Capitol Hill: The Scale of Stimulus

Published on December 13, 2017

In the wake of last night’s upset win by the Democrat Doug Jones for the Alabama Senate seat, Senate Majority Leader Mitch McConnell moved quickly this morning to confirm that Jones will not be seated until January. For McConnell, it postpones the day of reckoning with only a one-seat Republican margin, a margin that will empower Senate Democrats and Republican moderates.

But that is a story for 2018, while for the remaining days of 2017, the most immediate effect of the Jones victory is a steely-eyed determination by the Republican leadership to maintain a twin track of momentum to pass both the “The Tax Cut and Jobs Act” and another extension of the FY2018 Continuing Resolution by no later than next Thursday. That is when the current CR expires, at midnight, and it is when the Alabama results were initially expected to be certified, although Alabama state officials are now pushing the certification date back to around the turn of the year.

*** While uncertainties remain over the final versions of both bills, on balance we still believe the tax cut bill will pass before the end of next week. It is likely the corporate tax cut will be lifted to 21% or 22% from the initially proposed 20%, with last minute changes to lower the highest individual tax rate. On the CR, Senate Majority Leader McConnell will need between eight to twelve Democratic votes to pass the spending bill which, on top of the Republican demands to boost defense spending, means it will only pass with an equivalent increase in non-defense discretionary spending. ***

*** Passing the two Republican priority bills will translate into a significant, higher than expected boost to the fiscal stimulus next year. Federal spending we suspect could be set to rise next year by as much as $200 billion, and the higher spending levels are likely to become the new budget baseline, without substantial but unlikely discretionary spending cuts or entitlement reforms. That comes in addition to the built-in stimulus of some $150 billion a year in deficit-financed tax cuts. ***

Needless to say, the fiscal impact on Federal Reserve policy is certain to have been a dominant issue in the Federal Open Market Committee discussions these last two days. And how it is likely to influence the Federal Reserve’s base case rate path next year is equally certain to be the first and repeated question put to Chair Janet Yellen in her farewell press conference later this afternoon.

Tax Cut Timeline

Until quite literally yesterday afternoon, there had been limited progress on the major compromises needed between the differing Senate and House versions of H.R. 1. But the conferees are believed to have reached a compromise on mortgage deductibility, dropping the cap from the current $1,000,000 to $750,000 instead of the House’s proposed $500,000, a possible drop in the top tier tax rate to offset the hit to blue states from the cap on State and Local Tax (SALT) deductions, and a possible, but we believe still to be determined, bump up to 21% in the corporate rate.

Indeed, the most immediate effect of the Jones victory is that the Republican leaderships in Washington have ordered the House-Senate tax conferees to wrap up all differences today and to present a final combined bill ready for floor consideration in a day or two. It is even possible, in their drive to make the most of their clout in the Senate before it is cut in half in January, that the Republicans deciding the final cuts to the tax conference report will cut individual tax rates even deeper, partially as a primal political reaction and mostly to widen the window for negotiations over tax policy years from today.

But among the big stakes issues still to be resolved are the final status of the Alternative Minimum Tax, estate tax, and deduction to allow for state and local taxes, as well as the pass-through status for small business owners. The House also threw in a change in the law barring churches and other tax-exempt groups from openly politicking.

The list is a weighty one and complex in how each will alter the whole, but the final deal is likely to only come together when the last detail is nailed down that brings all the other moving parts rapidly into place.

The Final Steps

President Trump will be giving a pep talk to the Senate and House conference committee negotiators in a speech later today. It was meant to follow up on the release by Treasury of its analysis of the macro-economic effects of the tax cut legislation, but that amounted to barely a page and was met with near universal skepticism, and has since been quietly dropped.

Whatever the final compromises the conference committee is able to patch together, we remain fairly certain that the unified tax bill will require more funds than the 20 percent corporate rate will produce. That will especially be the case if, as it likely, the Senate prevails in its demands for more generous levels of the tax treatment for pass-through entities and higher deductibles for home mortgages.

