Hoisington Quarterly Review and Outlook – 4Q 2016
The 2016 presidential election has brought about widely anticipated changes in fiscal policy actions. First, tax reductions for both the household and corporate sectors along with a major reform of the tax code have been proposed. In conjunction, a novel program of tax credits to the private sector has been discussed to finance increased outlays for infrastructure. Second, provisions have been suggested to incentivize domestic corporations to repatriate $2.6 trillion of liquid assets held overseas. Third, there is talk of regulatory reform along with measures to increase domestic production of energy. Finally, various measures related to international trade have been discussed in an effort to reduce the current account deficit.
Judging by sharp reactions of U.S. capital and currency markets, success of these proposals has been quickly accepted. Such was the case with the fiscal stimulus package of 2009, as well as with Quantitative Easings 1 and 2; initially there were highly favorable market reactions. In these cases the rush to judgment was misplaced as widespread economic gains did not occur, and the U.S. experienced the weakest expansion in seven decades along with lower inflation. It could be that the fundamental analytical mistake now, like then, is to assume that the economy is “an understandable and controllable machine rather than a complex, adaptive system” (William R. White, in his 2016 Adam Smith Lecture “Ultra-Easy Money: Digging the Hole Deeper?” at the annual meeting of the National Association of Business Economists). While many of the aforementioned proposals include pro-growth features, it appears that there is an underestimation of the nega tive impact of delayed implementation and other lags. Additionally, the risks of unintended adverse consequences and outright failure are high, especially if the enacted programs are heavily financed with borrowed funds and/or monetary conditions continue to work at cross purposes with the fiscal policy goals.
Tax Cuts and Credits
Considering the current public and private debt overhang, tax reductions are not likely to be as successful as the much larger tax cuts were for Presidents Ronald Reagan and George W. Bush. Gross federal debt now stands at 105.5% of GDP, compared with 31.7% and 57.0%, respectively, when the 1981 and 2002 tax laws were implemented. Additionally, tax reductions work slowly, with only 50% of the impact registering within a year and a half after the tax changes are enacted. Thus, while the economy is waiting for increased revenues from faster growth from the tax cuts, surging federal debt is likely to continue to drive U.S. aggregate indebtedness higher, further restraining economic growth.
The key variable to improve domestic economic conditions is to cut the marginal household (middle income) and corporate income tax rates. Due to the extremely high level of federal debt, if the deleterious impact of higher debt on growth is to be avoided, then these tax cuts must be expenditure-balanced to the fullest extent possible along with reductions in federal spending (which has a negative multiplier).
Providing tax credits to the private sector to build infrastructure should be more efficient than the current system, but this new system has to first be put into operation and firms with profits must decide to enter this business. Moreover, all the various rights of way, ownership and environmental requirements suggest that any economic growth impact from the infrastructure proposal is well into the future.
However, if the household and corporate tax reductions and infrastructure tax credits proposed are not financed by other budget offsets, history suggests they will be met with little or no success. The test case is Japan. In implementing tax cuts and massive infrastructure spending, Japanese government debt exploded from 68.9% of GDP in 1997 to 198.0% in the third quarter of 2016. Over that period nominal GDP in Japan has remained roughly unchanged (Chart 1). Additionally, when Japan began these debt experiments, the global economy was far stronger than it is currently, thus Japan was supported by external conditions to a far greater degree than the U.S. would be in present circumstances.
One of the tax proposals with wide support gives U.S. corporations a window to repatriate approximately $2.6 trillion of foreign held profits under the favorable tax terms of 10% or 15%. There is a catch, however. To ensure that all funds are brought home, the tax is due on all of the un-repatriated funds even if only a portion is brought back to the United States.