Tax Cuts in the Stockings
The Republican party, after ramming through bills in the Senate and House in record time, is pushing to reach consensus on a final tax cut bill that can pass both houses. Not surprisingly, Democrats have labeled these bills as a massive giveaway to the rich. Any seasoned witness to politics over the last several decades will recognize that as the go to strategy of the left. Based on polls, it is working, and in my opinion, the characterization is pretty fair. As I noted previously ( The Gini is Out of the Bottle ), I believe the GOP is making a serious long-term political miscalculation. At a time when income disparity is at an all-time high, and the party took power based on populist themes such as the tragedy of “the forgotten man”, passing legislation perceived to primarily benefit corporations and wealthy individuals reeks of political tone deafness. Republicans also spent the last several years raving about the recklessness of government deficits, but are set to throw caution to the wind now that they are in control. Unless the economic boom Republicans envision arises without deficits expanding, which I think unlikely (see ’80’s Nostalgia: Glue That Binds the GOP ), this will be political suicide in the long-run.
Initially though, if the GOP succeeds, there could be a short-term spike in economic activity. However, if the last 8 years of extraordinary monetary stimulus can be likened to a constant morphine drip, a deficit financed tax cut is more akin to a sugar high. Gorging on rum cake and egg nog (the adult version) may make for a delightful evening around the Christmas tree, but morning inevitably brings regret.
Implementing deficit spending late in an economic cycle will leave little fiscal room when it may be needed. Business cycles may be double the length they were 50 years ago, but no one should think they no longer exist. At some point, the economy will hit a rough patch, and policy makers should not be fretting about deficits at that time. A prudent approach to tax reform, a laudable goal, would be to produce a revenue neutral bill. Granted, that doesn’t have the cachet of “tax cuts for Christmas”. Republicans are hoping they can produce enough of an economic buzz to get them through the 2018 elections. From a Republican perspective, the ugly outcomes of recent special elections in Virginia and Alabama, make that an imperative.
As I laid out in a previous post ( The Case of the Missing Capex ), lack of investment by corporations has nothing to do with their present tax rates, and CEO’s have been completely noncommittal in promising new capex, or jobs, if corporate taxes are cut. A historically low capacity utilization rate, which is a function of both excess capital and weak demand, implies there has not been a need for higher capital expenditure. Also, job openings are at all-time highs. The problem is finding qualified people to fill those jobs.
Supporters of corporate tax cuts have focused on the fact that the U.S. has one of the highest “statutory” tax rates in the world at 35% (39.1% with state taxes included). However, a large number of available loopholes makes that number rather meaningless. Because of the complexity involved in comparing global tax rates, estimates vary widely. The “effective” tax rate, which is what corporations actually end up paying, is roughly half the “statutory rate” according to the Congressional Budget Office ( Effective Corporate Tax Rates ).
A favorite argument of proponents for cutting corporate taxes in recent years has been to point to low tax countries like Ireland as examples. Ireland has lower corporate rates than any other country in the EU, and that has coincided with much higher growth rates, due to foreign investment. However, using a country like Ireland, where annual GDP is only about 1.5% that of the U.S., as an example supporting arguments for implementing similar policies in the U.S., is disingenuous. Such small countries can experience extraordinary growth rates fueled by a tiny sliver of global investment. The U.S. composes approximately one-fifth of global GDP (depending on how it’s measured). It would take a substantial portion of global foreign investment switching to the U.S. to impact growth significantly.
Furthermore, as previously noted, corporate leaders have shown no desire to utilize tax cut windfalls for either domestic investment, or creating new jobs. More importantly, as far as jobs are concerned, the U.S. doesn’t seem to need stimulus.
Late Cycle and Tightening Labor Markets
The U3 unemployment rate, which is the headline rate that is typically monitored by economists and market watchers is now at 4.1%. U3 excludes “marginally attached” and “part-time for economic reasons” workers. The former refers to people who would like to work, but have been discouraged from looking by an inability to find work. The latter term indicates people who are working part-time only because they have been unable to find full-time work. The U6 measure is shown in Chart 1 back to 1994, which is as long as it has existed.
Notice the grey areas in the chart, denoting recessions, and the levels of unemployment around these periods. The lagging aspect of labor markets is fully evident, as unemployment continues to rise even after the end of recession.
