Could the US election unplug or charge up the energy transition? 

Ritu Vohora

You know, the CBO estimates, that spending to service debt will exceed the spending on national defense in 2024, which is, you know, mind boggling.

Right, Blerina?

Blerina Uruçi

It's quite unprecedented. And and there's been a lot of discussion about this. But here we are. We have a high interest rate expense for our debt and deficits.

[Music]

 Ritu Vohora

The U.S. presidential campaign is heating up as November's election looms large. Welcome to “The Angle” from T. Rowe Price, our podcast on the forces shaping financial markets. In this special edition, we’ll be taking a look inside the U.S. election maze. I'm Ritu Vohora, global capital markets investment specialist here at T. Rowe Price Associates in London, and I'll be your host as we unravel the key aspects around fiscal policy, trade, and the implications on both sectors and the broader economy. 

In today's episode, we'll be discussing the potential U.S. election impact on fiscal policy. I'm delighted to be joined by Blerina Uruçi, our chief U.S. economist. Welcome, Blerina. It's so great to have you back on another episode of “The Angle.” 

Blerina Uruçi

Thank you, Ritu. I’m really looking forward to it. I'm so happy to be back.

 Ritu Vohora

It's great to have you, and I'm sure we'll have a great conversation ahead. So let's get stuck right in, Blerina. The U.S. has been running a significant fiscal deficit for years now, which is adding to the ballooning amount of national debt. You know, this seems to be the elephant in the room that no one wants to talk about ahead of the U.S. election, so maybe you could start with helping us understand the fiscal situation.

Blerina Uruçi

That's right, Ritu. It's so topical, and and yet we're not hearing a lot about it in the political agenda of either candidates, frankly. So let's start with some facts. Last year, the U.S. deficit was about 1.7 trillion, which adds up to 6% of GDP. I think it's helpful to talk about deficits as a share of the economy because as our economy grows, government spending needs and tax revenues also increase, so it's always helpful to scale these statistics by the size of the economy. Then by the end of this year, the deficit is projected to be even higher and get closer to 7% of GDP, according to the Congressional Budget Office, which is one of my trusted sources for government and deficit statistics.

But numbers are not very helpful without context. So is 6% or 7% of GDP a large deficit, or even a sustainable deficit? When I look at an 80-year history of the U.S. deficit as a share of the economy, the current deficit is about twice as high as the historical average, which includes deficits during recessions. 

Ritu Vohora

Oh, wow. So the current deficit is unusually high, even by historical standards. 

Blerina Uruçi

That's right. And not only this, it looks even larger if you compare it with deficits outside of recessions, when automatic stabilizers typically help to lower deficits. So let's look at the primary fiscal balance, which excludes government spending on interest payments for its debt. This is 4% of GDP. 

Ritu Vohora

Blerina, you, you mentioned sort of automatic stabilizers. What do you mean by that? And why do they matter? 

Blerina U

So what I mean by automatic stabilizers is this: deficits are supposed to be larger during a recession and then smaller during an expansion. And here is why – during a recession, when output falls and the unemployment rate increases, the government is simultaneously bringing in less tax revenues and spending more to provide benefits, such as unemployment insurance, or even tax breaks to try and jumpstart the economy and business spending. 

And in fact, it would be quite counterproductive if the government decided to cut spending dramatically at the same time as the economy is going through a recession, because this would compound the pain on workers and on businesses. And this is why during the Covid recession, the deficit went from 4% of GDP to close to 15% of GDP. And during the global financial crisis, it widened to about 10% from 1% the year prior.

Now, during expansion periods of the economy, the opposite is true. The automatic stabilizers mean that when GDP grows, the government collects more tax revenues, needs to spend less to cushion the economy from a recession, and then the deficit automatically becomes smaller without the government needing to pass on new spending and tax measures or new legislation. What we have today is a deficit that is not as large as at the peak of the pandemic-related recession. So we're 6% today, compared to 15% in 2020. But at the same time, the government is spending both on discretionary and non-discretionary items much more than it's bringing in in tax revenues. Ritu Vohora Okay, so I guess there's a mismatch now between, as you outline there, what the government is bringing in versus what they're spending. So, closing the deficit would typically be a top policy priority, right? What challenges could a new president face in implementing any changes then to fiscal policy? 

