MIKE TOWNSEND: As we head into the July Fourth holiday weekend, Congress seems a bit stuck. Back in the early spring the president proposed two ambitious spending plans, one focused on infrastructure and the other on social programs.
Since then, there have been weeks of on-again, off-again infrastructure negotiations among the two parties on Capitol Hill. There have also been lots of grand pronouncements about turning the president’s other ideas into legislation that can pass Congress with only Democrats in support.
Yet three months after the president first unveiled his plans, Congress has not drafted even a single piece of legislation on any of them. The uncertainty has sparked a lot of questions from investors about whether infrastructure spending will ever turn from idea into reality, about whether the much-discussed tax increases on individuals will ever actually happen, about whether the ongoing spending spree by Congress will have long-term ramifications―for good or for ill―on the economy and inflation, and more.
Welcome to WashingtonWise, an original podcast from Charles Schwab. I’m your host, Mike Townsend, and on this show, our goal is to cut through the noise and confusion of the nation’s capital and help investors figure out what’s really worth paying attention to.
That episode generated a lot of interest, so I’m going to dive into five of the most frequently asked questions I’ve gotten in recent weeks. Many of those questions are not new, but they’re still very much on investors’ minds, so I wanted to offer some updates.
Let’s kick things off with the big question of the moment, which is “What in the world is going on with these infrastructure negotiations?”
Last week, President Biden and a bipartisan group of 21 senators reached a deal on an outline for an infrastructure package, with about $600 billion in new spending, along with some repurposing of other funds that will ultimately take the total agreement up to about $1.2 trillion over the next several years. It includes money for roads and bridges, public transit, rail, water projects, broadband expansion, and more.
But it’s important to remember that the agreement right now is literally a two-page outline. It still needs to be turned into actual legislation, and it still needs to pass both the House and the Senate. As you might imagine, there is plenty of grousing about the package from both sides of the aisle, so this is definitely not a done deal yet.
The White House envisions the infrastructure package as the first step in a two-step process. First, get enough bipartisan support for this bill that it can pass the Senate with a filibuster-proof supermajority of at least 60 votes. While there’s a lot that can still go wrong along the way, the path to that outcome has taken shape: Eleven of the 21 senators who worked on the plan are Republicans. If they bring some of their colleagues along, then there should be plenty of votes to exceed the 60-vote threshold for overcoming a filibuster, even if a few Democrats vote against the bill because they think it’s too small.
The second step is to use the budget reconciliation process to pass a package of spending focused on social programs without Republican support. And despite Democrats having slim majorities in both the House and the Senate, that’s the piece that Democrats are more worried about. They’re worried that the relatively modest infrastructure package is all they will get. That’s why you’re hearing many lawmakers talk about wanting a quote-unquote “guarantee” that the second package will happen. Of course, there are no guarantees in Congress.
Even the president himself caused a kerfuffle last week on this point, saying that he would not sign the infrastructure bill until the second piece of legislation is also ready for his signature. The Republicans who were part of the negotiations cried foul, saying that was never part of the deal. And the White House ended up walking back from that ultimatum a couple of days later.
It’s all very indicative of just how fraught this process will be over the next couple of months. The Senate is now taking a break for the July Fourth holiday and won’t be back in session until the week of July 12, so lawmakers will resume the process of trying to craft the infrastructure agreement when they return. There’s a lot of difficult work to get this done―and lots of opportunities ahead for it all to fall apart.
The market reacted positively to the news, pushing the S&P 500® and the Nasdaq to record highs last week. Infrastructure spending historically has tended to benefit the Industrials and Materials sectors.
My view is that chances are good that Congress will pass the infrastructure bill, though there will almost certainly be some further twists and turns along the way. And it’s going to take some time―I think it’s unlikely that anything can get through both chambers until September.
The second bill is tougher to forecast. Democrats hold majorities in both the House and Senate, so they should be able to craft a bill that can pass both chambers. But, because those margins are so narrow, this is where the ideological divisions within the Democratic party will come fully into view.
