Winning two Georgia Senate races gives Democrats control of the U.S. Senate by the narrowest of margins – and for the fourth time in the history of the Republic there will be a 50–50 Senate with Vice President-elect Kamala Harris able to cast the 51st vote.
What can we expect from a unified, albeit narrowly, Democratic Washington? We expect more spending on COVID-19 relief in the near term with a longer-term focus on “economic rebuilding,” a central message of President-elect Joe Biden’s campaign, which could include an infrastructure bill, healthcare, and other non-economic priorities such as a voting rights bill. However, as we move from campaign rhetoric to the realities of policymaking, investors should prepare for the invariably bumpy and slow process of passing comprehensive legislation, especially with a 50–50 Senate.
Fiscal priorities for 2021
We believe that with control of Washington in 2021, the Democrats will likely focus on four fiscal priorities:
- More COVID relief: An additional round of COVID stimulus will likely be the Biden administration’s first priority, with a deadline of mid-March when many of the provisions in the $900 billion (roughly 4% of U.S. GDP) December-passed COVID bill expire. No one knows for sure how big a bill will be signed into law, but given the virus’s trajectory and the bumpy rollout of vaccinations, in our base case we think relief will probably be in the $1 trillion range – but it could be higher (or a touch lower). The size and speed of passage will depend on how Democrats choose to pass the bill – whether it is through “regular order” in the Senate (which requires 60 votes) or through a process called “reconciliation,” which has numerous strings attached, but only requires 50 votes. Additional support for households and small businesses impacted most severely by the pandemic (similar to the most recent stimulus) would almost immediately invigorate economic activity, in our view, while additional support for state and local governments could help avoid the longer-term drag state budget cuts had following the financial crisis.
- Infrastructure focused on economic recovery: The Biden campaign’s “Build Back Better” slogan is likely to manifest as an economic recovery and job-creation plan focused on infrastructure spending. Democrats are envisioning a broad definition of infrastructure – not just roads and bridges, but also a national broadband network, green energy, and school investment. However, such a comprehensive bill with its many committees of jurisdiction would require significant work – and bipartisanship – in Congress. Consequently, we think infrastructure legislation would be a focus in the second half of 2021 at the earliest, and even then, it may take longer to pass. While the devil will be in the details, this type of spending has the potential to have more lasting economic benefits than targeted aid, and could increase productivity (and maybe inflation) in the longer run. Infrastructure and related spending would likely be in the range of $1 trillion – $2 trillion (4.5%–9% of GDP), most likely spread out over several years.
- Healthcare spending: Democrats flipped the House in 2018 by campaigning on healthcare, and that messaging seems to have resonated even further in 2020 amid the pandemic. As a result, we think shoring up the Affordable Care Act (ACA) will be a major Democratic priority, with new urgency given the pending case in front of the Supreme Court and recent changes to the court’s composition. Since the more revolutionary “Medicare for All” approach lacks broad-based support, we expect Democrats to focus on changing the existing framework to put the ACA on firmer legal footing, make it more affordable for middle income earners, and allow Medicare to negotiate drug pricing with pharmaceutical companies. We estimate the total cost of such a bill would be roughly $500 billion – $700 billion (3%–4% of GDP). We expect the Democrats to try to pass these changes with reconciliation.
- Tax hikes would finance higher spending: Although the Biden campaign has proposed nearly $4 trillion in tax hikes to offset some of the spending, the reality of trying to raise taxes in a time when the U.S. economy is still recovering from a sharp recession means that tax changes will likely be more evolutionary than revolutionary. Raising the corporate tax rate to 28% as Biden has proposed will likely be difficult given the narrowly divided Congress; instead, we think the corporate tax rate may land at a more modest 24%–25%. Even more likely, Democrats could focus on alternative ways to raise revenue through corporate taxes that are more politically popular, such as an alternative minimum tax or adjustments to the GILTI tax (on global intangible low-taxed income). While it’s still unclear exactly what the priorities will be, we think these types of changes could raise $500 billion – $700 billion in revenue.
On personal taxes, we expect the focus to be on raising taxes only for top earners. The top tax bracket is likely to go back to 39.6%, which would raise approximately $500 billion over 10 years. Other changes, such as reducing the estate tax exemption, abolishing the step-up in basis, and increasing capital gains for those making more than $1 million per year are possible sources of revenue as well, but could also face some of the legislative realities of a narrowly divided Senate. We could also see a Democratic Washington reinstate the SALT (state and local tax) deduction in some capacity (either in its entirety or simply by increasing the current $10,000 deduction), a welcome development to many residents in high-tax states.
All in all, we expect tax increases could reach $1 trillion – $1.5 trillion over 10 years, but even if passed in 2021 they won’t likely take effect until 2022. Investors wondering whether they will see rapid and revolutionary changes in tax policy coming from a Democratic-majority Congress should probably temper these expectations.
Implications for the economic outlook
Despite the pandemic’s drag on the economic recovery over the last few months, the combination of an improving public health outlook and significant fiscal stimulus leads us to expect U.S. growth to reaccelerate sharply this year, far surpassing consensus estimates heading into the Georgia election. An additional $500 billion – $1 trillion of spending, for example, could add 2.5–5.5 percentage points to a no-new-stimulus baseline GDP growth projection of more than 4% in 2021. Though the timing and details of spending will be an important determinant, net government spending could boost real U.S. GDP growth to over 7% in 2021. The $900 billion of stimulus passed in December is designed to filter into the economy quickly, and should also help bridge the gap between near-term economic weakness and a better public health outlook later in the year. While the additional fiscal stimulus boost is likely to produce an even stronger-than-previously-expected U.S. growth rebound in 2021, it’s likely to have more moderate effects on inflation amid the lingering effects of the coronavirus-induced recession. Inflation lags growth and improvements in the labor market, and still isn’t likely to reach 2% this year.
The key remaining uncertainty is the impact these policy changes will have in the longer run. The details of any infrastructure package will dictate any productivity or labor supply gains, and these factors, as well as any tax changes that are able to get through Congress, will impact the longer-run growth and deficit outlook for the U.S. While we still see limited near-term inflation pressures, larger fiscal stimulus increases right-tail inflation risks in the longer run, particularly given the Fed’s desire to tolerate higher inflation.
To learn more about the economic and investment implications of a changed Washington, please visit our U.S. election website.
Libby Cantrill is PIMCO’s head of public policy, and Tiffany Wilding and Allison Boxer are PIMCO economists.