US Economics Analyst

Issue No: 09/40October 9, 2009

Goldman Sachs Global Economics,

Commodities and Strategy Researchat https://360.gs.com

The US Budget: The Good, the Bad, the Ugly, & Then…

Jan Hatziusjan.hatzius@gs.com212 902 0394Ed McKelveyed.mckelvey@gs.com212 902 3393Alec Phillipsalec.phillips@gs.com202 637 3746Andrew Tiltonandrew.tilton@gs.com212 357 2619David Kelleydavid.kelley@gs.com212 902 3053

Next week the Treasury Department is apt toreport a $1.4trn deficit for fiscal year (FY)2009, which ended September 30. Includingthe subsidy costs of the GSE takeover, thisappears to be almost $1.6trn, in line with thelatest CBO and OMB estimates and lower than our own $1.725trn. The final result isgood news compared to expectations that ranclose to $1.9trn earlier this year.The bad news is that the underlying deficit isworsening. In combination, stagnation intax revenue, ongoing growth in mandatoryoutlays, a step-up in spending under theexisting stimulus program, and the likelyextension of various measures should keepthe deficit near $1.6trn in FY 2010 despite alarge drop in financial stabilization outlays.The ugly part of the story is that the longer-term imbalance remains intractable. Wenow see the primary deficit (which excludesnet interest) at 2% of GDP or more, and our 10-year projection of overall deficit nowtotals $10½trn versus $9trn previously.Year by year, the deficit never falls below4½% of GDP, and by the end of the decadeit rises back to 5½%. Numbers like this will eventually promptcorrective measures, just as a stark but lessworrisome budget outlook did in 1990.With this perspective, our 10-year budget projections should be interpreted as a baseline of what we think would happenunder policies that currently look likely,rather than as a forecast of what will happen.The trick for policymakers will be to movenimbly from the need for more stimulus nowto the eventual need for fiscal restraint whenthe economy is stronger. Fortunately, thefinancing backdrop is reasonably favorable:the debt run-up looks manageable, Treasuryhas ramped up its auctions, and the buyersare there despite fears to the contrary.

A Deeper Long-Term Deficit Profile

-12-10-8-6-4-20050607080910111213141516171819-12-10-8-6-4-20GSCBO BaselineOMBSource: CBO. OMB. Our calculations.Percent of GDPPercent of GDPBudget Balance:Fiscal Year

The Primary Balance Stays Large

-12-10-8-6-4-202080910111213141516171819-12-10-8-6-4-202GS RevisedGS as of JulyCBO BaselinePercent of GDPPercent of GDPSource: CBO. OMB. Our calculations.Fiscal Year Primary Balance:

Important disclosures appear at the back of this document.

GS Global ECS US Research US Economics AnalystIssue No: 09/40

October 9, 2009

I. The US Budget: The Good, the Bad, the Ugly, & Then…

Last week the US Treasury closed the books on fiscalyear (FY) 2009, a year that will go down as a game-changer in modern US budget history. According toestimates by the Congressional Budget Office (CBO),the Treasury will report next week that the FY 2009deficit was just over $1.4 trillion (trn). This is morethan triple the FY 2008 shortfall and, at 9.9% of GDP, by far the largest relative to the size of the economysince World War II. Both revenues and outlaysreached extremes not seen in more than 50 years (15%and 25% of GDP, respectively).The good news is that prospects looked worse earlier in the year, when we and the government agenciesexpected large outlays for stabilization of the financialsystem to push the deficit to nearly $1.9trn. Restatingthe budget figures to include the net present value of the subsidy rendered by the federal takeover of thegovernment-sponsored enterprises (GSEs) to conformto CBO’s accounting treatment of these transactions,the FY 2009 deficit appears to be almost $1.6trn.(The Treasury counts only the cash outlays arisingfrom these transactions.) This is right in line with thelatest estimates provided in late August by both theCBO and the Office of Management and Budget(OMB), and it is much better than our late-Julyestimate of $1.725trn.

A $1.6 Trillion Deficit for FY 2010

The bad news is that the underlying fiscal imbalanceis apt to widen further as the economy struggles torecover from the deepest recession in more than 70years. By our reckoning, the combination of virtualstagnation in federal revenue, ongoing growth inmandatory outlays, a step-up in spending under theAmerican Recovery and Reinvestment Act (ARRA),and a modest dose of additional stimulus will keep thedeficit at about $1.6trn in FY 2010 despite a largedrop in financial stabilization outlays.On the revenue side of the ledger, our expectation of almost no change in FY 2010 (+0.6%) contrastssharply with the latest CBO and OMB estimates,which show increases of 7.6% and 9.2%, respectively,as of late August. However, we feel comfortable withour lower figure given the following considerations:

1. Weakness in wages and salaries is likely to keeptax withholdings roughly flat in FY 2010.

Typicallythe federal government collects 70%-80% of itsrevenue through withheld personal income taxes andtaxes for social insurance (almost all of which are alsowithheld). In FY 2009 this share was at the high endof the range as other revenues were cyclically weak.As shown in Exhibit 1, year-to-year changes in thethree-month average of withheld taxes track year-to-year changes in wage and salary income quite closely;when gaps have occurred in recent years, withholdingshave been weaker because of legislated tax cuts.Collections of withheld taxes are starting FY 2010 in adeep hole as wages and salaries are about 5% belowtheir year-earlier level. Although we expect this toimprove as the labor market stabilizes and the year-ago comparisons become “easier,” the underlyingfundamentals do not point to significant growth. In particular, we expect nonfarm payrolls to follow the pattern of previous “jobless” recoveries, turning onlymodestly positive in 2010, while wage gains shouldcontinue to diminish as the unemployment rate driftsup from an already high level. For the fiscal year as awhole, we forecast no net change in wage and salaryincome; under these circumstances, tax withholdingsare apt to be roughly flat for the fiscal year as well.