Blerina Uruçi 

This is a good question because it requires a lot of political will from both sides of the aisle in order to bring down deficits. This is what we know from history. And as I see it, the challenges of any future administration are twofold. First, they're related to the process through which new budgets are crafted and approved in congress. And then the second challenge is because of some factors that are driving the deficit. They are beyond the control of the government, and they're more structural in nature. The government is spending over 2% of GDP on debt servicing costs every year. Now here, what happened is when the Fed started increasing interest rates to bring down inflation, the debt servicing ratio started to increase. And the CBO expects this to continue increasing and to peak to 4% of GDP. That's quite a large number. Ritu Vohora It’s a lot. Blerina Uruçi It's a large number for the economy. That's right. And we know that the government cannot control interest rates and how much it pays in terms of interest for borrowing in the Treasury markets. This is because those interest rates are controlled by Fed policy, which reflects where you are in the business cycle. But it also reflects a premium that the market demands in order to hold government debt, which is the risk premia. So whomever comes to power will have to contend with high and rising debt servicing costs in any case. 

Ritu Vohora 

Okay. That's interesting. And indeed, I think, you know, the interest expense has risen to a near all-time high. And given the projections, it will surpass any level ever seen as a percentage of GDP in the U.S. And in fact, the CBO estimates that spending to service debt will exceed the spending on national defense in 2024, which is, you know, mind boggling. Right, Blerina? Blerina Uruçi It's quite unprecedented. And there's been a lot of discussion about this. And so, but here we are. We have a high interest rate expense for our debt and deficits. And that means that any future administration will need to lean on the primary deficit to reduce overall deficits and to bring the debt-to-GDP ratio on a more stable or downward path. 

But within this primary deficit, there are some spending items that are mandated by law. This mandatory spending includes Social Security, Medicare, Medicaid, veteran programs, and so on, which adds up to about roughly 6% of GDP. Now, as the population ages, the spending in these programs will increase. It will not decrease. And, and that's a challenge that the governments face. So here we have two structural examples, and the last example that I want to bring into this discussion has more to do with the partisan nature of passing budgets in the U.S. in recent years. The president's budget needs approval in both chambers of congress, the senate and the house. With the rise of partisan politics, budget negotiations have become increasingly difficult, and passage of new laws, less common. Just one final thing Ritu, here. Like, historically, it's only been possible for the U.S. to reduce its debt and deficits when there is broadly based public support behind these measures. And this has been achieved through bipartisan bills. But the rise of populist politics and policies in the past decade or so, has meant that most new legislation passed in in congress has either lowered taxes or increased spending, which has led to the trend widening in the fiscal deficit. 

And then in specific terms, the big focus next year will be are we going to extend the Tax Cuts and Jobs Acts? As many of those, tax provisions expire in 2025. And if we have, a change in administration, will that administration repeal some aspects of the Inflation Reduction Act? Ritu Vohora Okay, that's really interesting, and I think you make a really important point there that especially to achieve their policy goals and push through any legislative reform, you know, be that on tax cuts or spending, what matters most is who controls congress, right? It's not just around, who's elected. And so that's both the house and the senate. So of course, if we get a divided government, that can make things a lot harder. So now you outline there, Blerina, the key provisions of the I think it was the 2017 Tax and Jobs Act, also known as the TCJA. We love an acronym! are slated to expire at the end of 2025. And that means the next president will face a significant fiscal cliff. 

Where do the parties stand on their taxation priorities? 

Blerina Uruçi 

So this is one aspect of the agenda of both candidates that we have more details about. They have strong views here, so let's start with the Republican candidate. And actually, before I start with our priorities, let me say this— This disclaimer, let's call it. At this point in the campaign, these are promises, campaign promises. Candidates could walk back on them. They're vague on detail. We don't know how they would implement many of these measures and exactly how much they would cost, but here is what we know so far. Ritu Vohora Policy and rhetoric are two different things right, Blerina? Blerina Uruçi Exactly. The reality. It is the dream and the reality of making policy. And so from the Republican side, they would really like to see as much of the TCJA extended as possible. So there's your acronym again, Ritu. So this is Trump's signature piece of legislation that covers both business and individual tax provisions, and extending the majority of the policy could cost up to 4 trillion over the next ten years, or about. 

