According to the most recent Congressional Budget Office (CBO) projection, the federal budget deficit for the fiscal year 2018 (which ends on September 30) will reach $793 billion, or 3.9% of gross domestic product (GDP). This figure is $230 billion larger than the CBO previously estimated in June 2017, largely because legislation enacted since then reduced potential revenues and increased anticipated spending.1
The government runs a deficit when it spends more money over the year than it collects in tax revenue. To cover the difference, the government must borrow money from investors through the sale of Treasury bonds. Annual budget deficits add to the national debt, which already exceeds $21 trillion.2
As things stand, the budget shortfalls are not projected to end any time soon. In fact, the federal deficit is projected to widen substantially over the next several decades, reaching 9.5% of GDP by 2048.3
Here’s a closer look at the nation’s current fiscal situation and what it could mean for future economic growth.
The Tax Cuts and Jobs Act, which took effect in January 2018, included permanent rate reductions for corporations and temporary ones for individuals. The CBO projects that the tax law will stimulate economic activity and increase annual real GDP by 0.7%, on average, between 2018 and 2028.4
The Bipartisan Budget Act of 2018, passed by Congress in February, is a two-year budget deal that raises statutory spending caps that have been in place since 2011. It allows for $80 billion in additional spending for defense and $63 billion for domestic programs in 2018, and similar amounts for next year. The Consolidated Appropriations Act, a massive 2,232-page spending bill approved in March 2018, provides $1.3 trillion in government funding through fiscal year 2018.5
Despite higher GDP growth, these three bills are expected to increase deficits by $2.7 trillion between 2018 and 2027, with $1.7 trillion from reduced revenues and $1.0 trillion from increased spending.6
While discretionary spending is controlled by Congress on an annual basis, mandatory spending (primarily for programs such as Social Security, Medicare, and Medicaid) is set automatically by formulas. Mandatory programs will account for about 38% of federal non-interest spending in 2018.7
Going forward, mandatory spending is projected to rise by an average of 6% per year, reaching $4.4 trillion by 2028. This trend is partly due to demographics, as a large population of baby boomers become eligible for benefits. In addition, health-care costs per Medicare and Medicaid beneficiary are likely to grow faster than the economy over the long term.8
If the nation stays on its current path, debt held by the public will grow from roughly 78% of GDP in 2018 to 96% of GDP by 2028, according to CBO projections. This would be the highest level since 1946 and more than two times the average over the last 50 years.9
Rising debt combined with higher interest rates will increase the government’s annual interest costs, which would roughly double between 2018 and 2028 (when measured as a percentage of GDP).10
The CBO expects that a significant rise in federal spending will boost the U.S. economy in the short run, especially in 2018 and 2019. However, it is likely to lower real GDP in later years, when rising debt payments take a bigger bite out of tax revenues, resulting in even larger deficits.11
Increasing federal borrowing to cover large deficits could erode Treasury bond values.12 The Treasury is selling more bonds to finance higher debt at the same time the Federal Reserve is winding down its bond-buying program. To some degree, the expected increase in the supply of available Treasury bonds could be offset by an increase in demand if new Treasuries offer higher yields, but imbalances of supply and demand could spur some market volatility.
Another concern is that the economy and inflation could heat up too quickly, prompting the Federal Reserve to raise rates at a faster pace. And with debt mounting, lawmakers may have less flexibility to use fiscal policies to respond to future economic challenges.
The widening deficit also highlights some key challenges in balancing the federal budget. Tax breaks are often welcome, but they reduce revenue unless they generate large-scale economic growth. Many costly government programs are popular, essential, or both. Eventually, it could take some hard choices to reduce annual deficits and keep the national debt from rising to unsustainable levels.
U.S. Treasury securities are guaranteed by the federal government as to the timely payment of principal and interest. Bonds not held to maturity could be worth more or less than the original amount paid.
January is typically a strong month for the municipal bond market, but 2018 began with the worst January performance since 1981, driven by rising interest rates and uncertainty over changes in the Tax Cuts and Jobs Act (TCJA).1 The muni market stabilized through April 2018, but uncertainty remains.2 The tax law changed the playing field for these investments, which could affect supply and demand.
