The US Senate recently passed its tax bill supporting the Trump administration’s tax reform measures, which call for a $1.5 trillion net tax stimulus. Supporters of these tax cuts have argued they will result in stronger economic growth, as did the tax cuts of Ronald Reagan in the 1980s and George W Bush in the early 2000s. We aren’t quite convinced of this argument, though. A larger stimulus should boost near-term growth, but over the medium term a bigger stimulus may not lead to a much stronger economic outlook. Instead, it could cause higher rates and potentially lower growth.
The trouble with the output gap
During much of the time following the global financial crisis, the US has had a large output gap. In other words, there was significant difference between the actual output of the economy and the output it could produce at full employment. In this situation, a sustained period of above-trend growth is required to close the gap. Accordingly, monetary and fiscal easing are something akin to complements, as anything that boosts demand is largely welcome.
However, with US unemployment having fallen to 4.1%, the output gap is probably closed. Any boost to demand that takes growth above potential would be inflationary. Monetary and fiscal policy become substitutes, with easier fiscal policy requiring the central bank to offset this with tighter monetary policy.
This conclusion is based on several assumptions:
Assumption #1: Full employment
The level of full employment in the US is crucial as it determines the constraints on economic growth. When there is an output gap (and especially when rates are pinned at the zero lower bound), the constraint on growth is almost entirely the demand side. Policies that boost demand – easier monetary and fiscal policy – help the economy grow above its potential and close the output gap, therefore causing stronger growth. Almost no one doubts that, all else equal, tax cuts can boost demand.
However, when the output gap has closed, the binding constraint on growth is the supply side or, put another way, potential growth. Demand growth above potential is inflationary, and so an inflation-targeting central bank is required to offset it with tighter monetary policy. The economy is only allowed to grow as fast as its potential, so growth can only be boosted by improving the supply side.
It’s likely that the US economy is at, or extremely close to, full employment.
This is why today’s tax cuts aren’t analogous to the Reagan- or Bush-era tax cuts. Unemployment in the US. was above 10% at the start of 1983, and hovered at 5.8% at the start of 2003. There was an output gap in both cases. Today, the unemployment rate is 4.1% and it is likely to fall further in the near term given the persistence of above-trend growth. Therefore, it’s likely that the US economy is at, or extremely close to, full employment.
Assumption #2: Fed follows the Taylor Rule
We believe the Fed would respond to the inflationary pressures generated by above-trend growth by closely following the Taylor Rule. The fact that the Fed has continued to tighten policy while inflation has fallen even further below target suggests revealed preferences pointing to a non-symmetric inflation target (above 2% is worse than below 2%). It also gives us reason to think the central bank would move quickly to offset anything it expected to increase inflationary pressure.
By contrast, the US economy in 1983 and 1984 was benefiting from a reprieve from aggressive interest-rate hikes to control inflation. The growth boost in 1983 and 1984 was probably a consequence of monetary easing through the second half of 1982 and the first half of 1983. Indeed, at first glance all the fluctuations of demand in the early to mid-1980s seem to be the result of Fed Chair Paul Volcker’s policy choices. Likewise, in 2003 and 2004 the U.S. economy benefited from monetary easing following the Fed’s first deflation scare. By contrast, US monetary policy today is gradually tightening after remaining highly accommodative for several years.
Certainly, we could be mistaken about the Fed’s reaction function. It could be that the Fed takes the view that it can boost the supply side by stimulating demand. Or perhaps political pressure influences the new Fed leadership, and rates are kept low as a result, with inflation being allowed to creep higher. Or perhaps it makes a good old-fashioned policy error by underestimating the risk of inflation and not tightening policy enough.
But if you agree that the output gap is largely closed, and that the Fed will respond in a standard way to inflationary pressure, the only way you get any material medium term impact from tax cuts is on the supply side. This is where the third assumption comes in.
Assumption #3: Lack of supply-side stimulus
Tax cuts certainly can improve the supply side, and this is a much more economically convincing case for the Reagan tax cuts than demand-side based arguments. Additionally, the current US corporate tax code can certainly be made more efficient and growth-friendly by reducing the headline rate and closing certain loopholes. However, we’re sceptical that the current proposals will have the big impacts envisioned by the likes of the Tax Foundation. For example, the US is not a small open economy in the context of global capital markets. Furthermore, some of the purported gross domestic product gain will need to be paid to the foreign suppliers of the capital, so the uplift to domestic income could be much smaller.
Most importantly, there is a fundamental difference between revenue-neutral improvements to the tax code and deficit-increasing measures when output gaps are closed. Monetary offset works by crowding out private-sector investment (which you can think of as freeing the resources to fund the deficit), and so is typically thought to reduce potential growth. And presumably at some point in the future you need some (probably distortionary) tax increase to pay for the deficit increase – although perhaps at this stage, the government’s long-run budget constraint is not that important.
It’s different this time, which isn’t necessarily bad. The US economy is humming along with full employment, and growth expectations have improved over the past few months. But to expect that passing new tax cuts will result in more of a good thing seems short-sighted. Congress should look at historical trends before jumping to conclusions.
The article above was previously published on Aberdeen Asset Management’s ‘Thinking Aloud’ blog on 14th December 2017