Tax reform in the US is poorly timed
US tax reform is in the pipeline. The ultimate goal of the multi-faceted plan is to boost economic growth significantly. However, this seems unrealistic. Given the late-cyclical nature of the US economy and the type of measures being proposed, the stimulus to growth will be limited. Moreover, the US central bank would most likely tighten its policy stance more aggressively than currently planned to curb the stimulating effects, should the tax reform unexpectedly provide a strong growth impulse. Besides, the measures threaten to worsen the already precarious public finances in the US. In this respect, too, the timing of the fiscal incentives is therefore far from optimal.
Versatile tax reform
For President Trump, it will be like a Christmas gift from heaven: a first Republican success is in the making with the possible introduction of tax reform. Although some points of contention are still under discussion, a final proposal is likely in the short term. The proposed tax reform will then be submitted for approval to the Senate and the House of Representatives. If a majority votes in favour, the reform becomes law. It will reduce taxes for both companies and individuals. The most important element is a reduction in the corporate income tax rate from 35% to 21%. From an international point of view the American tariff is relatively high. The planned reduction will therefore significantly improve the competitiveness of American companies.
The proposal also includes an adjustment of personal income tax brackets. According to the Republicans, this reform will reduce taxes for all Americans. However, independent estimates have shown that the greatest benefits will go to the wealthiest. Additionally, the tax plan includes measures that reduce the maximum mortgage interest relief and limit the deduction of state taxes. According to the White House, the ultimate goal of the tax reform is to create 25 million jobs in the US over the next decade and increase annual economic growth to 4%.
American economy already in a late-cyclical stage
These targets are rather ambitious, if not unrealistic. They seem infeasible, especially against the background of the current state of the American economy. Yet saying that the tax plan will not contribute anything to US growth is a bridge too far. However, the impact will mainly be felt in the short to medium term.
Indeed, in terms of the economic cycle - the cycle that reflects the upward and downward movements of economic growth - the US is in a late-cyclical phase. This means that the growth peak will gradually be reached and that a slowdown in growth is in the pipeline. We expect that the reduced corporate tax rate and tax relief for individuals will give a positive impulse to growth in the short to medium term, postponing the expected slowdown in growth. However, this growth impulse will be limited in both size and duration. Indeed, the largest tax benefits will go to the wealthiest American citizens who will largely save or use the tax benefit for further capital accumulation. This limits the positive impact on GDP growth.
Fiscal multipliers measure the impact of tax changes on economic growth. They also indicate that the growth impact of the reform will be small. The Congressional Budget Office (CBO) estimates the multiplier of lower corporate taxes to be between 0.0 and 0.4. This means that one dollar of tax reduction only produces 0 to 0.4 dollars of additional growth. Tax reduction for the highest incomes also has a very low multiplier. The fact that the growth effect of the tax measures is so low is not only due to the type of measures but also due to their timing. The late-cyclical nature of the US economy makes it very unlikely that the tax reform will lead to a new sustained growth spurt, as much of the available production capacity has already been utilised and full employment has been practically achieved. The growth peak in the economic cycle is likely to be merely postponed.
Significant budgetary impact
The positive economic impact of the reform plan will therefore be rather limited and short lived. Additionally, given the limited historical evidence of positive effects of tax reductions on productivity growth, we do not expect a significant strengthening of the long-term economic growth potential. The latter is important because it implies that the tax reform could have a significant negative impact on US public finances. The Republicans claim that the plan will finance itself by boosting economic growth. However, as mentioned above, this assumption is not justified. Therefore, the tax reductions will not be budget neutral and will increase the annual budget deficit. This in turn will increase US public debt. Several nonpartisan estimates show that the reform would increase public debt even further than under unchanged policies. Higher public debt increases government credit demand. This can increase interest rates and make credit more expensive for private companies and households. If, as a result, they reduce their demand for credit (the so-called crowding out effect), businesses and households will cancel their investment plans. This may weigh on economic growth in the longer term.
The investment climate can also be clouded by the prospect of a faster rise in public debt, which could further fuel the debate on the debt ceiling. The temporary agreement between President Trump and the Democrats on raising that ceiling expired earlier this month. In order to prevent the US government from defaulting on its financial obligations without exceeding the debt ceiling, exceptional measures are currently in force that provisionally limit government borrowing. However, these measures only offer a temporary relief. The debt ceiling will have to be debated in the first half of 2018. This certainly does not promise to be an easy task and can create uncertainty, which could stifle the intended investment dynamics. In any case, also from this point of view, the tax reform comes at a bad time.
Clash with monetary policy
While the US government is opening the money tap, the central bank - the Federal Reserve or Fed - is doing the opposite by tightening its policy. The Fed has already raised its policy interest rate several times. Moreover, it has recently started to reduce its balance sheet total. If the tax reform increases growth and inflation more than expected, this could lead to a more aggressive policy tightening than planned by the Fed to avoid overheating. These higher interest rates will reduce economic growth. Ultimately the opposite of what the Republicans want to achieve.