When considering these dynamics, keep in mind that bond prices and yields have an inverse relationship, so increased demand generally drives bond prices higher and yields lower, and vice versa. Any such changes directly affect the secondary market for bonds and might also influence new-issue bonds. If you hold bonds to maturity, you should receive the principal and interest unless the bond issuer defaults.
Municipal bonds are issued by state and local governments to help fund ongoing expenses and finance public projects such as roads, water systems, schools, and stadiums. The primary appeal of these bonds is that the interest is generally exempt from federal income tax, as well as from state and local taxes if you live in the state where the bond was issued. Because of this tax advantage, a muni with a lower yield might offer greater value than a taxable bond with a higher yield, especially for investors in higher tax brackets.
The lower federal income tax rates established by the new tax law would cut into this added value, but the difference is relatively small and unlikely to affect demand. Many taxpayers, especially in high-tax states, may find munis even more appealing to help replace deductions lost to other TCJA provisions, including the $10,000 cap for deductions of state and local taxes.3 Tax-free muni interest can help lower taxable income regardless of whether you itemize deductions.
The large corporate tax reduction from a top rate of 35% to 21% is likely to have a more significant effect on demand for munis. Corporations, which own a little less than 30% of the muni market, may hold on to bonds they currently own but become more selective in purchasing future bonds.4
|Federal Income Tax Rate||Taxable Equivalent Yield on 3% Muni|
The supply of new municipal bonds dropped after the fiscal crisis as local governments became more cautious about borrowing. The TCJA further tightened the market by eliminating “advanced refunding” bonds, issued to replace older bonds at lower interest rates, which have accounted for about 15% of new issues.5
This is expected to reduce the supply of bonds for the next three years or so, but the long-term effects are unclear. If interest rates continue to climb, there is less to gain by replacing older bonds, but local governments may issue taxable bonds if they see an opportunity to reduce interest payments. There may also be changes to the structure of future muni issues.6
Munis are considered less risky than corporate bonds and less sensitive to changing interest rates than Treasuries, making them an appealing middle ground for many investors. For the period 2007 to 2016, which includes the recession, the five-year default rate for municipal bonds was 0.15%, compared with 6.92% for corporate bonds. Most of those defaults were related to severe fiscal situations such as those in Detroit and Puerto Rico. The five-year default rate for investment-grade bonds (rated AAA to BBB/Baa) was just 0.05%.7
Treasuries, which are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, are considered the most stable fixed-income investment, and rising Treasury yields, as occurred in early 2018, tend to put downward pressure on munis.8 However, Treasuries are more sensitive to interest rate changes, and stock market volatility makes both Treasuries and munis appealing to investors looking for stability.
The most convenient way to add municipal bonds to your portfolio is through mutual funds, which also provide diversification that can be difficult to create with individual bonds. Diversification is a method used to help manage investment risk; it does not guarantee a profit or protect against investment loss.
Muni funds focused on a single state offer the added value of tax deductibility for residents of those states, but smaller state funds may not offer the level of diversification found in larger states. It’s also important to consider the holdings and credit risks of any bond fund, including those dedicated to a specific state. For example, in October 2017, many state funds still held Puerto Rico bonds, which are generally exempt from state income tax but carry high credit risk.9
If a bond was issued by a municipality outside the state in which you reside, the interest may be subject to state and local income taxes. If you sell a municipal bond at a profit, you could incur capital gains taxes. Some municipal bond interest may be subject to the alternative minimum tax.
The return and principal value of bonds and bond fund shares fluctuate with changes in market conditions. When redeemed, they may be worth more or less than their original cost. Bond funds are subject to the same inflation, interest rate, and credit risks associated with their underlying bonds. As interest rates rise, bond prices typically fall, which can adversely affect a bond fund’s performance. Investments offering the potential for higher rates of return involve a higher degree of risk.
Mutual funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
1, 8) CNBC, February 28, 2018
2) Bloomberg, 2018 (Bloomberg Barclays U.S. Municipal Index for the period 1/1/2018 to 4/16/2018)
3-4, 6) The Bond Buyer, February 12, 2018
5) The New York Times, February 23, 2018
7) Moody’s Investors Service, 2017
9) CNBC, October 10, 2017
The Tax Cuts and Jobs Act, a $1.5 trillion tax cut package, was signed into law on December 22, 2017. The centerpiece of the legislation is a permanent reduction of the corporate income tax rate. The corporate rate change and some of the other major provisions that affect businesses and business income are summarized below. Provisions take effect in the tax year 2018 unless otherwise stated.
