaying entry into programs to reflect the longer life expectancy in the future. Non-defense discretionary spending could decline up to 2% of GDP. Defense spending with increase its share of the budget.
• As an alternative to austerity, the US could attempt to grow its way out of the problem. This would require a plan to boost productivity, expand the labour force, and promote capital spending. The candidate with the most sensible approach to immigration, public investment (climate, infrastructure, etc.), and improving the business climate for innovation and global trade will have the most favourable impact on public finances. You decide…..I already have!
• A successful fiscal plan would be extremely bullish for financial markets, especially as it would allow the US Federal Reserve to cut interest rates even more than is expected at present.
• Financial markets have been patient so far. Unfortunately, I expect deficit-induced market volatility will be required before US policymakers address the debt/deficit issue head on, regardless of who resides in the White House in January.