Moody’s has cut the U.S.’s sovereign credit rating from the highest possible rating (Aaa) to one notch below (Aa1). According to CNBC, the agency lowered the rating due to the growing burden of the federal government’s deficit and the rising costs the U.S. now faces due to interest rates. Moody’s joins Standard & Poor’s, which downgraded the U.S. in August 2011, and Fitch Ratings, which downgraded the U.S. rating in August 2023. The U.S. credit rating has significant market wide effects, as demonstrated by the Dow, S&P 500, and NASDAQ indices all being down at the start of trading. In this article, I discuss these effects and why U.S. tax revenues are affecting this downgrade.
The U.S. Credit Rating
Like individual consumers, rating agencies provide sovereign countries with a credit rating. The country then uses this rating to issue debt; better ratings allow countries to pay lower interest, and weaker ratings require countries to pay higher interest. Six factors are important in determining a country’s credit rating: per capita income, GDP growth, inflation, external debt, level of economic development, and default history. A credit rating agency like Moody’s independently evaluates a country on these primary factors and more to provide a rating that ranges from Aaa (highest quality and lowest credit risk) to C (lowest quality, usually in default and low likelihood of recovering principal or interest).
The U.S. Tax Revenue Problem
According to Forbes, Moody’s is concerned that the government’s debt is a significant contributor to the U.S. credit rating downgrade. This debt sits at an inflection point at the House of Representatives, which is in the process of developing and passing Trump’s second major piece of tax reform. If passed, this tax bill will make many of the original provisions from the 2017 legislation permanent and will lower tax liabilities for many U.S. taxpayers. As reported by Reuters, this bill would add $3 trillion to $5 trillion to the U.S. debt (which currently sits at $36.2 trillion). As this debt continues to accumulate, the U.S. increasingly faces the risk of default, which has undoubtedly influenced Moody’s decision to downgrade the credit rating.
While tax collections are not one of the six explicit factors highlighted above, they appear to be a significant driver of Moody’s decision. For instance, Fortune cites a statement by Moody’s that interest payments on U.S. debt will take up 30% of [tax]
revenue by 2035 and another statement that while spending continues to increase, government revenue remains broadly flat. Thus, the increasing debt and tax revenues appear to be linked in the eyes of the credit rating agencies.
As with any tax revenue problem, the U.S. has two options: spend less money or collect more money. In terms of the former, the U.S. appears to be poised to continue to increase spending via many of the provisions from the 2017 Tax Cuts and Jobs Act being renewed and made permanent. As reported by Forbes, several additional provisions are expected to be added, like enhanced State and Local Tax Deductions, increased Child Tax Credits, higher Federal Estate Tax exemptions, and tax deductions for corporate R&D activities. While the current House bill does have plans to increase collections from places like university endowments, The Tax Foundation estimates a significant increase in spending over the next ten years to the tune of over $4 trillion.
In terms of the latter, the current administration appears to be set on diminishing the U.S. ability to collect tax revenues. As reported by Forbes, the IRS workforce continues to be dissolved, which can lead taxpayers to avoid or evade income taxes at higher rates. Academic research published in The Accounting Review provides evidence that funding the IRS is critical to enforcing tax laws and that the amount of tax revenues collected from IRS enforcement can exceed what the U.S. spends to fund the agency. Put differently, for every dollar the U.S. invests in the IRS, the study suggests that more than one dollar gets returned in the form of higher tax collections.
Given the signals Trump and the House of Representatives have sent regarding their plans to lower tax revenues, lax tax law enforcement, and raise debt, it is unsurprising that Moody’s has responded with a credit rating downgrade.
The Impacts Of A Lower Credit Rating
While the U.S. no longer has a perfect credit rating with any of the three major credit rating agencies, it is important to point out that it is just one notch below perfect. With an agency like Moody’s, there are 22 notches, and moving from Aaa to Aa1 does not suggest imminent financial disaster. However, this lower credit rating means the government will pay more money for its debt. These impacts are already seen with U.S. 10-year treasury yields moving above 4.5%. Higher treasury yields tend to trickle down to individual taxpayers with higher borrowing costs for things like mortgages and car loans, which can slow down the economy. Given this warning signal sent by Moody’s, the U.S. may want to consider expanding tax collections as a means to offset the negative impacts of a credit rating downgrade.
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