Understanding the Impact of U.S. Credit Downgrades and Budget Issues for Everyday Investors

With Moody’s recent decision to lower the U.S. credit rating from Aaa to Aa1, all three major rating agencies have now removed America’s top-tier debt status. This follows Fitch’s downgrade in 2023 and Standard & Poor’s similar move back in 2011. Moody’s action comes at a time when Congress is working on a new budget bill that could increase yearly deficits, highlighting tensions between tax reduction policies and financial sustainability. Many regular investors are wondering how these developments might affect their personal financial strategies.

Budget talks have regularly created market uncertainty

Over the past fifteen years, negotiations about the federal budget and arguments over the debt ceiling have often caused market swings. Notable examples include the 2011 Standard & Poor’s downgrade of U.S. debt, the 2013 fiscal cliff situation, and government shutdowns in 2018 and 2019. Despite these disruptions, agreements were eventually reached in each case, allowing markets to recover and continue growing.

Interestingly, after the unprecedented 2011 downgrade that triggered a market drop, the S&P 500 fully recovered within months. Though it may seem strange, even with these downgrades, U.S. Treasury securities continue to be viewed as safe investments during unstable market periods and remain crucial to financial markets.

When considering national debt and Washington budget conflicts, it’s important to maintain perspective. As citizens and voters, it’s reasonable to worry about the country’s unsustainable financial direction. Finding solutions to these problems isn’t simple, and various expert groups and proposals have failed to meaningfully reduce yearly budget shortfalls.

While these issues matter, it’s best not to make sudden changes to your investment portfolio because of them. Though past fiscal problems and downgrades created uncertainty, markets have historically stabilized and recovered over time. A disciplined approach focused on long-term goals, spreading investments across different assets, and solid investment basics – rather than reacting to Washington headlines – remains the best strategy for achieving financial objectives.

Moody’s downgrade happens as investors shift focus from tariffs to Washington’s budget proposal. Markets performed well after last year’s election partly due to expectations of growth-friendly policies and an extension of the 2017 Tax Cuts and Jobs Act (TCJA), but the Moody’s announcement reminds us of ongoing fiscal challenges.

Specifically, Moody’s highlighted that “successive US administrations and Congress have failed to agree on measures to reverse the trend of large annual fiscal deficits and growing interest costs,” and that they “do not believe that material multi-year reductions in mandatory spending and deficits will result from current fiscal proposals under consideration.”

Tax Cuts and Jobs Act provisions may soon be extended or made permanent

Congress is currently working on a new budget bill with provisions that continue to evolve. The latest proposal aims to provide stability by extending individual tax cuts from the TCJA that would otherwise expire after 2025. This would prevent a potential “tax cliff” where tax rates would return to pre-TCJA levels, possibly disrupting the economy. By addressing these issues well before the expiration date, lawmakers hope to create certainty for both households and businesses.

This comprehensive tax package includes many provisions affecting both businesses and individuals. Key elements, which might still change, include:

For Individuals:

• Making the TCJA individual tax rates permanent, keeping the top rate at 37%
• Increasing the child tax credit from $2,000 to $2,500 through 2028
• Possibly raising the state and local tax (SALT) deduction cap from $10,000 to $30,000
• Exempting tips and overtime pay from income tax through 2028
• Making interest on car loans tax-deductible through 2028
• Creating a new savings account called “money account for growth and advancement” (“MAGA accounts”) for children under 8 to use for education, small business investments, and first-home purchases

For Businesses:

• Increasing the pass-through business deduction from 20% to 23% and making it permanent
• Bringing back 100% bonus depreciation for qualified business assets acquired between January 2025 and 2029
• Reinstating research and development tax deductions

The proposal doesn’t include a “millionaire tax” or changes to carried interest tax treatment that some had expected. The debt ceiling, which limits how much the country can borrow, might also be raised by $4 trillion.

Budget shortfalls may continue to increase the national debt

While the current proposal includes about $1.6 trillion in spending cuts through changes to programs like Medicaid and food assistance, these reductions are smaller than the tax cuts and spending increases in other areas.

Yearly budget deficits are important because they add to the national debt, which now exceeds $36 trillion – roughly $106,000 for every American. Reports suggest the proposed budget could add approximately $3 trillion or more to the debt over the next decade. The most recent estimate from the Joint Committee on Taxation, a nonpartisan congressional committee, indicates the debt could grow by $3.7 trillion during this period.

The national debt has grown significantly in recent decades, with interest payments continuing to rise. Since most federal spending goes toward mandatory programs like Social Security and Medicare, finding agreement on major spending cuts is politically difficult. This is why some experts worry that tax rates may eventually need to increase, even if the TCJA is extended or made permanent soon.

Although deficit and debt levels matter for the economy’s long-term health, their immediate impact should be viewed in context. Markets have historically performed well under various levels of government debt and deficit spending. Surprisingly, some of the strongest market returns in the past twenty years came after the worst deficits, typically because these coincided with economic crises when markets were already at low points. In other words, making investment decisions based solely on government spending and deficits would not have been helpful.

The bottom line? The U.S. credit rating downgrade reflects worries about America’s long-term financial path. The current budget negotiations may further complicate these concerns. However, history suggests that investors can best navigate these challenges by staying invested and sticking with a long-term financial plan.