Ritu Vohora 

Oh, wow, that's not a small amount. 

Blerina Uruçi 

Not at all. It's 400 billion per year if we do some simple math. Now, these if you extend these policies, then you're losing future tax revenues. And then the Trump campaign is arguing that this potential lost of future income could be offset by increasing import tariff revenues. And here we've heard the promise of a 20% across the board tariff on imports entering the U.S. And then another priority of the Trump campaign has been to roll back some of the provisions in the Inflation Reduction Act. Ritu Vohora Yeah. And in fact, Blerina we’ll be talking about those two exact topics in, in future episodes. And we'll get into much more detail in those. 

Blerina Uruçi 
That's right. 

Ritu Vohora 
So what does it mean from a Democrat’s perspective then? 

Blerina Uruçi 
First of all, I'm looking forward to that episode. 

Ritu Vohora 
[laughing] 

Blerina Uruçi 
And so on the other side of the aisle, the Democrats have taken a more distributional approach to their tax policy. For instance, they're emphasizing that they want to make sure taxes on those earning under 400K of income do not increase. And then they want to provide more tax credit for childcare policies, and so on. 

And they want to make up for the expense of this through higher corporate tax rates, higher taxes on individuals on the top quantile of the income distribution, and also maybe increasing taxes on company stock buybacks. 

Ritu Vohora 
And I think the Harris campaign has actually suggested raising corporate tax for the 21% that it's currently at to 28%, which is quite a significant amount higher. 

Blerina Uruçi 
That's right. And again, here, the focus seems to be on larger corporations. There are other aspects of her tax policy, such as providing tax credits for home builders, tax credits for opening new businesses that seem to favor more smaller businesses and this part of the economy. She's also promising a tax credit for first time homebuyers as well. 

Blerina Uruçi 
I think this her policy and vision on the housing market seems to be interesting to me, and it's coming at a time when the housing market here in the U.S. is particularly frozen because of higher mortgage rates, as well as a lack of supply of homes in the market. 

Ritu Vohora 
Okay. So it seems like a bit of a redistribution of wealth from the Harris side, but it looks like overall both candidates have expensive agendas ahead. And obviously with a divided government, achieving sort of some of these possibilities is much less fiscally expansionary then under either president as well. So given what you've said, Blerina, I think both candidates have limited fiscal headroom, given some of the numbers you've quoted. What about the other side of the budget, around spending, you know. How do their spending priorities differ? 

Blerina Uruçi 
So we know a lot less here. And Trump and the Republicans, in general, have been quieter about their spending priorities. But we do know that they favor more military spending. Trump in the past has talked more about building shipbuilding, in particular. But at the same time, there is a difference here with Republicans being less keen on international foreign aid for military interventions. 

On the Democratic side, again, I think the Harris campaign is focused on preserving and expanding benefits, spending for families, for lower income workers. She has this commitment to invest in affordable childcare and long-term care and a focus on student loan forgiveness, which was, let's call it, inheriting, Biden administration priority. But as you said, at this stage, the tax provisions of the candidate agenda are much better understood than their spending intentions. 

And in the end, what they end up achieving and implementing will depend on whether we have a divided government or not. Divided governments, historically, help to rein in fiscal spending in the U.S. and lead to lower deficits. 

Ritu Vohora 
Thanks, Blerina, but so what I'm hearing from you is that regardless of either outcome, even if we get a divided government, it still looks like the deficit will likely widen from where it is today. And in fact, you know, I came across an interesting statistic from Barclays, and they showed that just a 1% increase in the U.S. deficit could lead to a 40-basis point increase in long-term bond yields, which I thought was incredibly fascinating. And so, you know, maybe to wrap up the conversation, Blerina, let's let's bring it all together. What does it mean for the economy and indeed markets to live in a world of higher fiscal deficits and of higher debt? For example, could both their policies be inflationary? Does this create further upside risks to bond yields? And importantly, what are the implications for growth? 

