Shooting Oneself In The Foot: Why The Sequester Will Knock A Percentage Point Or More From 2013 US Tech Market Growth

Andrew Bartels
Vice President, Principal Analyst
March 1, 2013

Well, it looks like the folks in Washington have done it. The device, called "sequestration," that imposes mandatory across-the-board cuts in Federal defense and non-defense spending is actually going into effect. That mechanism was created back in 2011 at the time of the US debt ceiling crisis as an outcome so terrible that it would force Republicans and Democrats to find a compromise that starts reducing the US Federal deficit. Instead, it has itself become the compromise between a Republican plan that would impose all of the planned $85 billion in budget cuts in the current fiscal year on non-defense spending, and an Obama proposal for $85 billion in tax increases, future cuts in entitlement spending, and selected defense and non-defense cuts. Republicans would rather see actual cuts in current US spending, even if that cuts spending on defense, their favorite category of Federal spending, rather than support any increase in taxes. And Democrats would rather see cuts in non-defense discretionary spending rather than in Social Security or Medicare, even if that means many of their favorite Federal programs will face cuts.  

Most economists have estimated that the $85 billion in cuts in Federal spending will shave about half a percentage point from US real GDP growth, which was already projected to be a relatively weak 2% or so. On the positive side, consumer spending has been relatively good — 2.1% growth at an annual rate in Q4 2012 and rising at a 2.4% annual rate in January 2013. Residential construction has also been on a growth path, increasing at a 17.5% rate in Q4 2012 after 13.5% growth in Q3 and 8.5% growth in Q2. Business investment recovered from a down Q3 (when fears of the fiscal cliff caused purchases of structures, equipment, and software to fall by 1.8%) with an 11.7% rise in Q4; that could reverse, however, due to the impacts of continuing political gridlock on business confidence. But government spending fell by 6.9% in Q4 2012, as Federal agencies (especially Defense) started cutting in anticipation of sequestration. That big cut in government spending pulled US real GDP growth down to a revised 0.1% increase in Q4 2012. Sequestration will continue that trend, leading to declines in government purchases that will partially offset the improving consumer, housing, and business investment sectors. At the same time, nothing good comes from these forced cuts in US Federal spending, because the current deficit is being easily financed in financial markets where business and consumer demand for credit is weak. The real US deficit problem lies five or more years in the future, when expanding entitlement programs like Social Security and Medicare and flat taxes will create a widening gap between Federal revenues and Federal spending. So, sequestration is a purely symbolic act, which does little to address the deficit problem but does impose real costs on the US economy. 

Turning to the tech market, we think sequestration will have two negative impacts on the US tech buying by business and governments.  

First, the direct impacts will be an almost certain drop in purchases of IT goods and services by Federal agencies, with a secondary but lesser decline in state and local IT purchases. The Federal government represents about 9% of the US tech market, and state and local governments a similar proportion. So, with most Federal civilian agencies facing a 5% budget cut and Defense Department non-personnel spending facing a 7% cut (see "Where The Cuts Will Fall," The New York Times, February 23, 2013), Federal government IT purchases are facing possible reductions of up 5% to 7%. Hardware purchases will probably fall even more than that, because these are easily delayed or deferred. IT outsourcing will feel little impact, because these are already committed by contract. Federal purchases of software and IT consulting and systems integration are likely to experience 5% to 7% decreases, as projects get cancelled or delayed and as agencies shift from on-premises licensed software deployments to SaaS offerings with lower initial costs.  

Second, there will be the indirect impacts, as reduced Federal spending flows through the economy and slows overall economic growth. Our rule of thumb is that every one percentage point increase or decrease in nominal GDP translates into one- to one-and-a-half percentage point increase or decrease in tech spending by the private sector. So, if US real GDP growth is a half percentage point less than expected and nominal GDP is reduced by a similar proportion (assuming no change in inflation), than tech purchases would be 0.5% to 0.75% lower.  

We are still tuning our forecasts in light of the actuality of sequester and other factors (e.g., revised Q4 2012 data on business investment in computer equipment, communications equipment, and software, and the publication next week of the US Census Bureau's Q2 2012 Services Survey with its data on IT consulting services, IT outsourcing, and telecommunications services. But our preliminary assessment is that the two impacts of sequestration will cause us to reduce our US tech market forecast from the 7.5% growth we projected in our Global tech market ("Global Tech Market Outlook 2013 To 2014 – In Local Currencies, The US Will Lead 5.4% Global Tech Market Growth In 2013 And 6.7% Growth In 2014," January 3, 2013), to a new projection in the 6% to 6.5% range. That is still not bad. But it could have been better if sequestration could have been avoided or if it were more balanced by including taxes and changes to entitlement benefits.  


Related Posts