First, Federal spending is a component of GDP, which measures the output of the entire economy. For more, see Discretionary Fiscal Policy. Second, higher income taxes take money out of consumers' pockets, regardless of where the tax is imposed. Business taxes are passed on through higher prices, or through layoffs and reduced investment for companies that can't raise prices. For more, see Supply-side Economics
In March 2013, the first phase of sequestration kicked in. This required a mandatory 10% Federal budget cut for the remaining nine months of 2013. It was created by Congress and the President to resolve the 2011 debt crisis.
Disagreements over how to reduce the debt means a debt crisis every time the debt ceiling needs to be raised. Long-term, balancing the budget means a reduction in the largest unfunded budget item, military spending AND/OR tax hikes. Social Security pays for itself, and Medicare partially does, at least for now.
As Washington wrestles with the best way to go about this, it creates uncertainty about tax rates, benefits and federal programs. Businesses react to this uncertainty by hoarding cash, hiring temporary instead of full-time workers, and delaying major investments. Don't expect a robust recovery until the debt-to-GDP ratio is closer to the 77% benchmark level recommended by the International Monetary Fund. It was 102% when the debt exceeded $17 trillion on October 17, 2013.
Economic growth, as measured by Gross Domestic Product (GDP), will drop to an anemic 1.4% rate in 2013, predicts the Congressional Budget Office (CBO). This is worse than 2012's lackluster 1.9% growth rate. By 2014, economic growth will return to a healthy 3.4% rate, IF Washington resolves it political standoff. It will accelerate to a robust 3.6% growth rate by 2018, settling back into a moderate 2.2% rate by 2023. (Source: CBO, The Budget and Economic Outlook: FY 2013-2023, Summary Table 2)
The Federal Reserve forecasts GDP growth accelerating to somewhere between 2.8% and 3.0% in 2014. It will improve to between 3% and 3.5% in 2015, before settling into a slower 2.5% to 3.3% range after that. (Source: FOMC Committee, Economic Projections of Federal Reserve Board Members and Bank Presidents, September 18, 2013)
The CBO forecasts that the unemployment rate will drop to 5.3% by 2023. This again assumes that sequestration occurs, which boosts the jobless rate to 8% by the end of 2013. However, resultant deficit reduction will spur renewed economic vigor, driving the rate down to 7.6% in 2014, and 5.5% by the end of 2018. (Source: CBO, The Budget and Economic Outlook: FY 2013-2023, Summary Table 2)
However, the Fed is slightly more optimistic in the short run. It forecasts unemployment dropping slightly in 2013, somewhere between 7.1% and 7.3%. The rate will further drop in 2014 to somewhere between 6.4% and 6.8%. In 2015, the rate will drop even further, within a range of 5.9% and 6.2%. (Source: FOMC Committee, Economic Projections of Federal Reserve Board Members and Bank Presidents, September 18, 2013)
The $17 trillion debt, and sequestration, means that the U.S. really can't afford to wage large ground wars anymore. The successful raid to eliminate Osama bin Laden showed that special ops are more cost-effective. In the FY 2012 budget, security spending (including Homeland Security, Overseas Wars and Veterans Administration) reached a peak of $895 billion -- more than either Social Security or Medicare. This was projected to shrink to a low of $749 billion by FY 2015, which will help the budget deficit drop to $610 billion that year. (Source: FY 2013 Federal Budget, Summary Tables, Table S-5: Proposed Budget by Category)
Despite temporary bumps along the road, the dollar will continue its long and gradual decline in value. First, foreign investors are concerned that the U.S. is allowing the dollar to decline so the relative value of its debt is less. Second, the Federal Reserve's quantitative easing has put additional downward pressure on the dollar, by lowering interest rates. Tapering in 2014 will allow rates to rise, temporarily putting moderate upward pressure on the dollar's value.
Over the long term, foreign investors are diversifying their portfolios with more non-dollar denominated assets -- even the euro. Result? Higher import prices, contributing to inflation, as well as lower export prices, spurring economic growth. However, the good news is that it will be a gradual dollar decline, not a dollar collapse.
High gas prices translate into higher food prices, which are also part of a long-term trend. They've risen 2%-3% annually since 1990, and are expected to increase 3-4% in 2013.
There are two policy shifts that drive up corn prices, which affects feedstock. The U.S. government takes some corn out of production for bio-fuels, while the World Trade Organization (WTO) limits the corn and wheat stockpiles that the U.S. and European Union (EU) are allowed to subsidize. Third, as the global standard of living improves, more people can afford more meat, taking even more grains out of production.
Rising food prices and volatile gas prices will raise fears about hyperinflation. However, it won't happen. The Federal Reserve is vigilant about reversing quantitative easing and raising the Fed Funds rate when needed. Fed Chairman Ben Bernanke has followed the exit plan to absorb the liquidity the Fed pumped into banks since August 2007.
The most important role of the Fed is managing public expectations of inflation. Once the public expects inflation, it becomes a self-fulfilling prophecy. The Fed can maintain confidence in the economy by demonstrating moderation, resulting in less extreme changes in public economic behavior. Result? Core inflation will remain under 2%.
Bernanke based this on how former Fed Chair Paul Volcker ended the stagflation of the 1970s. By keeping interest rates high, it reassured the public it was committed to preventing inflation.
Many states have worked through the shadow inventory of homes headed for the foreclosure pipeline. As a result, the housing market recovered first in "non-judicial process" states. This is occurring in other states as they catch up. It might take 10 years, but eventually home prices will recover to their 2006 levels.
The only hiccup to this rebound will be in 2014, when the Fed reverses quantitative easing, and in 2015, when it raises the Fed funds rate. As mortgage rates rise, housing prices will drop to offset the higher cost to homebuyers. Hopefully this will only be enough to prevent another asset bubble, but not enough to dry up demand.