Senator Bernie Sanders of Vermont, who chairs the Senate Budget Committee that will be putting together the second bill, has talked openly about drafting a $6 trillion package. Moderate Senator Joe Manchin of West Virginia drew a top line over the weekend, saying he didn’t want to spend more than $2 trillion.
That’s a pretty big gulf between two members of the same side―but it’s a gulf that will ultimately need to be overcome. Manchin and Sanders will both need to sign off on the same package, as Democrats need all 50 of their senators to agree in order to move a bill through the Senate. Can that happen? We’ll see.
All of this drama brings us to another question I’m hearing from investors, which is about whether taxes are going up.
The bipartisan infrastructure deal announced last week contains no tax increases. Under the plan, the IRS would get an increase in resources to close the so-called “tax gap”―the difference between the taxes owed and those actually paid. Hundreds of billions of dollars in taxes go unpaid every year.
But it’s likely that the second bill will include tax increases. Earlier this year, the president proposed four separate tax increase measures: increasing the corporate tax rate; returning the top individual tax rate to 39.6%, where it was prior to the 2017 tax law; taxing capital gains and dividends as ordinary income for individuals earning more than $1 million per year; and ending the step-up in basis for inherited assets.
Now, Republicans across the board oppose any tax increases. But in the context of this bill, that doesn’t really matter. As long as Democrats can come up with legislation that can be supported by at least 216 Democrats in the House and all 50 Democrats in the Senate, they don’t need to worry about Republican opposition. Of course, meeting those thresholds won’t be easy.
Of the four proposals put on the table by the president, taking the top individual rate back to 39.6% is the most likely to happen. There is little, if any, opposition among Capitol Hill Democrats to that idea.
Democrats are also generally in agreement that raising the corporate tax rate makes sense. The president proposed 28%, but a number of Democrats have said that’s too high. Consensus seems to be settling around a 25% rate.
But the two tax proposals that would most directly impact investors face a much more uncertain path. The president’s call to tax capital gains and dividends as ordinary income for the wealthiest filers has already received significant pushback. If the top individual income tax rate is increased to 39.6%, and you add to that the 3.8% Net Investment Income Tax that’s already on the books, that would create a top capital gains rate of 43.4%. Some Democrats think that will discourage investment.
I continue to think it’s unlikely Congress will raise the rate that high. A contingent of Democrats are advocating a more modest increase―perhaps a top rate of 28%. That seems more politically achievable. But even that is uncertain.
Of particular concern to investors is that the president has called for the new capital gains rate to be retroactive back to April of this year when he first proposed it. Again, it’s important to remember that the president can’t make that happen on his own―Congress will decide when any tax increases should go into effect. And I can tell you that most of the discussion in Washington―both on Capitol Hill and among analysts in town―has focused on making them effective at the beginning of 2022.
Lawmakers on both sides of the aisle are voicing opposition to the president’s call to end the step-up in basis for inherited assets. They argue that it could be damaging to family farmers or owners of multi-generation family businesses. Right now, that proposal seems to be the most controversial, so don’t be surprised if it changes significantly, or even gets dropped.
We’ll get more clarity on taxes later this month as the task of actually writing the legislation picks up steam. Until there is more clarity around these possible tax increases, investors may want to take a wait-and-see posture before making any portfolio changes. My sense is there will be time later this year to do so if it becomes necessary.
All this talk of government spending and tax increases leads investors to ask: Is anyone on Capitol Hill interested in addressing the huge federal deficit and the ever-growing national debt?
The question has become particularly important in the wake of all the emergency spending that was approved by Congress―more than $5 trillion since March of 2020.
So let’s do a quick check-in on where things stand.
For fiscal year 2020, the federal government ran the largest deficit as a percentage of the economy since 1945 and the end of World War II. In those 12 months the deficit grew by $3.1 trillion―that’s more than 15% of GDP.
When you add all of the annual budget deficits together you get the national debt, which is now north of $28 trillion.