Raising the corporate rate to 22 or even 23 percent could fill in some gaps and thereby secure the minimal 50 (or possibly 51 votes) in the Senate, but there is fierce resistance to such an increase in the House and among some within the Trump Administration.

The target nevertheless is to finalize the conference committee report on the tax cut bill by this weekend, setting the stage for an up or down Senate vote early next week on Monday but probably Tuesday, followed by the House vote on Tuesday or Wednesday. In theory, that will give the Republicans time to get the Senate and House passed bill to President Trump for his signature into law by Wednesday or Thursday.

The political pressure on the Republican leadership to shepherd the bill through as quickly as possible is extremely high. If anything goes wrong on this very tight schedule, it could open the door to demands for changes by the various warring factions within the GOP, especially the deficit hawks anxious over the size of the added deficits.

The GOP leadership is concerned, and for good reason, that any delays to when the vote on the CR will have to be held may make at least one or two Republican Senators balk on the tax bill, when they are being asked in short order to vote for what is shaping up to be significant boosts to discretionary spending to avoid a shutdown of the federal government after midnight next Thursday.

In other words, the political imperative to pass the tax cut bill before December 22 was not just to get ahead of the moving target of when Alabama will be certifying the results of yesterday’s special Senate vote, but to also get in front of the CR vote.

Busting Open the Spending Caps

The next Continuing Resolution, as with all Appropriations bills, requires a minimum of 60 votes to pass in the Senate, meaning that Majority Leader McConnell needs a minimum of eight — and possibly as many as twelve — Democratic votes to offset possible Senate Republican objectors to whatever deal is reached with Senate Democrats.

The higher the number of Republicans who balk on the CR spending totals, the higher the demands by the Democratic Senate Minority Leader Chuck Schumer who, as McConnell knows, holds most of cards on the CR.

Senate Democrats will start by demanding a boost in non-defense spending above the sequestration caps and may add in their preferred extension of DACA. DACA, however, may not necessarily be included in the final CR, but as a separate bill tied to “border security.”

Pro-defense Republicans, led by Senator John McCain, make the case that after more than 15 years of wars, the military needs to be replenished with money and materiel. Indeed, McCain points his finger at previous budget cuts for the losses of life in recent aviation and naval catastrophes. The typical way the Congress bridges these gaps is by agreeing to boost spending on both the defense and non-defense programs.

We understand that circulating on Capitol Hill among appropriators is a “bridge” that will cost an extra $200 billion for FY18 ending next September 30.

That would solve immediate budget problems, at least politically. But if the House and Senate appropriators do fund an extra $200 billion (or more) above the FY17 trend line for FY18, it will be impossible to reconcile the big boost in defense and non-defense discretionary spending with the $1.5 trillion of tax cuts over ten years that the Joint Committee on Taxation estimates will be initially offset by revenues.

We understand, however, that the joint Republican leaderships will avoid any reconciliation of these divergent tax and appropriations numbers as if, in effect, there are two budgets treating tax and appropriations as two independent acts of Congress.

While this may allow the current congressional majorities to escape a dark December, the unanswered questions will return with a vengeance when FY19 spending bills are being drawn up next summer that could be based on the new, significantly higher, baseline set by this year’s busting of the sequester spending caps.

There is still an open question on what will happen to the caps left over from the sequester. Will the extra $200 billion in FY18 set a new trend line — in other words, bumping up yearly spending by at least $200 billion for each of the next nine years, or instead is the CR deal next week just a one-time deal? That will depend on which party controls Congress in FY19 and FY20.

And that is probably one additional reason why the Republican leadership is bracing for the next year’s mid-term elections. It may prove to be ideologically and rhetorically difficult to stick to their low tax and low deficit talking points, but on the other hand, the GOP will not want to be pushing for deep, offsetting spending and entitlement cuts just as they are going into the mid-term elections that are likely to be seen as a referendum on Republican governance.

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