2 December 2017

In a swanky Washington restaurant in 1974, economist Arthur Laffer presented Dick Cheney and Donald Rumsfeld (future VP and US Secretary of Defence) a doodle on the back of a napkin.  What appeared was a diagram of the now infamous “Laffer Curve”.  The graph depicts the relationship between tax rates and tax revenues. Laffer theorised that the disincentives from higher taxes lead eventually to lower (not higher) tax revenues. Similarly, lower tax rates could produce such a “supply side” economic expansion that tax revenues would rise – tax cuts would pay for themselves!  The two ambitious Republican leaders were thrilled.  And, this supply side thinking informed the tax policies in both the Reagan and George W. Bush presidencies (of course, GHW Bush famously regarding it as “voodoo” economics)!

As NY Yankee baseball hero Yogi Berra famously proclaimed, “It seems like déjà vu, all over again”! The Trump administration has presented a tax reform plan cutting both corporate and individual tax rates, which Treasury Secretary Mnuchin promises will pay for itself.  Will the “Tax Cuts and Jobs Act (TCJA)” produce the promised supply side response in investment, jobs, wages, GDP and tax revenues, or is the plan a risk too far?

Business Investment:  Boom Times Ahead?

The supply side logic is based on the belief that US corporations are taxed too much, and lower corporate taxes will lead to higher investment, which in turn would boost long term GDP growth and tax revenues.  There are many ways to compared business taxation globally, but most suggest that US taxes are somewhat higher than abroad.  Chart 1 illustrates that the US statutory tax rate is the highest amongst the G7 nations.  While tax rates vary significantly throughout Europe (12% in Ireland to 34% in France), the EU average of 25% is well below the USA’s 39% (Federal 35%). What is also notable is that the USA is the only OECD nation which has not cut its corporate tax rate since 2000.

After taking various deductions/credits into account, the US “average effective” tax rate declines to 27%, which remains higher than 15-20% elsewhere.  However, as US treatment of corporate deductions is more generous, the gap with the rest of the G7 is narrower than at the statutory level. (Even more technically, the “marginal effective” tax rate measures the levy on new, debt-finance investments.  The combination of the higher US statutory rate combined with more generous treatment of interest expenses narrows further the tax gap compared to rivals).

Furthermore, US corporate taxes represent only 2.2% of GDP, comparable to the rest of the G7.  Supply side proponents might take heart from the fact that Canada, the UK, and Japan collect more tax revenue, despite their lower tax rates.  However, on the other hand, lower tax rates in Germany and France produce lower tax revenue than in the USA.  The international evidence more broadly is similarly inconclusive, although most countries with low tax rates collect more tax revenues/GDP than the USA.

It sounds plausible that higher after-tax returns on capital will lead to more business fixed investment – a key factor in lifting a nation’s long term growth rate. And, to be sure, lower business taxes will provide an additional boost to corporate profitability; indeed, a 20% US tax rate will boost S&P 500 EPS by 10% in 2018. With corporate profits at peak levels and interest rates low, this should be an ideal environment for business investment.

However, how big a response should one expect? Chart 2 illustrates that US capital spending has been declining steadily for decades (after accounting for cyclical variations).  Importantly, this secular trend was not altered by the 1988 decision to reduce the corporate tax rate from 47% to 35%.

Likewise, Chart 3 illustrates that the decline in business investment has not been limited to the USA.  Capital spending has been sluggish world-wide: in countries with both low and high levels of corporate taxation.  This suggests that more powerful global factors lie behind business investment decisions in the US and world-wide – not simply the level of taxation. Healthy fundamentals should produce stronger business investment next year in the USA and globally, but the level of corporate taxation is likely to play only a minor role.

In addition, the Trump administration believes that the repatriation of profits held abroad by US firms will produce a surge in investment at home.  Again, the impact is easy to overstate.  To be sure, firms have built up a huge stockpile of cash overseas waiting for clarity about the new tax regime.  However, if profitable US investments had existed, these firms could have borrowed funds at low interest rates, and repaid these loans after the tax reform.  Thus, it is more likely that repatriated profits will be returned to shareholders through dividends and share buybacks.

Trickle Down: Will Higher Profits Boost Wages?

To be sure, everyone agrees that corporate tax cuts will boost corporate profitability.  However, the consensus breaks down about the distribution of these gains between shareholders and workers.  There is reason to be sceptical about the Trump team’s assertion that improved corporate performance will “trickle down” to workers through higher wages.

Chart 4 highlights the tenuous link between wages and corporate profits.  Indeed, during the past 35 years the share of national income going to workers has declined steadily.  At the same time, the percent accruing to corporate profits has been on a secular rise, and is currently near a cyclical peak what would American workers say about this, not to mention Karl Marx!).