Individuals who receive business income from pass-through entities (e.g., sole proprietors, partners) generally report that business income on their individual income tax returns, paying tax at individual rates.
For tax years 2018 through 2025, a new deduction is available equal to 20% of qualified business income from partnerships, S corporations, and sole proprietorships.
For those with taxable incomes exceeding certain thresholds, the deduction may be limited or phased out altogether, depending on two broad factors:
For those with taxable incomes not exceeding $157,500 ($315,000 if married filing jointly), neither of the two factors above will apply (i.e., the full deduction amount can be claimed). Those with taxable incomes between $157,500 and $207,500 (between $315,000 and $415,000 if married filing jointly) may be able to claim a partial deduction.
The cost of tangible property used in a trade or business, or held for the production of income, generally must be recovered over time through annual depreciation deductions. For most qualified property acquired and placed in service before 2020, special rules allowed an up-front additional “bonus” amount to be deducted. For property placed in service in 2017, the additional first-year depreciation amount was 50% of the adjusted basis of the property (40% for property placed in service in 2018, 30% if placed in service in 2019).
The Act extends and expands first-year additional (“bonus”) depreciation rules. Bonus depreciation is extended to cover qualified property placed in service before January 1, 2027. For qualified property that’s both acquired and placed in service after September 27, 2017, 100% of the adjusted basis of the property can be deducted in the year the property is first placed in service. The first-year 100% bonus depreciation percentage amount is reduced by 20% each year starting in 2023 (i.e., the first-year bonus percentage amount will be 80% in 2023, 60% in 2024, 40% in 2025, and 20% in 2026) until bonus depreciation is eliminated altogether beginning in 2027.
For qualified property acquired before September 28, 2017, prior bonus depreciation limits apply — if placed in service in 2017, a 50% limit applies; the limit drops to 40% if the property is placed in service in 2018, and to 30% if placed in service in 2019.
Note that the timelines and percentages are slightly different for certain aircraft and property with longer production periods.
Small businesses may elect under IRC Section 179 to expense the cost of qualified property, rather than recover such costs through depreciation deductions. The Tax Cuts and Jobs Act increases the maximum amount that can be expensed in 2018 from $520,000 to $1,000,000, and the threshold at which the maximum deduction begins to phase out from $2,070,000 to $2,500,000. Both the $1,000,000 and $2,500,000 amounts will be increased to reflect inflation in years after 2018. The new law also expands the range of property eligible for expensing.
Under pre-existing corporate tax rules, U.S. companies were taxed on worldwide profits, with a credit available for foreign taxes paid. If a U.S. corporation earned profit through a foreign subsidiary, however, no U.S. tax was typically due until the earnings were returned to the United States, generally in the form of dividends paid. This system contributed to some domestic corporations moving production overseas and may have led some multinational companies to keep profits outside the United States.
The new law fundamentally changes the way multinational companies are taxed, making a shift from worldwide taxation of income to a more territorial approach. Under the new rules, qualifying dividends from foreign subsidiaries are effectively exempted from U.S. tax. This is accomplished by allowing domestic C corporations that own 10% or more of a foreign corporation to claim a 100% deduction for dividends received from that foreign corporation to the extent the dividends are considered to represent foreign earnings.
The new law also forces corporations to pay U.S. tax on prior-year foreign earnings that have accumulated outside the United States in foreign subsidiaries, through a one-time “deemed repatriation” of the accumulated foreign earnings. U.S. shareholders owning at least 10% of a specified foreign corporation* may be subject to a one-time tax on their share of accumulated untaxed deferred foreign income; deferred income that represents cash will be taxed at an effective rate of 15.5%, other earnings at an effective rate of 8%; the resulting tax can be paid in installments. The tax applies for the foreign corporation’s last tax year that begins before 2018. The one-time tax is also not limited to C corporations; it can apply to all U.S. shareholders, including individuals (special rules apply to S corporations and REITs). After paying the one-time deemed repatriation payment, foreign earnings can be brought back to the United States without paying any additional tax.
*Includes controlled foreign corporations (CFCs) and non-CFC foreign corporations (other than passive foreign investment companies, or PFICs) if there is at least one 10% shareholder that is a U.S. corporation.