Macro update (reconciliation (tax/spending legislation), debt limit)

Recent/upcoming developments… House Republicans are conducting their planning retreat in Florida this week, at which they are trying to achieve unity on their various fiscal priorities.  Thus far, they have not outlined any plans beyond those on which we commented last Friday.  The most notable development was a speech by President Trump, at which he not only re-iterated his desire to see their “reconciliation” (tax/spending) bill include border security, energy provisions, and an extension of the expiring provisions of his 2017 Tax Cuts and Jobs Act (TCJA), but for the first time since the election, that he also wants to eliminate taxes on overtime and Social Security.  Since the election, he has repeatedly mentioned eliminating taxes on tips.  During his Davos speech this week, he also mentioned a desire to reduce the tax rate on domestic producers to 15%.  Notably, the Florida retreat has highlighted tensions Congressional Republicans are confronting between Trump’s expansive demands, and the desire by conservatives to reduce the deficit, a priority Johnson emphasized this week.  While this planning retreat was underway, the focus in DC was on various memos issued by OMB that call for a freeze/review on federal loan/grant programs.  A federal judge imposed an injunction on the spending freeze until early next week and OMB clarified that the freeze only applies to a more targeted set of programs.

* Consistent with what we outlined on Friday, Speaker Johnson (R-LA) outlined a timeline for the reconciliation bill, which would involve starting the process with a vote in the House Budget Committee next week, passage of the budget resolution in both the House and Senate in February, passage of the reconciliation bill itself at the House committee level in March, and in the full House in April.

* The various tax cuts Trump proposed would have a $3.8t impact on the deficit (i.e., $2t for overtime, $1.3t for Social Security, $300b for tips, $200b for 15% tax rate for domestic producers), over and above the $5t impact from TCJA extensions, though it’s important to note that Republican leaders have said they want to use a “current policy” baseline, which would mean the TCJA extensions would essentially be counted a status quo and not contribute to the deficit.

* Johnson this week for the first time openly floated the possibility of addressing the debt limit on a bipartisan basis, though this is apparently something that’s been under consideration for a number of weeks.  As previously noted, there is consideration of pairing it with the FY25 appropriations (i.e., government funding) bill and disaster aid, which needs to pass by mid-March.  Democrats have not yet signaled a willingness to work with Republicans on a deal of this nature, but it appears Republicans are coming to the conclusion that this approach is more feasible than achieving the unity that would be necessary to address the debt limit on a partisan basis (as part of the reconciliation bill).

* While the initial memo released by OMB yesterday appeared to put at risk ~$100b in discretionary spending (i.e., a rough estimate of all the departments with major loan/grant programs), as well as potentially even Medicaid, they subsequently clarified that “Medicaid, SNAP, federal student loans, Pell Grants, Head Start, Section 8 rental assistance, and aid to small businesses and farmers” are not their focus.  Instead, the White House emphasized that their focus is on the programs identified in the various Executive Orders (EOs) issued by President Trump last week (i.e., spending on clean tech) including funding to NGOs, foreign governments and other “large discretionary contracts.”  OMB released a list outlining the impacted programs.  Congressional Republicans were largely supportive of OMB’s spending freeze, with some (e.g., Senate Appropriations Committee Chair Collins (R-ME)) expressing concern about its scope, others (e.g., Senate Majority Leader Thune (R-SD)) noting that it was a normal review, and others (e.g., House Majority Whip Emmer (R-MN)) emphasizing that the freeze reflected Trump’s electoral mandate.

Our outlook… While the goal of the House Republican treat this week is to achieve unity around their fiscal agenda, it revealed notable signs of tension.  ~50 of the 218 House Republicans did not attend, and Rep. Roy (R-TX), an influential conservative, was critical of it.  The conflict between Trump’s expansive tax proposals and the simultaneous emphasis House Republicans are putting on deficit reduction also exposed material tensions.  These tensions are all manifesting themselves even without consideration of possible differences between House and Senate Republicans.  Ultimately, our view is that this dynamic will have two implications.  First, the timeline for passage of the reconciliation bill is likely to be lengthier than has been discussed up to this point, with our view now that the probability of its enactment in May is 10%, 50% in July, and 40% in December.  Second, the scope of the bill is likely to be more modest than what Trump called for, with a more realistic outcome being that it reduces the deficit by $1t (using a current policy baseline that doesn’t count the deficit effects of extending TCJA), and that outside of the TCJA extension, it is only likely to include a tax cut for tips, though also may include a reduction in the tax rate for domestic producers.

* In order for Trump to fulfill his repeated campaign promises, the reconciliation bill will need to include some additional tax cuts beyond extending TCJA.  As I’ve previously noted, the tax cut on tips is the only of his additional ideas that have generated distinct receptivity among Republicans.  There has not been strong receptivity to a tax cut for domestic producers (e.g., House Majority Leader Scalise (R-LA) appeared non-committal to it this week), but we still consider it to be a possible addition to the bill, given Trump’s repeated calls for it.  The size and lack of receptivity to cutting taxes on overtime and Social Security make them unlikely.

Watch for these developments… We are continuing to watch for signs of enthusiasm (or lack of it) among Republicans for Trump’s various proposed tax cuts, as well as whether he and/or the White House signals a recognition that they a bill will only ultimately include a subset of what he’s proposed.  And, we’re continuing to watch for indications of unity among Republicans (particularly from conservatives such as Rep. Roy) about the level of deficit reduction that will be required by their budget resolution.  While most of the focus in recent weeks has been on the House, we’re also continuing to watch for how aligned Senate Republicans are on the allowable deficit in the budget resolution and the baseline it will use, as well as whether they are backing off their push for two reconciliation bills, rather than the one being advocated by House Republican leaders.  It’s important to note that the window is rapidly closing on passing two reconciliation bills this year, even if Senate Republicans are interested in that approach, and the longer it takes for them to weigh in, the more likely it is that they agree to pass a single bill.  This decision will come to a conclusion in the next couple of weeks when Senate Republicans decide how to deal with the budget resolution that the House plans to pass.