Wages are more responsive to the degree of labour market slack and productivity trends (more on this later).  With the US unemployment rate low, I expect compensation to pick up next year, but not as a result of improved corporate profitability resulting from lower taxes.

Tax Reform: Panacea for Sluggish Economic Growth?

To be sure, US GDP growth during this recovery has been disappointing. Whether tax reform will provide a remedy will depend on its impact on business investment, labour force growth, and productivity trends.

We have already illustrated that the impact on investment should be positive, but small.  Meanwhile, it is plausible that the lower tax rates for individuals (also part of the Trump plan) may boost US labour supply, although these tax cuts will be eliminated in 2025.  However, there are far more powerful factors behind America’s weak labour force growth. Indeed, US labour supply has advanced only a modest 0.6% annually during the past 15 years – half the pace of the preceding decade. Well known demographic factors lie behind this trend — slowing population growth and an aging population.  Tax reform will not materially impact these potent forces. Meanwhile, President Trump’s wish to curb immigration will reinforce weak labour supply growth.

Moreover, sluggish labour force growth is not limited to the USA, and does not appear effected by the level of corporate taxation. The Japanese labour force has remained unchanged during the past 25 years.  In the European Union, meanwhile, labour supply has advanced recently a mere 0.3% per year, half the pre-crisis rate.

Weak productivity growth lies at the heart of America’s disappointing economic performance and stagnant real wages.  However, it is hard to argue that the level of corporate taxation is the cause.  To be sure, post-crisis gains in US worker efficiency are roughly one-third the pre-recession pace.  Again, however, Chart 5 highlights that this is a global problem.  Post-crisis productivity advances have slowed world-wide – in both high and low tax countries.  In particular, recent labour efficiency gains in the United Kingdom have been the most sluggish, despite enjoying the lowest G7 corporate tax rate.

Debt Dynamics: A Risk too Far?

Even before the tax reform debate, the United States confronts important fiscal challenges in coming years.  To be sure, the USA has succeeded its budget deficit to 3.5% of GDP from 12% in 2010.  Nevertheless, the shortfall remains too large to prevent a continued rise in national debt. For instance, the CBO forecasts that under current law (excluding the TCJA) the budget deficit will rise to 5% of GDP, and the nation’s Federal debt/GDP ratio will balloon from 77% to 91% of GDP by 2025 (and more thereafter).

In addition to the challenges of paying for an aging population, rising interest rates will adversely impact future debt dynamics. I estimate that budget cuts totalling at least 3% of GDP (likely more) will be required to stabilise the debt load in the coming years.

I am often confused when pundits wax lyrically about the success of the Reagan tax regime.  During his presidency, the budget deficit rose from 1% to 5% of GDP and the debt ratio rose from 30% to 50% of GDP (it continued to rise until the Clinton years).

The far more precarious starting point now will make fiscal miscalculation cost more costly than under President Reagan.  A consensus has emerged that the TCJA will increase future deficits (and debt level) between $1-1.5-trillion (even after optimistic “dynamic scoring”).  The budget impact will be greatest in the next few years, adding over 1% of GDP to the deficit in each of the next three years.   By 2027, the plan will raise the debt/GDP ratio an additional 5% (nearing 100% of GDP).

The Administration’s more optimistic budget impact is based on GDP growth assumptions of 3%pa.  Currently, most economists believe the US growth potential is around 1.75%.  And, even the most ardent tax reform advocates, believe the tax cuts will only lift LT growth to 2-2.25%.

In addition compounding future fiscal risks, the TCJA contains distributional inequities.  To be sure, all income groups will enjoy a tax cut next year. However, the non-partisan Joint Committee on Taxation projects that lower-income Americans will experience higher taxes overall, while the tax burden on more affluent groups will decline (Table 1).

Conclusions and Strategic Implications

• The TCJA should boost America’s long term GDP trajectory, but only modestly. Improving productivity through education, training, and infrastructure should be the priority.
• The TCJA will complicate further a precarious US fiscal outlook. Despite important future spending demands, fiscal consolidation of 3% of GDP or more will be required over the medium term in order to stabilise America’s rising debt burden.
• I expect some version of the TCJA to pass before Christmas: President Trump comes good on his promised gift to the nation!  The TCJA should boost S&P 500 EPS by 10% in 2018.  However, the plan is now largely discounted.  I see /S&P 500 upside limited to  2,700 during thenext 12 months.
• The additional fiscal expansion will lead to 4 Fed rate hikes next year, with 10-year yields heading towards 2.75%. The USD will appreciate towards Euro 1..12 and JPY 120.