US tax cuts will soon receive President Trump’s signature, marking the first piece of major legislation of his term in office. The tax reform has been put together with unusual haste, as the Republicans fear losing their majority in the late 2018 elections.
In the end the politicians could not make the numbers add up. To keep the overall deficit increase within the $1.5tr permitted (over the next ten years), the corporate rate will be 21% (rather than the hoped for 20%) and the income tax cuts are set to expire in eight years. Everyone assumes they will be renewed, so the increase in the deficit will be larger than $1.5tr, but the subterfuge meets the political needs.
With US profits seeing typical headwinds for a mature economic cycle, the cut of several percentage points in the effective tax rate will be welcome. One slight disappointment is a 15.5% tax rate on repatriated cash earnings, rather than the hoped-for 10%, but the revenue difference is about enough to allow a percent off the corporate tax rate.
The Fed does not seem to think that the tax cuts will have much impact on growth. Last week it raised its 2018 growth forecast by 0.4ppts (and 2019 by 0.1ppt), while leaving its expectation of a 0.2ppt drop in the unemployment rate unchanged. That allowed the Fed to continue to look for three rate hikes next year. We would expect the next move to come in March, to leave open the possibility of four hikes if necessary.
The Fed has spent the past year trying to slow growth down with a series of interest rate hikes. It follows that if tax cuts boost growth significantly, then the Fed will have to try harder – and raise rates faster.
Cutting taxes when the economy is at full employment is likely to suck in more imports to satisfy some of the extra demand. The trade deficit is already running at a ten-year high (and half of that is with China) and is set to increase. The risk of trade friction seems likely to intensify in the coming year.
US government debt is already over 100% of GDP and the budget deficit is just above the 3% of GDP that is considered prudent – and it is rising, even before the tax cuts. The bond market could see some pressure from the wider budget deficit that will come from cutting taxes.
US budget deficit is already widening
Already the Fed is affecting supply and demand now that it has started to run down its balance sheet. This will be shrinking at an annual rate of $600bn before the end of 2018. The budget deficit is running at just under $700bn and tax cuts will add about $200bn to it next year, so net new supply will roughly double. Bond yields could see upwards pressure due to the need to absorb the extra supply.
The tax plan probably increases the risk of recession in late 2019 or 2020 for two reasons. First, because of the Fed response. Second, because the next policy step is likely to be to cut welfare payments in reaction to the rise in the government deficit. Both of these things will take time, but could be putting downward pressure on growth by 2020. Still, this is too far in the distance to be a concern at the moment.Disclaimer applicable to recommendation
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