ROI-The US fiscal hole has an AI problem at its core: Mike Dolan

Washington has a multitrillion-dollar fiscal problem. U.S. Treasury Secretary Scott Bessent's answer, so far, is to look ​for loose change down the back of the sofa. His tentative nod to fiscal tightening last week has done little to reassure ​markets facing the highest U.S. government borrowing costs in decades — not least because the deficit's structural drivers, ‌from ​mandatory social spending to falling corporate-tax revenues and a planned defense-spending boost, remain untouched. Now the AI investment boom — and its uncertain payoff — sits at the center of both the short-term fiscal squeeze and market unease. Perhaps inadvertently, Bessent sparkedscrutiny of the sheer scale of U.S. budget deficits with an insufficient and slightly clumsy attempt to cap rising long-dated U.S. Treasury yields by increasing relatively small bond buybacks. Defending the buyback as merely "signaling" to markets, Bessent said new ‌fiscal moves were afoot to keep a lid on annual deficits running at about 6% of GDP. They would focus on savings from fraud, waste and other government spending inefficiencies. But few analysts believe tackling fraud and waste will make serious inroads into the budget shortfall, and the government efficiency and downsizing drive of 2025 also stalled. Even the prospect of what Bessent called "peak deficit" for this administration convinced few. Falling corporate-tax revenues this year — partly because of booming business and the AI frenzy — and proposals for a near-50% rise in total defense spending through fiscal 2027 are helping keep the budget gap wide. Yet ‌high and rising mandatory spending on health and social-welfare programs is seen by most as the biggest structural issue over time. At the margins, there's an annual interest bill on the $40 trillion total debt pile of more than $1 trillion, and uncertain and lumpy new revenues from President Donald ‌Trump's tariff campaigns. The bond market's anxiety runs deeper than anything Bessent is currently proposing. TheCongressional Budget Office conservatively projects debt held by the public will nearly double over the next 10 years, reaching $56 trillion by 2036 — a rise of some 20 percentage points as a share of GDP. That trajectory collides with high servicing costs, a Federal Reserve chair intent on shrinking the central bank's bond holdings and no political appetite for spending cuts or tax increases. "The prospect of fiscal consolidation seems unlikely to be realized," concluded Barclays economist Michael McLean, pointing out that even Trump's own plan last week was for a perplexing mix of faster growth bringing lower interest rates. Like many economists, McLean dissected the basics of the U.S. budget, noting that almost ⁠60% of the $7 trillion ​in annual government outlays is mandatory spending, mostly on Social Security and healthcare programs. ⁠Demographic and aging pressures have driven that spending 7% higher in the current fiscal year. The remaining $2 trillion in discretionary spending is split evenly between defence and everything else.

But the revenue side gets more interesting. AI TAX INCENTIVE As Bessent himself pointed out last week, waves of factory and data-center construction are being immediately expensed against corporate profits under Trump's 2025 tax ⁠cuts in the One Big Beautiful Bill Act (OBBBA), contributing to a significant drop in corporate-tax revenues. Tariff expenses are also being written off for tax purposes. McLean at Barclays points out that overall government revenue seems sound at near historical norms of about 17% of GDP, and overall tax receipts are up 3% in fiscal 2026. But beneath ​that top line, corporate-tax revenues are down 23% — mainly as a result of the OBBBA’s allowance for immediate full expensing and bonus depreciation that has been lapped up by companies pumping hundreds of billions into the AI push. Corporate tax rates have been falling for ⁠years, and these latest tax provisions are permanent. With the AI buildout in its early throes, corporate tax receipts may well remain depressed over the medium term as businesses continue to make large deductible capital investments. "We are therefore skeptical that the U.S. has reached peak fiscal deficit. The administration may be able to report a smaller deficit. It is much less clear that ⁠it ​can change the underlying fiscal trajectory," McLean said. The AI wave is hitting Treasury bonds from both angles: a short-term drain on Federal tax revenues and competition for financing from massive long-dated bond issuance by hyperscaler firms building AI infrastructure. Though this is primarily coming from the U.S. and China, the global totals are starting to add up — and are extraordinary.

Morgan Stanley estimates that $350 billion to $400 billion in AI-related public investment-grade debt will be issued in 2026, with some $1.4 trillion of new capex planned for 2027. Since the middle of this year alone, some $92 billion has been financed across all debt markets. If ⁠the AI boom is stoking inflation and Treasury is simultaneously trying to cap the long-term yields as they adjust to reflect it, the Fed faces a problem — even if it views the investment wave and its productivity promise as net positives. In that environment, Fed easing should ⁠be off the table. But tensions between the Fed and Treasury may well ⁠build if the central bank's inflation target continues to prove elusive. And if Fed hawks win the day, Bessent's plans to cut servicing costs by shortening debt maturities may be derailed. Longer term, the stakes for AI eventually repaying the trillions spent on building and developing it grow ever higher. (The opinions expressed here are those of Mike Dolan, a columnist for Reuters.) Enjoying this column? Check out Reuters Open Interest (ROI), your essential new source for ‌global financial commentary. Follow ROI on LinkedIn, and X. And ‌listen to the Morning Bid daily podcast on Apple, Spotify, or the Reuters app. Subscribe to hear Reuters journalists discuss the biggest news in markets ​and finance seven days a week.

(By Mike Dolan; Editing by Marguerita Choy)