More relevant to the present situation is the current level of U6, at 8%. In October, U6 dipped to 7.9%, the lowest since 2001! It’s been a long slog down from the depression level of 17.1% in late 2009. Wages have been lackluster, but at least part of that was due to excess slack in labor markets. That slack is no longer there.
U6: Total Unemployed + Marginally Attached + Part-Time for Economic Reasons
Source: U.S. Bureau of Labor Statistics and Federal Reserve
Chart 2 shows the JOLTS (Job Openings and Labor Turnover Survey) Job Openings measure. Job openings went to a an all-time high (data series only goes back to 2000) in 2015, and after plateauing during that slow period, powered higher as the global economy started accelerating in 3Q of last year. Notice that Chart 2 is virtually an inverse of Chart 1. Job openings are typically at their highest level a year or so before recession. The point I want to make here is that while a healthy labor market is a wonderful thing, it often presages the end of the cycle. Excessive job openings implies that companies cannot find qualified workers. In effect, the labor market is getting tight, and that likely means inflation could inflect higher, and with it, interest rates.
JOLTS – Job Openings
Source: U.S. Bureau of Labor Statistics and Federal Reserve
Inflation Quiescent, Deficits Not
In actuality, I don’t expect a sharp spike in inflation due to burgeoning tightness in labor, but I do believe we’re reaching an inflection point. Warnings of hyperinflation have repeatedly been proven hyperbolic, despite continued record monetary stimulus. This is due to secular forces that have so far dominated the cyclical ( see Are We There Yet? ).
However, U.S. Federal budget deficits, shown in Chart 3 (negative numbers denote deficits), have recently begun to worsen, after improving since the end of the crisis. Some of this has been caused by recent spikes in spending for hurricane relief, but the trend started back in 2016. Deficits this year began at the highest levels since 2013 as a percentage of GDP, and have averaged about -3.5% this year.
U.S Federal Budget Surpluses or Deficits as a Percentage of GDP
Source: U.S. Treasury and Federal Reserve
The effect of deficits on an economy are a subject of much confusion. As is the case for many economic variables, analysis of deficits depends on the particular economic circumstances. In some circles, deficits are to be avoided at all costs through the imposition of balanced budget amendments, but such policies are incredibly short-sighted.
For example, the extraordinary deficits of 2008, which topped out at -10.1%, were a function of both collapsing revenue, and skyrocketing unemployment. If the government had been forced to cut spending under such circumstances, the result would have been catastrophic. A debt deflation spiral similar to the early 1930’s would have ensued, and it’s possible even the Federal Reserve’s unprecedented monetary support would not have stopped it.
GOP is Drinking its Own Bathwater
However, we now have a completely different set of conditions. The U.S. economy is on solid footing, with recent GDP growth around +3%. Labor markets are tightening, as we are now 8 years into a recovery. While inflation is under control, it’s no longer at record low levels (+2.2% for CPI YoY). And yet, deficit hawks led by the Tea Party wing of the Republican Party have now chosen to jettison their previous aversion to budget deficits in order to promote stimulus the economy doesn’t need. No credible analysis has been provided to justify the Republican’s assertion that these tax cuts will pay for themselves. History does not support this these either ( ’80’s Nostalgia: Glue That Binds the GOP ). And yet, they persist.
Increasing deficits in a weakening economy can mitigate that weakness. However, increasing them in a strong economy near full employment, can lead to accelerating inflation and interest rates. The Fed is in the process of tightening liquidity by increasing the Fed funds target, and drawing down their balance sheet. So far, they have been doing this at a glacial pace. Markets have continued to expect that leisurely pace to continue. The GOP tax plan is coming at the worst possible time.
As I see it, and I’ll continue to expound in later posts, interest rates are the “Achilles Heal” of the global economy. More accurately, the point of weakness is liquidity, which has been provided in prodigious quantities by global central banks. In order for that to continue, inflation must stay low. We are now approaching a situation where central banks may have to react to higher potential inflation, which means expectations for rates would go higher. I anticipate a jubilant reaction from Republicans if they get a tax bill passed, which for them, will equate to a “Merry Christmas”. Equity markets will probably remain quite jolly into the new year as well. I guess we can all just worry about the hangover later.