How To Prepare Your Business For The Government's Response To The Deficit

By Andrew Duguay, Chief Economist
Previously published on Forbes.com

An already high deficit was aggravated by exorbitant stimulus packages. These were necessary measures, of course, but they placed the U.S. economy in a precarious position for the next possible downturn. The Congressional Budget Office projected that 2020’s federal government spending would reach $4.7 trillion, and that was before the current crisis, which resulted in $2.4 trillion in additional spending — so far.

As a result, the U.S. debt-to-GDP ratio has reached its highest level since World War II, which is the closest instance of an economy with a large deficit increasing spending mightily to counteract a recession. In using this past experience as a blueprint, the U.S. government can implement one of three actions, or a combination thereof, to rein in the ballooning deficit. Given that it is not clear which of these actions will be taken, the business community will need to plan for four potential scenarios, starting in 2021.

Scenario 1: An Increase In Taxes

The most direct way to close the gap is by increasing revenue through raising taxes. While there are many ways to increase taxes, whether it be on individuals or corporations, the general rule is it can slow economic growth. Business leaders and investors need to prepare accordingly.

If taxes are raised on individuals, that could curtail consumer spending, which would have the greatest effect on consumer-facing business. Since a rise in consumer taxes isn’t always allocated evenly among Americans, companies must monitor any impact on their core customer base.

With regard to corporate taxes, higher taxes will sometimes prompt companies to restructure their operations so factories and offices are in states or countries with lower tax rates. This can affect the supply chain and have repercussions for U.S. companies across multiple industries. Additionally, companies that are directly affected by any new taxes will find it challenging to grow their workforce, which could affect hiring.

Scenario 2: Spending Cuts

Spending cuts on government programs can be a way to reduce the deficit and avoid painful tax hikes, but it can also inflict economic pain on those who benefit most from the spending. This can lead to reduced employment in the public sector, and perhaps even the private sector. The challenge in cutting spending is that the largest outlays are also some of the most popular, with Social Security, Medicare, and defense spending accounting for over half of all government spending.

U.S. manufacturing, particularly defense spending, has been among the biggest beneficiaries of government spending in the past decade. This could have a significant effect on the industry depending on the amount of spending that is pulled back by the federal government. In this scenario, companies that benefit from federal procurement or subsidies would need to prepare for a localized downturn.

Scenario 3: Suppression Of Interest Rates

It would not be out of the realm of possibilities to see the federal government and Federal Reserve take actions to suppress interest rates below the rate of inflation. This strategy essentially creates back-door taxation of savers, both corporate and individuals, who see inflation rise faster than the interest in their savings accounts. The heavily indebted government benefits by being able to borrow and roll over existing debt at interest rates lower than inflation.

Suppressing rates can provide opportunities to make acquisitions and other investments. Companies that have solid balance sheets and capital will have opportunities to grow in this environment. Additionally, continued low-interest rates can have disproportionate impacts on some industries, like real estate. Within these industries, there would be opportunities to capitalize on the increased activity.

Scenario 4: No Action Taken

If the government follows a version of the model developed post-World War II, then we could see a mixture of those three actions over the next few years, but if the government chooses not to address them, there is a fourth scenario to consider: It takes no action. If the U.S. government doesn’t pursue any of the aforementioned proactive measures to whittle down the deficit, then the economy will find itself particularly vulnerable in another recession that has the potential to be worse than the current economic downturn, with smaller government backstops to curb the downturn.

Until there are signs that the government is taking action, companies will need to keep ample reserves and not overleverage their assets. This conservative strategy will be essential for weathering the storm whenever the next downturn arrives.

Uncertainty Will Continue Into 2021

Although we don’t know if the government will follow the post-World War II model, we do know that the U.S. will need some form of response to counter the currency deficit. Whether it’s one or all of the previously outlined responses remains to be seen. Regardless, business leaders and investors must prepare for any permutation of the discussed responses, including a lack of response.

There are many ways for these responses to be implemented, and each variation can have a unique effect on specific businesses. Add to that the effect of the upcoming presidential election, which will add an additional element of uncertainty to business planning, especially given the nature of the traditional political association for each action. As such, it is especially important to understand the impact of these scenarios on each industry and sector in the long term and identify which business leaders are building flexible plans that allow them to react quickly.