Chief Global Strategist
I may have mentioned this before, but as a young lad, I had a very healthy appetite. Consequently, when deciding on a hobby, I prudently elected to go with “cooking”. My experiments included making fudge and my mother dutifully supplied me with sugar, vanilla and helpful advice. However, we possessed no candy thermometer and, as anyone in the fudge-making business will tell you, getting the temperature right is essential. Too hot and you end up with toffee or hard caramel. Too cold and you end up with a grim sludge, which no degree of refrigeration can render palatable. Making fudge is a delicate operation.
The Congress is likely now cooking up some fiscal fudge which will be revealed in the 2025 omnibus reconciliation bill. The phrase “fiscal fudge” implies some deviation from conventional bookkeeping and this is quite likely to transpire. The problem is that the budget is so structurally out of balance that, even if the 2017 tax cuts were allowed to expire on schedule at the end of 2025, the debt-to-GDP ratio would still rise rapidly in the years ahead.
As a practical matter, Congress is very unlikely to let this happen, as this would impart fiscal drag on an economy that might well be soft anyway by the end of this year. In addition, the President will want to see most of the additional tax cuts he proposed on the campaign trail enacted into law. However, achieving this within the constraints of Senate budget rules and the House budget resolution will require some finessing of the numbers. How much finessing and how much stimulus is crucial. Taken to an extreme, major fiscal stimulus in 2026 could boost both inflation and long-term interest rates. Consequently, investors will need to keep a close eye on the process to assess its implications for the economy and markets.
Problems with the Baseline
The most recent baseline estimates for the federal budget were released by the Congressional Budget Office (or CBO) just over two months ago and they show the expected path for deficits and debt under current law. In particular, they project that the budget deficit for fiscal 2025, which ends on September 30th of this year, will be $1.9 trillion, or 6.2% of GDP, rising to $2.6 trillion or 6.1% of GDP by fiscal 2034. The debt in the hands of the public climbs from $30.1 trillion or 99.9% of GDP to $49.6 trillion, or 117.1% of GDP over the same period.
These numbers may be a little optimistic. They depend on economic assumptions of 1.8% real economic growth, which, given prospects for much lower immigration, may be a little high, and a 10-year Treasury yield of 3.9%, which, given the potential extent of federal borrowing, may be a little low. Moreover, taken out to three decimals, the fiscal 2025 projected deficit of $1.865 trillion is only slightly higher than the actual $1.832 trillion outcome for fiscal 2024, while monthly data show the deficit already running $319 billion higher than last year through the first five months of fiscal 2025.
Anyway, in February, the House passed a broad budget resolution allowing for up to $4.5 trillion in tax cuts through fiscal 2034, partially funded by up to $2 trillion in spending cuts.
One problem with this is that, according to CBO estimates from last May1, if the current law baseline is employed, $4.6 trillion would be used up just in extending the 2017 tax cuts out to 2034. This would include extending individual income tax cuts, estate tax cuts, bonus depreciation and other corporate tax breaks.
Since this would be merely an extension of current policy, it wouldn’t impart any fiscal stimulus to the economy and, if it were partly financed through government spending cuts and tariffs, it would actually drag on the economy. Moreover, even this measure would only be able to avoid a filibuster according to a Senate rule, known as the Byrd rule, if it didn’t increase projected deficits beyond a 10-year window.
In addition, it would leave no room for the President’s campaign proposals including further corporate tax breaks for domestic production, the elimination of income tax on tips, overtime and social security, allowing new vehicle buyers to write off the interest on their loans and restoring the full deductibility of state and local taxes.
Flavors of Fudge
So how can Congress get around this?
One potential fudge would be to assume that the “baseline” refers to current policy rather than current law. This would essentially subsume the entire cost of extending the 2017 tax cuts into the baseline (since they are current policy), meaning that House and Senate Republicans could then focus on other tax cuts.
The Senate Parliamentarian could rule that this was not allowed under the Byrd rule. Indeed there doesn’t seem to be much point to the Byrd rule if a temporary tax cut that complied with it could then be used as a subsequent platform for making the same tax cut permanent on the basis that it was now in the baseline. However, this is really a matter first for the Parliamentarian and then, ultimately a question of how far Senate Republicans want to take things, since all rules by which the Senate governs itself could, in theory, be overturned by a simple Senate majority, including the idea of the filibuster in the first place.
However, if the Senate didn’t want to go that far, they could always employ a version of “sunset fudge”. The idea of sunset fudge is to let tax breaks expire within a few years so they don’t raise the deficit outside of the budget’s 10-year window. This is why most of the 2017 tax cuts, which only kicked in on January 1st, 2018, were set to expire eight years later. A more extreme version, could have tax cuts lasting only five years or have 10 years of spending cuts finance five years of tax cuts.
A third flavor of fiscal fudge is also possible. In February, James Fishback, the CEO of an investment firm, suggested in an X posting that 20% of the savings achieved by the Department of Government Efficiency, or DOGE, could be returned in a check to the roughly 79 million households expected to pay income tax in 2025. If the savings were $2 trillion, the checks could be as much as $5,000 each and would be paid out in July 2026 when DOGE itself is supposed to be wound down.
While the President has publicly expressed support for this idea, it is not clear where it stands as House and Senate Republicans work on the reconciliation bill. However, if the economy were to falter, the distribution of stimulus checks might seem attractive, particularly if the checks were based on future savings rather than current or previous cuts. As we have seen demonstrated during the pandemic, simple stimulus checks, rather than changes in tax rates, can be a very powerful tool in stimulating demand.
Investment Implications
Of course, the problem with all these varieties of fudge is that they promise near-term largesse to be financed by future frugality. Some of this might be appropriate if the economy finds itself stalled out at the end of this year. However, for investors wanting some guidance on the implications of all of this, the first place to look will be in the projected budget deficits for fiscal 2026 and fiscal 2027. If, as Congress reveals its plans, these numbers balloon higher from the 6.2% of GDP expected for fiscal 2025, both financial markets and investors will have received fair warning that both interest rates and inflation could head up from here.