A spectacular return to pure supply-side economics
While experts debate the effects of the Trump tax reforms, it is probably the most important economic policy decision of recent decades.
Since the sub-prime crisis 10 years ago, the US economy has been stuck in a growth regime that is modest by past standards, with deflationary pressures persisting in spite of an historically low unemployment rate. It is against this backdrop that the tax reform finally ratified in the last days of 2017 was greeted as a ‘Christmas present’ by financial markets after a year of false dawns under the Trump administration.
The US tax overhaul represents probably the most important economic policy decision taken anywhere in the world in recent decades — the last supply-side reforms of any magnitude go back almost 40 years to the Reagan era. Given that government debt has climbed from an average of 50% of GDP to 100% over the past 10 years in the developed world, launching a classic Keynesian demand-led economic policy would be difficult — and probably ill-suited to current economic conditions. Tax policy, by stimulating supply, would seem the only alternative. The fact that central banks’ monetary policies (even the Federal Reserve’s) were running out of steam made the reforms all the more necessary. Fiscal policy is now taking over from monetary policy in an effort to sustain growth.
The most significant aspects of the Trump reforms are the reduction in the statutory corporate tax rate from 35% to 21% and a 15.5% one-off tax on the estimated USD2,500 million in liquid assets held offshore by US multinationals.
Among the multiple objectives of the Trump tax overhaul, we are able to discern four main ones that chime with the supply-side inclinations of its authors.
First, the intention is to put the US back in the running in terms of tax competitiveness. The previous statutory rate in the US was the highest in the developed world, higher even than France’s. The new rate of 21% sits between the prevailing rate in Switzerland and Finland, and is below the 25% average for OECD countries).
A second objective is to recuperate the growth deficit accumulated since the US pulled out of recession in the second quarter of 2009. Had the recovery over the past nine years been as vigorous as during the Reagan era, real GDP in the US would be over USD3,000 billion higher than it actually is (USD23,000 billion instead of around USD20,000 billion).
Third, the tax stimulus aims to raise levels of employment. In the wake of the subprime crisis, the workforce participation rate fell from 67% of the working-age population to 63%, and has not recovered since. Opponents of the latest tax cuts claim they will be inflationary because a meaningful acceleration in real GDP growth above the annual average of 1.4% seen over the past 10 years at a time when unemployment is at the historically low level of 4.1% is coming too late in the economic cycle and will push wages substantially higher. By contrast, the designers of the tax overhaul remain convinced that the workforce participation rate will have to go back up to 67% before labour shortages start to pose an inflation threat.
Fourth, by stimulating “animal spirits”, the tax cuts are designed to boost the corporate investment cycle, seen as a cornerstone of future sustainable growth and a prime source of wealth redistribution. Considered crucial for lifting the participation rate back up to 67%, corporate investment in the US has lately been growing at an annual 4% compared with around 10% or higher during previous expansionary phases. Investment can be expected to re-accelerate as companies repatriate as much as USD1,000 billion from the vast profits they have parked overseas.
The consequences of this ground-breaking fiscal reform are not yet fully clear and are the subject of intense debate among economists and investors alike. But we believe that real economic growth in the US could accelerate to as high as 3% this year, while corporate investment could expand at a rate of 7% or more, bringing further job creation and a higher participation rate in its wake. Underlying inflation could rise slightly above the Fed’s 2% target in 2019, we believe. As a result, we think that six quarter-point hikes are possible over the coming 18 months in the US.
The effect of the corporate tax cuts on the profits of US companies is set to be spectacular. Before, 2018 earnings were expected to grow 12%. But now earnings this year are expected to rise by at about 17%. The impact on stock markets will be substantial. Total returns (assuming an average dividend yield of 2%) could reach almost 16%, according to some estimates. Such prospects make us bullish on US equities. By contrast, returns from Treasuries are bound to suffer from a rise in long-term yields (we see the 10-year T-note yield reaching 3% by year’s end). The improvement in US growth should help support the US dollar in the short term.
The US’s impressive supply-side initiative could take on another dimension if complemented by Keynesian-style public spending. Indeed, Congress is currently discussing President Trump’s proposals for a 10-year USD1,500 billion infrastructure spending programme. Wherever these discussions lead, it seems safe to assume that the recent ground-breaking changes in policy will enable the US to keep its economic and financial leadership in the world in the years ahead.