Blerina Uruçi 
Very good questions, Ritu. Not very easy to answer, mind you. 

Ritu Vohora 
We didn't say this was going to be easy, Blerina. 

Blerina Uruçi 
But here is what I would say on your first observation, there is a very rich body of research that basically says with higher deficits, investors should be asking for higher risk premia. Also, we've had an inflationary shock. We should be asking for a higher inflation premium when they hold U.S. government debt. And then when you look at the move in the ten-year yield over the last three months or so, and if you have an assessment of the neutral rate of interest rates in the U.S. economy of about 3.5%, it does seem like investors are not asking for much of a risk premium right now. 

So that would argue for, an increase in longer-term yields. And again, that would keep those debt servicing costs of the U.S. deficit higher than they've been historically. On the economic front, again, we go back to our disclaimer that what we know now are policy priorities that are poor in detail. We don't know very much about how much they're going to cost. 

We can comment directionally how they might affect the economy, but the net effect is quite hard at this stage. And and we'll get more clarity once we know which candidate has won the election. But I would pick four areas. I would start with tariffs. We know that Trump, has spoken about a 20% tariff across the board on imports entering the U.S. economy. 

We know he's serious about it because in his last administration, he did implement some tariffs as well. And so then here, we would expect a one-off shock to the price level. So this would be upside risk to inflation. But it would not be sustained inflationary shock. It's a one-off shock. And then the next phase to consider is the magnitude of the effect. And this would depend on how much pass-through there is from businesses to consumers. Countries that export or firms that export into the U.S., they might want to absorb some of this tariff increase so they don't lose market share in the U.S. And then the final piece is what happens to the U.S. dollar. If there is a U.S. dollar appreciation because of rising tariffs, this could also absorb the shock for the U.S. consumer. So this is an interesting one. It's a very hot, very highly contested area. But there are nuances to it, in my view. 

The second topic I would pick is immigration. Again, we have the Trump campaign promising to deport a large number of undocumented workers that currently reside in the U.S. We also know that over the last three years, there has been a positive supply shock to the U.S. economy in terms of increased labor supply from migrant workers. We don't know how many of these migrant workers are documented or not. And so again, I would say that if this deportation is successful, even if it manages to deport half the numbers that it promises, it could be a negative shock to the labor supply in the U.S., and it could make U.S. labor market tighter. I think this kind of inflationary shock is more sustained. It's not necessarily a one off. 

And then you get into things that are more specific to growth. How much of the TCJA will you extend or not? If you don't extend those measures, it's a direct fiscal headwind for the economy. Again, if you repeal the Inflation Reduction Act or parts of it, that's a headwind to the economy. And then what the Harris campaign is promising on housing tax credits for building houses, for buying houses, for opening new businesses, this type of thing would have a positive effect on growth. \

Ritu Vohora 
Okay. Well, certainly lots of things to be mindful as we count down to that election in November. But let's pause there. I think, you know, a lot of the topics you raised there we’ll be talking more about where the parties stand, particularly in areas like trade as well as the implications for sectors, such as energy in our next episode. So thank you so much, Blerina, as always, such a pleasure to hear your insights. 

Blerina Uruçi 
Thank you, Ritu. 

Ritu Vohora 
So all eyes are on the presidential race. But it's really after the ballot that the direction of U.S. fiscal policy will really matter. From potential tax changes to new spending priorities, the decisions made in the wake of the election could play an important role in shaping both the economic outlook and the investment landscape. Thank you for listening to “The Angle.” 

We look forward to your company on future episodes. You can find more information about this and other topics on our website. Please do rate and subscribe wherever you get your podcasts. “The Angle”— better questions, better insights only from T. Rowe Price. 

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There is no guarantee that any forecasts made will come to pass. 

This podcast episode was recorded in September 2024. 

Publication referenced in this podcast include: “US Elections: Fork in the Road,” Barclays, 2024. 

This podcast is copyright 2024 by T. Rowe Price.