Tax cuts one year on: ‘we are on a very unstable fiscal path’
Trump’s reforms lifted short-term growth and earnings but have widened the deficit
It was hailed as a “historic victory” by President Donald Trump, and a “heist” by Democratic senator and possible presidential contender Elizabeth Warren. A year after the $1.5tn tax cut was passed into law, the economic effects are becoming apparent.
The reductions have added octane to an already robust recovery, helping lift growth well above its trend rate and towards 3 per cent this year.
The sustainability of that expansion is far less sure, however. The Federal Reserve has stuck with estimates of longer-run growth at just 1.8 per cent — no higher than before the package was passed — and business investment fell back sharply in the third quarter.
What may prove long-lasting is the damage wrought by widening budget deficits.
“We have had a big fiscal push — a big increase in spending, and a big increase in the deficit due to tax cuts,” said Alan Auerbach, an economics professor at University of California, Berkeley. Despite the current strength of the economy, the prognosis down the road was less encouraging. “We are on a very unstable fiscal path”.
Investment
Companies made bold promises after the tax cuts were pushed through Congress, pledging a total $194bn of investments, alongside wage boosts for around 2m employees and $7bn in one-off bonuses, according to analysis of 751 corporate announcements. Assuming the spending is spread over five years, the lift to growth over that period from those specific announcements is modest — amounting to a couple of tenths of a per cent, according to Dana Peterson of Citi, who compiled the data.
At the same time, wage growth has shown greater buoyancy, advancing to 3.1 per cent according to the November jobs report. It is hard to establish how much of this is down to fiscal changes — the labour market has been getting progressively tighter for years. A durable acceleration in wage growth — which was predicted by Mr Trump’s economic advisers in advance of the tax cut — will rely in part on higher investment boosting US productivity.
It is premature to judge the enduring impact of the corporate tax cut on investment, but early evidence is decidedly mixed. After a strong first quarter of the year, when it grew an annual pace of more than 11 per cent, annualised growth in business investment decelerated to a modest 2.5 per cent in the third quarter. Given the scale of America’s oil industry, falling oil prices could impose a further drag on corporate spending.
Growth effects
There is no doubting the short-term growth effects of the deficit-fuelled package. The estimates from Citi point to a 0.7 percentage point boost to growth in 2018 from tax cuts and this year’s big public spending package — a stimulus that will extend into next year. But unless Congress takes measures to avoid a “fiscal cliff”, lower public spending will drag down growth in 2020, at a time when higher interest rates could also restrain the economy.
Analysis from Barclays argues that investment levels are still far too low to provide the kind of long-term lift in GDP growth that US Treasury secretary Steven Mnuchin has predicted. To boost growth to 3 per cent over a sustained period solely on the back of capital formation would require business investment to leap by 30 per cent, they estimate — dwarfing the growth seen to date.
The Fed has left its estimates of longer-term growth unchanged at 1.8 per cent in the face of all the tax reforms, suggesting it is not counting on any long-term boost to the economy.
The federal deficit
Mr Mnuchin argued that the tax reforms would pay for themselves via higher growth, but there is no evidence of that heady claim in the data. Given the strength of the economy, it is highly abnormal to see a widening budget deficit, but that is what is happening.
The deficit will this fiscal year hit $970bn, Congressional Budget Office projections show; that is 4.6 per cent of GDP, up from just under 4 per cent previously. Never in modern US history have deficits been this high outside a recession or war and its aftermath, according to the Committee for a Responsible Federal Budget.
If the tax cuts and spending increases are extended, public debt could rise from 78 per cent of GDP to 148 per cent by 2038, according to the CBO. The fiscal deterioration will start to drag on growth as private investment gets crowded out amid swelling government debt early in the next decade.
Earnings and returns
Cutting corporate America’s taxes predictably boosted its bottom line. Earnings in the S&P 500 had grown at 8.5 per cent in the quarter just before the Tax Cuts and Jobs Act was signed, but leapt by 28.4 per cent in the same period of 2018.
That, coupled with the repatriation of cash held overseas, gave boards a rare opportunity to pay off debt and bolster shareholder returns. Within six months, Moody’s calculated, 100 cash-rich companies repaid $72bn in debt and distributed $81bn to investors, cutting their collective cash hoard from $1.99tn to $1.8tn.
An FT analysis showed that just five tech companies bought back $115bn of stock in the first three quarters of 2018.
There was no such step-change in dividend payments, however, suggesting that boards remained wary of committing to more than a one-off increase in returns. And while the absolute sums spent on buybacks and dividends hit records, as a proportion of market value they have been higher in the recent past.
Market and corporate sentiment
The cuts to corporate tax rates built on a growing economy and investor optimism about the Trump administration’s deregulatory instincts to bolster market sentiment at the start of 2018, but the rally that greeted the new tax legislation was short lived, ending by late January.
US stocks picked up steam again as the strength of earnings and buyback spending became clear, but by the end of the year rising concerns about tariff battles had crowded out investors’ focus on the benefits of tax reform.
The mood swings were visible from the Business Roundtable’s quarterly survey of CEO confidence. Its index of sales projections and hiring and investment plans jumped 21.8 points in the first quarter of the year to 118.6, its highest level since the survey began in 2002. Executives’ confidence peaked in February, however, with the index losing half of that gain by the fourth quarter.
The drag from trade wars
What changed the mood? In part, President Trump’s trade policy. In March, tariffs on imported steel and aluminium went into effect, delighting domestic steelmakers but leaving manufacturers of everything from washing machines to cars counting the cost. From June onwards, the administration ratcheted up penalties on a host of Chinese imports, prompting price rises and sweeping reviews of supply chains.
Tariffs, said Josh Bolten of the Business Roundtable in December, had become a “headwind” countering the tailwind from lower corporate taxes.
An FT analysis of earnings call and investor conference transcripts via Sentieo shows the change. In February, as companies came out with their first earnings reports after the Tax Cuts and Jobs Act was enacted, tax reform dominated the discussion between analysts and executives like no other topic. By the summer, however, tax talk had given way to concern about tariffs and trade wars.