Economists have argued in recent years that the accumulation of all that debt is fine because the interest rates on borrowing have been and remain historically low. For now, that may be true. But it won’t be true forever.
The federal government is borrowing a lot of money, but interest rates are at or below 1% on 10-year debt and less than 2% on 30-year debt. As a result, the cost to the government of servicing the debt this year is a relatively manageable $300 billion, according to Congressional Budget Office projections. That’s about one and a half percent of GDP. It is projected to stay at around that level for the next several years, before beginning to rise rapidly in the second half of this decade as interest rates rise. By 2030, the annual interest outlay is projected to be more than $660 billion. And that means that more money will have to be devoted to servicing the debt, and less to other spending priorities.
For the moment, though, the simple answer to the question is that not a lot of lawmakers on Capitol Hill are overly concerned about the federal debt. Many argue that the low cost of borrowing argues in favor of more investment in things that will pay off in the future. That’s the argument being made right now for infrastructure spending―that borrowing money now to invest in broadband expansion or improving roads and bridges and the like will pay off later by creating jobs and raising wages, which leads to more tax revenue, which helps the government keep financing its borrowing.
But the current environment effectively pushes tough decisions down the road. At the end of the day, there are a few simple steps Congress can take to get the budget deficit and the federal debt under control: It can raise taxes and it can cut spending. Of course, getting any Congress to actually do those things is the hard part, because raising taxes and cutting government spending is often a recipe for getting thrown out of office by the voters at the next election. So don’t expect Congress to curb its ways anytime soon.
But Congress can’t avoid making one very tough decision about the debt in the coming weeks. And that’s the source of one of the most urgent questions investors are asking right now: What’s happening with the debt ceiling?
The debt ceiling, also known as the debt limit, is a cap put by Congress on the total amount of debt that the government can accumulate. It’s designed to act as a kind of checkpoint for Congress to ensure that government spending does not get too out of control.
Congress suspended the debt ceiling in 2019―basically giving itself carte blanche to spend as much as it wanted. At the time, of course, Congress had no way of knowing that a pandemic was coming and that it would have to spend trillions of dollars in response. Not having a debt ceiling made that spending easier. But the suspension was temporary―and that temporary period is set to expire on July 31. The terms of the suspension mean that the debt ceiling automatically becomes whatever the debt is as of August 1. As a result, on August 1, we will be up against the ceiling, and the Treasury will no longer be able to borrow money. That puts the government at risk of defaulting on its debt, something the United States has never done. Only Congress has the power to raise or suspend the debt ceiling, and historically speaking, this is not an unusual event. Congress bumps up against the debt ceiling every couple of years, and despite frequent complaining and posturing, lawmakers have never failed to raise or suspend it before the government defaults. A few times, notably in 2011 and 2013, it has come very close to default, but even then Congress acted in time. But whenever there has been any uncertainty about when or whether Congress would act to increase or suspend the debt ceiling, it has triggered significant market volatility―and investors are concerned that this could be happening again soon.
Last week, Treasury Secretary Janet Yellen testified before Congress, and she used the opportunity to sound an ominous warning. “I think defaulting on the national debt should be regarded as unthinkable,” Yellen said in testimony to a Senate Appropriations subcommittee. She went on to say, “Failing to increase the debt limit would have absolutely catastrophic economic consequences.”
She called on Congress to address the issue before the end of this month, to avoid any uncertainty in the financial markets.
In past years, the Treasury Department has been able to stave off default for a few months by taking what it calls “extraordinary measures” like suspending contributions to government pension funds, essentially buying Congress some additional time.
But Yellen indicated last week that emergency COVID-19 programs have added uncertainty to the government’s cash flow, and she warned lawmakers that the United States could face a serious risk of default by late August.
So will Congress take action to raise or suspend the limit? In a word, yes. It will happen because it always happens. At the end of the day no one on Capitol Hill wants to find out what the fallout would be if the United States defaults on its debts. But that doesn’t mean it will be easy. And the risk of market volatility in the weeks ahead is very real.
