United States: Republican tax reform - short-term gain, long-term pain
December 21, 2017
President Donald Trump is on the verge of obtaining the first major legislative victory since he took office this year, after Congress passed a sweeping overhaul of the tax system on 20 December. The reform, which is expected to cost USD 1.5 trillion over the next ten years, delivers a sizeable permanent tax reduction for corporations and a more modest, temporary cut for households. Republicans argue the measures are vital to rekindling the U.S. economy, but Democrats contend the bill will mostly benefit higher-income taxpayers. Analysts argue the passage of the bill will only provide a modest boost over the near term given the mature state of the economic cycle. In the longer term, economists expect the fiscal changes will substantially increase federal deficits at a time when U.S. debt is already on an upward trajectory.
The debt-financed bill represents the most important overhaul of the tax code in over three decades. The headline provision is the reduction of the corporate tax rate from 35% to 21%, which will bring the U.S. rate below the OECD average. This is expected to significantly alleviate the tax burden on U.S. companies as well as generate greater capital inflows. Such changes, proponents of the bill argue, could trickle down into workers’ purses and fuel stronger employment growth. A transition from a worldwide to a territorial tax system could also encourage U.S. businesses to invest domestically.
Additional capital spending would, in turn, be incentivized by businesses’ ability to fully expense short-lived capital investment for five years and the bill’s new cap for small-business investment at USD 1.0 million. A lower corporate rate is expected to level the playing field for the country to attract foreign investment, which could help lift productivity growth and increase the U.S. long-term potential. The boost, however, will be mitigated to an extent by the cap in the interest deduction on operating losses.
On top of lower corporate taxes, the Republican bill grants temporary cuts for individuals. The reform lowers the rates in all brackets, decreasing the top individual income tax rate to 37.0% from 39.6% and increasing the income threshold to which the top rate applies. The tax rewrite, however, sets an expiration date of 2025 for most of the cuts, in order to comply with Senate budget rules. Estimates from the Tax Policy Center note that average after-tax income would rise 2.2% next year, which analysts argue will provide a boost to household spending over the near term.
Despite the potential upsides to growth, the overhaul to the tax code has been met with widespread skepticism among our panel of analysts. The U.S. economy is currently running at full capacity, fueled by an exceedingly tight labor market. Against this backdrop, fiscal stimulus is widely seen as untimely; the impact is expected to be limited and risks translating into higher inflation instead of economic growth. The distribution of the tax cuts also disproportionately benefits upper income earners, who have a much lower propensity to consume compared to middle- and low-income individuals.
In addition, businesses take time to adjust their investment objectives, which could delay the impact of the tax reform on GDP growth. The extent to which lower corporate rates will lift growth is also largely dependent on the use of after-tax earnings. While Republicans argue higher earnings will be used to invest and raise salaries, recent experience shows that a large proportion of additional earnings following a tax reduction are used on dividends and share buybacks. This is undoubtedly beneficial for shareholders and equity markets, but could limit the impact of the reform on investment flows.
The Republicans’ bid to boost economic growth at a time when the economy is in a mature phase could spark stronger inflationary pressures—bolstered by the repeal of the Individual Mandate—just as the Federal Reserve is removing monetary stimulus. Although there is heightened uncertainty regarding how the Fed will respond, particularly given the high level of turnover on the Board over the next year, higher price pressures and stronger growth could see FOMC officials accelerating the pace of interest rate normalization, which would act as a constraint to growth and offset any fiscal boost delivered by tax cuts.
Fed Chair Janet Yellen confirmed in mid-December that most FOMC participants had factored the reform in their estimations. The participants’ individual projections saw the median 2018 GDP growth forecast being upgraded four-tenths of a percentage point to 2.5% and the median 2019 GDP growth expectation up one-tenth of a percentage point to 2.1%. The number of interest rate hikes expected per year as well as participants’ inflation projections were largely unchanged from the September estimates, which Yellen warned was largely due to substantial uncertainty surrounding the impact of the tax reform.
Another important caveat is the long-term effect of the tax reform. Despite Republican claims that the bill will pay for itself through stronger economic growth, most estimates suggest the tax plan could add more than USD 1.0 trillion to U.S. debt stocks by 2027. The personal income tax reductions are the biggest single element in the tax reform, with an estimated cost of USD 1.2 billion over ten years. These cuts will be paid through the issuance of additional debt, the interest burden of which will mount as the Federal Reserve tightens monetary conditions. These prospects are particularly bleak against an already deteriorating fiscal situation and will reduce the government’s ability to respond to an economic downturn.
The fiscal burden on the federal government will ease from 2025 onward, when most individual tax cuts expire per Senate budget rules. However, this sets the ground for a future government to either allow taxes to revert to their previous levels or extend the cuts. The former would alleviate some of the fiscal strain, but could put brakes on the economy at the wrong moment. The latter would extend the timeline of the fiscal boost but to the detriment of the government’s fiscal accounts, which would eventually require spending cuts elsewhere.
All told, the unprecedented fiscal boost has the upside potential of increasing productivity growth through higher capital expenditure, as well as lifting aggregate demand in the short-term through a combination of lower taxes and higher individual and corporate spending. That said, the debt-financed package will incur higher fiscal deficits for a federal government that is already facing rising expenditures related to an aging population. In addition, the Federal Reserve could respond to any signs of overheating in the economy with more aggressive policy tightening, which would undo any gains from the reform.
Author: David Ampudia, Economist