The federal debt limit is once again in the news as the country rapidly approaches a critical deadline on June 1. Investors are understandably nervous about Washington failing to reach an agreement, a possibility that both sides agree would be a self-inflicted catastrophe. While it’s unclear how this will play out in the coming weeks, the fortunate news is that financial markets are mostly taking these events in stride, likely due to the expectation that “This too shall pass.” We discuss below some things to know.
1. Federal borrowing reached the debt limit this past January: First, it’s important to understand what the debt limit is and is not. In simple terms, the federal government borrows money to pay its bills by issuing Treasury securities. This is necessary because the federal government often operates with a deficit whereby spending (on defense, Social Security, emergency pandemic stimulus, and more) exceeds government revenues (which consist primarily of tax revenues). While tax revenues increase as the economy grows (even without raising tax rates), they have been outpaced by spending over time. This borrowing adds to the national debt which hit the $31.4 trillion debt ceiling in January. Since then, the Treasury Department has been employing what it calls “extraordinary measures” to ensure that the country does not default on its obligations.
Thus, the only question around the debt ceiling is whether the government can and should pay its bills. This is akin to signing the papers for a new car then afterwards requesting an increase to your credit limit. For most of us, the decision to buy something can’t be separated from whether we will pay for it, even if it’s with debt. Unfortunately, the Congressional process for approving a budget by September 30 each year is separate from whether the Treasury can actually pay the bills.
2. Near-term Treasury rates have jumped but longer-term rates are steady. The U.S. is currently experiencing a standoff between Democrats and Republicans over the debt limit. The House recently passed a bill increasing the debt limit through March 31, 2024, or until the national debt increases by another $1.5 trillion, but it includes provisions that make it unlikely to pass the Senate and be signed into law. Previous debt ceiling standoffs have occurred, but despite investor concerns, they have had little long-term impact on markets, with the exception of the 2011 debt ceiling crisis, which led to Standard & Poor’s downgrading the U.S. debt and the stock market falling into correction territory. The U.S. has never defaulted on its debt, and economists and policymakers agree that doing so would lead to turmoil in the financial markets and increase borrowing costs for businesses and everyday citizens. Despite the political grandstanding around the issue, a new budget will likely be approved, and markets will bounce back. We believe this will be the case once again – brinkmanship, then an agreement.
3. Income tax rates are still low by historical standards. The US national debt has doubled over the past decade and has grown nearly every year over the past century, according to recent reports. Although most agree that the government should not spend more than it generates in tax revenues, this unfortunate reality has not been addressed by either party in recent years. As such, deficits are unlikely to go away, and investors need to focus on what they can control to differentiate how things work from how they would like them to be. One factor beyond the market and economic effects is that the odds of higher tax rates may increase as the national debt worsens. Today, the highest income tax rates are slightly above their lows after the Reagan tax cuts, but still far below historical peaks. High-earners in the mid-1940s paid rates as high as 94% on their marginal incomes. Even those in the lowest bracket would have paid 20% or more during the 1940s, 50s and 60s, which is double today’s rates. U.S. corporate tax rates were also among the highest in the world until the 2017 tax cuts. Engaging in a financial plan that takes advantage of relatively lower rates today and prepares for higher rates in the future can help to protect investors from future tax uncertainty.
The bottom line? The debt ceiling and federal debt issue will very likely be resolved in the coming weeks. As with many political issues, it’s important for investors to separate their concerns from the markets and not react too hastily. History shows that staying invested is the best approach to navigating drama in Washington.
As always, please reach out with any questions.