Many Democrats would like to work with the Republicans to make this a bipartisan effort―if for no other reason than doing so would allow everyone to share the blame for voting to permit the nation to accumulate even more debt. But some Republicans have said they want to pair a debt ceiling increase with a corresponding amount of spending cuts―something that’s unlikely to win much Democratic support at a time when the president is pushing to increase spending to juice the economic recovery.
Democrats could also use the budget reconciliation process to increase the debt limit without Republican support. But that process has been used just four times to raise the debt ceiling―most recently in 1997.
One idea is to attach it to the bipartisan infrastructure deal―but some lawmakers are concerned that doing so would scuttle the fragile deal on roads and bridges.
Senator Patty Murray from Washington state, who is the third-ranking Democrat in the Senate, acknowledged the conundrum last week, saying, “It has to be done. I don’t know the path yet. Everybody is aware that it needs to be done.”
The longer the uncertainty lasts, the greater the risk of market volatility. And I think that’s the takeaway here―expect some short-term market volatility as we head to the end of July and into August, because while it’s virtually certain that Congress will do what it has to do eventually, the road getting there may be bumpy.
I want to wrap up with another timely question that I am hearing. It’s been a growing concern but was brought into sharp focus by last week’s approval by the House Judiciary Committee of six bills that target anti-competitive practices by some of the biggest tech companies. Investors in companies such as Amazon, Apple, Facebook, and Google want to know whether these bills can actually pass Congress, and whether they will spark volatility in the stock prices of these companies.
A little context first. Last year, House Democrats issued a 450-page report, the culmination of a 16-month investigation into anti-competitive behavior by these companies. That report contained a number of recommendations for government policy changes that were designed to rein in the companies.
Fast forward to June 2021―those policy proposals have been turned into the series of six bills that were considered by the House Judiciary Committee last week in a marathon session that actually went overnight. The bills are controversial. One would prohibit tech companies from giving an advantage to their own products over those of competitors―a proposal that could cause major issues for Apple’s App Store or Amazon’s branded products that it sells on its enormous e-commerce hub. Another would ban the companies from acquiring smaller competitors. And one bill could even force the companies to break up―Google, for example, could be forced to sell YouTube.
What’s interesting and notable about these bills is that they all have bipartisan support―but it’s an odd sort of bipartisan support. All of the bills passed the committee narrowly, with some Republicans joining the majority of Democrats in approving them, while several Democrats voted against them.
The tech companies’ share prices all fell modestly on the news of the committee’s passage of the bills. But don’t expect these stocks to be enormously impacted in the near future. They’re all lobbying hard against the bills, and these companies are powerful lobbying forces in the nation’s capital.
The legislative process is a long one, and while passage of a bill through a major committee is an important step, these bills still need approval by the full House, and later will face an even more uncertain future in the 50-50 Senate. House Speaker Nancy Pelosi, who has huge influence over what does and does not get a vote on the House floor, is being pressured to slow down the process by members of her own party who don’t support the bills. Particularly vocal in that opposition are several members from California, who worry that the bills single out a handful of companies that create tens of thousands of jobs and produce enormous tax revenue in their state.
The bottom line is that investors should keep track of this but not overreact to it. So many investors hold these companies, either directly or through mutual funds and exchange-traded funds, that it feels like legislation targeting these companies could impact almost every investor. But we’re still early in the Congressional process and these bills are a long way from becoming law. The short-term risk to these companies seems to be mostly “headline risk” rather than a real threat of dramatic changes to their core businesses.
That’s all for this week’s episode of WashingtonWise Investor. I’ll be back in two weeks, so please take a moment now to follow the show in your listening app so you don’t miss an episode. And if you like what you’ve heard, leave us a rating or a review—that really helps new listeners discover the show.
For important disclosures, see the show notes or schwab.com/washingtonwise, where you can also find a transcript.
I’m Mike Townsend, and this has been WashingtonWise Investor. Wherever you are, stay safe, stay healthy, and keep investing wisely.