2. Other individual taxes should fall further.

Thesetaxes include quarterly estimated payments made byindividuals who would otherwise be underwithheld plus the difference between final settlements paid inApril and refunds. The biggest drivers of these taxflows are year-to-year movements in interest anddividend income, the bulk of which is not subject towithholding, and in stock prices, which obviouslyaffect the capital gains and losses that taxpayers mustreport on securities that are sold during the tax year. Nine months into 2009, these drivers are all seriouslyunderwater relative to their 2008 levels, to a degreenot seen in more than 30 years in the case of dividendsand stock prices. This may sound odd given that thestock market has rallied sharply since March.

Exhibit 1:Tax Withholdings Should Stagnate

-10-5051015990001020304050607080910-10-5051015Withheld TaxesWages and SalariesPercent change, year agoPercent change, year agoSource: Dept. of the Treasury. Dept. of Commerce. Our estimates.3-Month Average:GS

GS Global ECS US Research US Economics AnalystIssue No: 09/40

October 9, 2009

However, despite that rally most of the major indexesare apt to post average annual declines of 20% or more between 2008 and 2009.Thus, the income on which most nonwithheld personaltaxes will be paid in FY 2010 is down sharply relativeto year-earlier levels. To illustrate the likely scale of the decline in the tax payments themselves, we plotfiscal year changes in nonwithheld tax paymentsagainst changes in the calendar year average of theS&P 500. As shown in Exhibit 2, the two movetogether, with tax payments showing a slight tendencyto lag. Meanwhile, refunds should rise for the samereasons. Altogether, we reckon that the net difference between nonwithheld taxes less refunds will narrowfurther in FY 2010 by about $40bn.

3. Corporate taxes and miscellaneous receipts willprobably provide an offsetting increase.

In the caseof corporate taxes, an increase seems likely given boththe likelihood of a modest upturn in profits and theimpending expiration of the 50% depreciation bonus.(Although this measure could be extended, we are not prepared to assume that, as discussed in yesterday’sdaily comment.) However, we do not anticipate thehuge gains—on the order of $40bn to $60bn—that the budget agencies show in their August updates; a figurecloser to $25bn seems more reasonable given our subdued economic outlook and the fact that thedepreciation bonus does not expire until year-end2009, three months into FY 2010. In the case of other receipts a comparable increase (this time consistentwith the official expectations) looks likely, especiallysince this category includes remittances of earnings onthe Fed’s vastly expanded balance sheet.On the outlay side of the ledger, we make only onesignificant change to the CBO baseline for FY 2010— the inclusion of $75bn in fiscal stimulus as part of athree-year $250bn set of unspecified measures. This“placeholder” has been part of our outlook sinceJanuary on the view that the economy would still look weak in 2010, with the unemployment rate high andstill rising. While the mere mention of more fiscalstimulus has sounded hopelessly out of touch with political sentiment during most of the year, the ideahas gained currency in recent weeks as the labor market has continued to weaken and data for other parts of the economy have disappointed expectations.As discussed in yesterday’s daily comment, piecemealrenewals of items such as extended unemployment benefits could add $50bn to $100bn to the FY 2010deficit with some of these—e.g., the new homebuyer tax credit—showing up as reduced tax revenue. Thus,with our sanity now rehabilitated, we are content tokeep our $75bn plug in place pending developmentson the legislative front in coming weeks.This assumption, coupled with the projected growth inmandatory outlays and a step-up in outlays alreadyapproved under ARRA, provides a full offset to thesharp drop in spending on financial stabilization thatmost budget analysts now assume for FY 2010. As aresult, we expect the deficit to remain close to the(approximately) $1.6trn FY 2009 result. Of course, inreality this represents deterioration in the underlyingtrend on the order of $318bn, the decline in financialstabilization outlays estimated in August by the CBO.Although this is disappointing given the size of the FY2009 deficit, budget deterioration at this stage of theeconomic cycle is far from unusual. In fact, as shownin Exhibit 3, widening in the deficit is the norm earlyin a recovery for precisely the two reasons we have just outlined—sagging revenue and fiscal stimulus.

The Longer-Term Outlook Worsens…

Beyond the new fiscal year that has just begun, the budget outlook is unusually uncertain, but it appears

Exhibit 2: Nonwithheld Taxes Drop Further

-40-200204080859095000510-40-2002040Nonwithheld Personal Income Taxes (FY)S&P 500*Percent change, year agoPercent change, year ago* Estimated for 2009.Source: Wall Street Journal. Department of the Treasury.Annual Average:

Exhibit 3:Deficit Widens in Early Recovery

-6-4-20247075808590950005-6-4-2024Federal Budget BalanceStandardized BalancePercent of Potential GDPPercent of Potential GDPSource: Congressional Budget Office.FY 1970 - FY 2007: