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What Has Been Happening to Real Wages? Sadly, Not Much

A.  Introduction

There is little that is more important to a worker than his or her wages.  And as has been discussed in an earlier post on this blog, real wages in the US have stagnated since around 1980.  An important question is whether this has changed recently.  Trump has claimed that his policies (of lifting regulations, slashing corporate taxes, and imposing high tariffs on our trading partners) are already leading to higher wages for American workers.  Has that been the case?

The answer is no.  As the chart at the top of this post shows, real wages have been close to flat.  Nominal wages have grown with inflation, but once inflation is taken into account, real wages have barely moved.  And one does not see any sharp change in that trend after Trump took office in January 2017.

It is of course still early in Trump’s term, and the experience so far does not mean real wages will not soon rise.  We will have to see.  One should indeed expect that they would, as the unemployment rate is now low (continuing the path it has followed since 2010, first under Obama and now, at a similar pace, under Trump).  But the primary purpose of this blog post is to look at the numbers on what the experience has been in recent years, including since Trump took office.  We will see that the trend has not much changed.  And to the extent that it has changed, it has been for the worse.

We will first take an overall perspective, using the chart at the top of this post and covering the period since 2006.  This will tell us what the overall changes have been over the full twelve years.  For real wages, the answer (as noted above) is that not much has changed.

But the overall perspective can mask what the year to year changes have been.  So we will then examine what these have been, using 12 month moving averages for the changes in nominal wages, the consumer price index, and then the real wage.  And we will see that changes in the real wage have actually been trending down of late, and indeed that the average real wage in June 2018 was below where it had been in June 2017.

We will then conclude with a short discussion of whether labor market trends have changed since Trump took office.  They haven’t.  But those trends, in place since 2010 as the economy emerged from the 2008/09 downturn, have been positive.  At some point we should expect that, if sustained, they will lead to rising real wages.  But we just have not seen that yet.

B.  Nominal and Real Wages Since 2006

It is useful first to start with an overall perspective, before moving to an examination of the year to year changes.  The chart at the top of this post shows average nominal wages in the private sector, in dollars per hour, since March 2006, and the equivalent in real terms, as deflated by the consumer price index (CPI).  The current CPI takes the prices of 1982-84 (averaged over that period) as the base, and hence the real wages shown are in terms of the prices of 1982-84.  For June 2018, for example, average private sector wages were $26.98 per hour, equivalent to $10.76 per hour in terms of the prices of 1982-84.

The data series comes from the Current Employment Survey of the Bureau of Labor Statistics, which comes out each month and is the source of the closely watched figures on the net number of jobs created each month.  The report also provides figures on average private sector wages on a monthly basis, but this particular series only started being reported in March 2006.  That is part of the reason why I started the chart with that date, but it is in any case a reasonable starting point for this analysis as it provides figures starting a couple of years before the economic collapse of 2008, in the last year of Bush’s presidential term, through to June 2018.

The BLS report also only provides figures on average wages in the private sector.  While it would be of interest also to see the similar figures on government wages, they are not provided for some reason.  If they had been included, the overall average wage would likely have increased at an even slower pace than that shown for the private sector only, as government wages have been increasing at a slower pace than private wages over this period.  But government employment is only 15% of total employment in the US.  Private wages are still of interest, and will provide an indication of what the market pressures have (or have not) been.

The chart shows that nominal wages have increased at a remarkably steady pace over this period.  Many may find that lack of fluctuation surprising.  The economy in 2008 and early 2009 went through the sharpest economic downturn since the Great Depression, and unemployment eventually hit 10.0% (in October 2009).  Yet nominal private sector wages continued to rise.  As we will discuss in more detail below, nominal wages were increasing at about a 3% annual pace through 2008, and then continued to increase (but at about a 2% pace) even after unemployment jumped.

But while nominal wages rose at this steady pace, it was almost all just inflation.  After adjusting for inflation, average real wages were close to flat for the period as a whole.  They were not completely flat:  Average real wages over the period (March 2006 to June 2018) rose at an annual rate of 0.57% per year.  This is not much.  It is in fact remarkably similar to the 0.61% growth in the average real wage between 1979 and 2013 in the data that were discussed in my blog post from early 2015 that looked at the factors underlying the stagnation in real wages in the decades since 1980.

But as was discussed in that blog post, the average real wage is not the same as the median real wage.  The average wage is the average across all wage levels, including the wages of the relatively well off.  The median, in contrast, is the wage at the point where 50% of the workers earn less and 50% earn more.  Due to the sharp deterioration in the distribution of income since around 1980 (as discussed in that post), the median real wage rose by less than the average real wage, as the average was pulled up by the more rapid increase in wages of those who are relatively well off.  And indeed, the median real wage rose by almost nothing over that period (just 0.009% per year between 1979 and 2013) when the average real wage rose at the 0.61% per year pace.  If that same relationship has continued, there would have been no increase at all in the median real wage in the period since 2006.  But the median wage estimates only come out with a lag (they are estimated through a different set of surveys at the Census Bureau), are only worked out on an annual basis, and we do not yet have such estimates for 2018.

C.  12 Month Changes in Nominal Wages, the Consumer Price Index, and Real Wages Since 2006

While the chart at the top of this post tracks the cumulative changes in wages over this period, one can get a better understanding of the underlying dynamics by looking at how the changes track over time.  For this we will focus on percentage changes over 12 month periods, worked out month by month on a moving average basis.  Or another way of putting it, these will be the percentage changes in the wages or the CPI over what it had been one year earlier, worked out month by month in overlapping periods.

For average nominal wages (in the private sector) this is:

Note that the date labels are for the end of each period.  Thus the point labeled at the start of 2008 will cover the percentage change in the nominal wage between January 2007 and January 2008.  And the starting date label for the chart will be March 2007, which covers the period from March 2006 (when the data series begins) to March 2007.

Prior to the 2008/09 downturn, nominal wages were growing at roughly 3% a year.  Once the downturn struck they continued to increase, but at a slower pace of roughly 2% a year or a bit below.  And this rate then started slowly to rise over time, reaching 2.7% in the most recent twelve-month period ending in June 2017.  The changes are remarkably minor, as was also noted above, and cover a period where unemployment was as high as 10% and is now just 4%.  There has been very little year to year volatility.

[A side note:  There is a “bump” in late 2008/early 2009, with wage growth over the year earlier period rising from around 3% to around 3 1/2%.  This might be considered surprising, as the bump up is precisely in the period when jobs were plummeting and unemployment increasing, in the worst period of the economic collapse.  But while I do not have the detailed microdata from the BLS surveys to say with certainty, I suspect this is a compositional effect.  When businesses start to lay off workers, they will typically start with the least experienced, and lowest paid, workers.  That will leave them with a reduced labor force, but one whose wages are on average higher.]

There have been larger fluctuations in the consumer price index:

But note that “larger” should be interpreted in a relative sense.  The absolute changes were generally not all that large (with some exceptions), and can mostly be attributed to changes in the prices of a limited number of volatile commodities, namely for food items and energy (oil).  The prices of such commodities go up and down, but over time they even out.  Thus for understanding inflationary trends, analysts will often focus instead on the so-called “core CPI”, which excludes food and energy prices.  For the full period being examined here, the regular CPI rose at a 1.88% annual pace while the core CPI rose at a 1.90% pace.  Within round-off, these are essentially the same.

But what matters to wage earners is what their wages earn, including for food and energy.  Thus to examine the impact on real living standards, what matters is the real wage defined in terms of the regular CPI index.  And this was:

With the relatively steady changes in average nominal wages, year to year, the fluctuations will basically be the mirror image of what has been happening to inflation.  When prices fell, real wages rose, and when prices rose more than normal, real wages fell.

Prices are now again rising, although still within the norm of the last twelve years.  For the 12 months ending in June 2018, the CPI (using the seasonally adjusted series) rose at a 2.8% rate.  The average nominal wage rate rose at a rate of 2.74% and thus the real wage fell slightly by 0.05% (calculated before rounding).  Average real wages are basically the same as (and formally slightly below) where they were a year ago.

D.  Employment and Unemployment

There is thus no evidence that the measures Trump has trumpeted (of deregulation, slashing taxes for corporations, and launching a trade war) have led to a step up in real wages.  This should not be surprising.  Deregulation which spurs industry consolidation increases the power of firms to raise prices while holding down wages.  And there is no reason to believe that tax cuts will lead quickly to higher wages.  Corporations do not pay their workers out of generosity or out of some sense of charity.  In a market economy they pay their employees what they need to in order to get the workers in the number and quality they need.  And although there can be winners in a trade war, there will also certainly be losers, and overall there will be a loss.  Workers, on average, will lose.

But what is surprising is that wages are not now rising by more in an economy that has reached full employment.  Federal Reserve Chair Jerome Powell, for example, has called this “a puzzle”.  And indeed it is.

The labor market turned around in the first two years of the Obama administration, and since then employment has grown consistently:

This has continued (although at a slightly slower pace) since Trump took office in January 2017.  The same trend as before has continued.  And this trend growth in net jobs each month has meant a steady fall in the unemployment rate:

Again, the pace since Trump took office is similar to (but a bit slower than) the pace when Obama was still in office.  But the somewhat slower pace should not be surprising.  With the economy at close to full employment, one should expect the pace to slow.

Indeed, the unemployment rate cannot go much lower.  There is always a certain amount of “churn” in the job market, which means an unemployment rate of zero is impossible.  And many economists in fact have taken a somewhat higher rate of unemployment (or at least 5.0%) as the appropriate target for “full employment”, arguing that anything lower will lead to a wage and price spiral.

But we have not seen any sign of that so far.  Nominal wages are rising at only a modest pace, and indeed over the last year at a pace less than inflation.

E.  Conclusion

There has been no step up in real wages since Trump took office.  Indeed, over the past twelve months, they fell slightly.  But while there is no reason to believe there should have been a jump in real wages following from Trump’s economic policies (of deregulation, tax cuts for corporations, and trade war), it is surprising that the economy is not now well past the point where low unemployment should have been spurring more substantial wage gains.

This very well could change, and indeed I would expect it to.  There is good reason to believe that the news for the real wage will be a good deal more positive over the next year than it has been over the past year.  But we will have to wait and see.  So far it has not happened.

The Simple Economics of What Determines the Foreign Trade Balance: Econ 101

“There’s no reason that we should have big trade deficits with virtually every country in the world.”

“We’re like the piggybank that everybody is robbing.”

“the United States has been taken advantage of for decades and decades”

“Last year,… [the US] lost  … $817 billion on trade.  That’s ridiculous and it’s unacceptable.”

“Well, if they retaliate, they’re making a mistake.  Because, you see, we have a tremendous trade imbalance. … we can’t lose”

Statements made by President Trump at the press conference held as he left the G-7 meetings in, Québec, Canada, June 9, 2018.

 

A.  Introduction

President Trump does not understand basic economics.  While that is not a surprise, nor something necessarily required or expected of a president, one should expect that a president would appoint advisors who do understand, and who would tell him when he is wrong.  Unfortunately, this president has been singularly unwilling to do so.  This is dangerous.

Trump is threatening a trade war.  Not only by his words at the G-7 meetings and elsewhere, but also by a number of his actions on trade and tariffs in recent months, Trump has made clear that he believes that a trade deficit is a “loss” to the nation, that countries with trade surpluses are somehow robbing those (such as the US) with a deficit, that raising tariffs can and will lead to reductions in trade deficits, and that if others then also raise their tariffs, the US will in the end necessarily “win” simply because the US has a trade deficit to start.

This is confused on many levels.  But it does raise the questions of what determines a country’s trade balance; whether a country “loses” if it has a trade deficit; and what is the role of tariffs.  This Econ 101 blog post will first look at the simple economics of what determines a nation’s trade deficit (hint:  it is not tariffs); will then discuss what tariffs do and where do they indeed matter; and will then consider the role played by foreign investment (into the US) and whether a trade deficit can be considered a “loss” for the nation (a piggybank being robbed).

B.  What Determines the Overall Trade Deficit?

Let’s start with a very simple case, where government accounts are aggregated together with the rest of the economy.  We will later then separate out government.

The goods and services available in an economy can come either from what is produced domestically (which is GDP, or Gross Domestic Product) or from what is imported.  One can call this the supply of product.  These goods and services can then be used for immediate consumption, or for investment, or for export.  One can call this the demand for product.  And since investment includes any net change in inventories, the goods and services made available will always add up to the goods and services used.  Supply equals demand.

One can put this in a simple equation:

GDP + Imports = Domestic Consumption + Domestic Investment + Exports

Re-arranging:

(GDP – Domestic Consumption) – Domestic Investment = Exports – Imports

The first component on the left is Domestic Savings (what is produced domestically less what is consumed domestically).  And Exports minus Imports is the Trade Balance.  Hence one has:

Domestic Savings – Domestic Investment = Trade Balance

As one can see from the way this was derived, this is simply an identity – it always has to hold.  And what it says is that the Trade Balance will always be equal to the difference between Domestic Savings and Domestic Investment.  If Domestic Savings is less than Domestic Investment, then the Trade Balance (Exports less Imports) will be negative, and there will be a trade deficit.  To reduce the trade deficit, one therefore has to either raise Domestic Savings or reduce Domestic Investment.  It really is as straightforward as that.

Where this becomes more interesting is in determining how the simple identity is brought about.  But here again, this is relatively straightforward in an economy which, like now, is at full employment.  Hence GDP is essentially fixed:  It cannot immediately rise by either employing more labor (as all the workers who want a job have one), nor by each of those laborers suddenly becoming more productive (as productivity changes only gradually through time by means of either better education or by investment in capital).  And GDP is equal to labor employed times the productivity of each of those workers.

In such a situation, with GDP at its full employment level, Domestic Savings can only rise if Domestic Consumption goes down, as Domestic Savings equals GDP minus Domestic Consumption.  But households want to consume, and saving more will mean less for consumption.  There is a tradeoff.

The only other way to reduce the trade deficit would then be to reduce Domestic Investment.  But one generally does not want to reduce investment.  One needs investment in order to become more productive, and it is only through higher productivity that incomes can rise.

Reducing the trade deficit, if desirable (and whether it is desirable will be discussed below), will therefore not be easy.  There will be tradeoffs.  And note that tariffs do not enter directly in anything here.  Raising tariffs can only have an impact on the trade balance if they have a significant impact for some reason on either Domestic Savings or Domestic Investment, and tariffs are not a direct factor in either.  There may be indirect impacts of tariffs, which will be discussed below, but we will see that the indirect effects actually could act in the direction of increasing, not decreasing, the trade deficit.  However, whichever direction they act in, those indirect effects are likely to be small.  Tariffs will not have a significant effect on the trade balance.

But first, it is helpful to expand the simple analysis of the above to include Government as a separate set of accounts.  In the above we simply had the Domestic sector.  We will now divide that into the Domestic Private and the Domestic Public (or Government) sectors.  Note that Government includes government spending and revenues at all levels of government (state and local as well as federal).  But the government deficit is primarily a federal government issue.  State and local government entities are constrained in how much of a deficit they can run over time, and the overall balance they run (whether deficit or surplus) is relatively minor from the perspective of the country as a whole.

It will now also be convenient to write out the equations in symbols rather than words, and we will use:

GDP = Gross Domestic Product

C = Domestic Private Consumption

I = Domestic Private Investment

G = Government Spending (whether for Consumption or for Investment)

X = Exports

M = Imports

T = Taxes net of Transfers

Note that T (Taxes net of Transfers) will be the sum total of all taxes paid by the private sector to government, minus all transfers received by the private sector from government (such as for Social Security or Medicare).  I will refer to this as simply net Taxes (T).

The basic balance of goods or services available (supplied) and goods or services used (demanded) will then be:

GDP + M = C + I + G + X

We will then add and subtract net Taxes (T) on the right-hand side:

GDP + M = (C + T) + I + (G – T) + X

Rearranging:

GDP – (C + T) – (G – T) – I = X – M

(GDP – C – T) – I + (T – G) = X – M

Or in (abbreviated) words:

Dom. Priv. Savings – Dom. Priv. Investment + Govt Budget Balance = Trade Balance

Domestic Private Savings (savings by households and private businesses) is equal to what is produced in the economy (GDP), less what is privately consumed (C), less what is paid in net Taxes (T) by the private sector to the public sector.  Domestic Private Investment is simply I, and includes investment both by private businesses and by households (primarily in homes).  And the Government Budget Balance is equal to what government receives in net Taxes (T), less what Government spends (on either consumption items or on public investment).  Note that government spending on transfers (e.g. Social Security) is already accounted for in net Taxes (T).

This equation is very much like what we had before.  The overall Trade Balance will equal Domestic Private Savings less Domestic Private Investment plus the Government Budget Balance (which will be negative when a deficit, as has normally been the case except for a few years at the end of the Clinton administration).  If desired, one could break down the Government Budget Balance into Public Savings (equal to net Taxes minus government spending on consumption goods and services) less Public Investment (equal to government spending on investment goods and services), to see the parallel with Domestic Private Savings and Domestic Private Investment.  The equation would then read that the Trade Balance will equal Domestic Private Savings less Domestic Private Investment, plus Government Savings less Government Investment.  But there is no need.  The budget deficit, as commonly discussed, includes public spending not only on consumption items but also on investment items.

This is still an identity.  The balance will always hold.  And it says that to reduce the trade deficit (make it less negative) one has to either increase Domestic Private Savings, or reduce Domestic Private Investment, or increase the Government Budget Balance (i.e. reduce the budget deficit).  Raising Domestic Private Savings implies reducing consumption (when the economy is at full employment, as now).  Few want this.  And as discussed above, a reduction in investment is not desirable as investment is needed to increase productivity over time.

This leaves the budget deficit, and most agree that it really does need to be reduced in an economy that is now at full employment.  Unfortunately, Trump and the Republican Congress have moved the budget in the exact opposite direction, primarily due to the huge tax cut passed last December, and to a lesser extent due to increases in certain spending (primarily for the military).  As discussed in an earlier post on this blog, an increase in the budget deficit to a forecast 5% of GDP at a time when the economy is at full employment is unprecedented in peacetime.

What this implies for the trade balance is clear from the basic identity derived above.  An increase in the budget deficit (a reduction in the budget balance) will lead, all else being equal, to an increase in the trade deficit (a reduction in the trade balance).  And it might indeed be worse, as all else is not equal.  The stated objective of slashing corporate taxes is to spur an increase in corporate investment.  But if private investment were indeed to rise (there is in fact little evidence that it has moved beyond previous trends, at least so far), this would further worsen the trade balance (increase the trade deficit).

Would raising tariffs have an impact?  One might argue that this would raise net Taxes paid, as tariffs on imports are a tax, which (if government spending is not then also changed) would reduce the budget deficit.  While true, the extent of the impact would be trivially small.  The federal government collected $35.6 billion in all customs duties and fees (tariffs and more) in FY2017 (see the OMB Historical Tables).  This was less than 0.2% of FY2017 GDP.  Even if all tariffs (and other fees on imports) were doubled, and the level of imports remained unchanged, this would only raise 0.2% of GDP.  But the trade deficit was 2.9% of GDP in FY2017.  It would not make much of a difference, even in such an extreme case.  Furthermore, new tariffs are not being pushed by Trump on all imports, but only a limited share (and a very limited share so far).  Finally, if Trump’s tariffs in fact lead to lower imports of the items being newly taxed, as he hopes, then tariffs collected can fall.  In the extreme, if the imports of such items go to zero, then the tariffs collected will go to zero.

Thus, for several reasons, any impact on government revenues from the new Trump tariffs will be minor.

The notion that raising tariffs would be a way to eliminate the trade deficit is therefore confused.  The trade balance will equal the difference between Domestic Savings and Domestic Investment.  Adding in government, the trade balance will equal the difference between Domestic Private Savings and Domestic Private Investment, plus the equivalent for government (the Government Budget Balance, where a budget deficit will be a negative).  Tariffs have little to no effect on these balances.

C.  What Role Do Tariffs Play, Then?

Do tariffs then matter?  They do, although not in the determination of the overall trade deficit.  Rather, tariffs, which are a tax, will change the price of the particular import relative to the price of other products.  If applied only to imports from some countries and not from others, one can expect to see a shift in imports towards those countries where the tariffs have not been imposed.  And in the case when they are applied globally, on imports of the product from any country, one should expect that prices for similar products made in the US will then also rise.  To the extent there are alternatives, purchases of the now more costly products (whether imported or produced domestically) will be reduced, while purchases of alternatives will increase.  And there will be important distributional changes.  Profits of firms producing the now higher priced products will increase, while the profits of firms using such products as an input will fall.  And the real incomes of households buying any of these products will fall due to the higher prices.

Who wins and who loses can rapidly become turn into something very complicated.  Take, for example, the new 25% tariff being imposed by the Trump administration on steel (and 10% on aluminum).  The tariffs were announced on March 8, to take effect on March 23.  Steel imports from Canada and Mexico were at first exempted, but later the Trump administration said those exemptions were only temporary.  On March 22 they then expanded the list of countries with temporary exemptions to also the EU, Australia, South Korea, Brazil, and Argentina, but only to May 1.  Then, on March 28, they said imports from South Korea would receive a permanent exemption, and Australia, Brazil, and Argentina were granted permanent exemptions on May 2.  After a short extension, tariffs were then imposed on steel imports from Canada, Mexico, and the EU, on May 31.  And while this is how it stands as I write this, no one knows what further changes might be announced tomorrow.

With this uneven application of the tariffs by country, one should expect to see shifts in the imports by country.  What this achieves is not clear.  But there are also further complications.  There are hundreds if not thousands of different types of steel that are imported – both of different categories and of different grades within each category – and a company using steel in their production process in the US will need a specific type and grade of steel.  Many of these are not even available from a US producer of steel.  There is thus a system where US users of steel can apply for a waiver from the tariff.  As of June 19, there have been more than 21,000 petitions for a waiver.  But there were only 30 evaluators in the US Department of Commerce who will be deciding which petitions will be granted, and their training started only in the second week of June.  They will be swamped, and one senior Commerce Department official quoted in the Washington Post noted that “It’s going to be so unbelievably random, and some companies are going to get screwed”.  It would not be surprising to find political considerations (based on the interests of the Trump administration) playing a major role.

So far, we have only looked at the effects of one tariff (with steel as the example).  But multiple tariffs on various goods will interact, with difficult to predict consequences.  Take for example the tariff imposed on the imports of washing machines announced in late January, 2018, at a rate of 20% in the first year and at 50% should imports exceed 1.2 million units in the year.  This afforded US producers of washing machines a certain degree of protection from competition, and they then raised their prices by 17% over the next three months (February to May).

But steel is a major input used to make washing machines, and steel prices have risen with the new 25% tariff.  This will partially offset the gains the washing machine producers received from the tariff imposed on their product.  Will the Trump administration now impose an even higher tariff on washing machines to offset this?

More generally, the degree to which any given producer will gain or lose from such multiple tariffs will depend on multiple factors – the tariff rates applied (both for what they produce and for what they use as inputs), the degree to which they can find substitutes for the inputs they need, and the degree to which those using the product (the output) will be able to substitute some alternative for the product, and more.  Individual firms can end up ahead, or behind.  Economists call the net effect the degree of “net effective protection” afforded the industry, and it can be difficult to figure out.  Indeed, government officials who had thought they were providing positive protection to some industry often found out later that they were in fact doing the opposite.

Finally, imposing such tariffs on imports will lead to responses from the countries that had been providing the goods.  Under the agreed rules of international trade, those countries can then impose commensurate tariffs of their own on products they had been importing from the US.  This will harm industries that may otherwise have been totally innocent in whatever was behind the dispute.

An example of what can then happen has been the impact on Harley-Davidson, the American manufacturer of heavy motorcycles (affectionately referred to as “hogs”).  Harley-Davidson is facing what has been described as a “triple whammy” from Trump’s trade decisions.  First, they are facing higher steel (and aluminum) prices for their production in the US, due to the Trump steel and aluminum tariffs.  Harley estimates this will add $20 million to their costs in their US plants.  For a medium-sized company, this is significant.  As of the end of 2017, Harley-Davidson had 5,200 employees in the US (see page 7 of this SEC filing).  With $20 million, they could pay each of their workers $3,850 more.  This is not a small amount.  Instead, the funds will go to bolster the profits of steel and aluminum firms.

Second, the EU has responded to the Trump tariffs on their steel and aluminum by imposing tariffs of their own on US motorcycle imports.  This would add $45 million in costs (or $2,200 per motorcycle) should Harley-Davidson continue to export motorcycles from the US to the EU.  Quite rationally, Harley-Davidson responded that they will now need to shift what had been US production to one of their plants located abroad, to avoid both the higher costs resulting from the new steel and aluminum tariffs, and from the EU tariffs imposed in response.

And one can add thirdly and from earlier, that Trump pulled the US out of the already negotiated (but still to be signed) Trans-Pacific Partnership agreement.  This agreement would have allowed Harley-Davidson to export their US built motorcycles to much of Asia duty-free.  They will now instead be facing high tariffs to sell to those markets.  As a result, Harley-Davidson has had to set up a new plant in Asia (in Thailand), shifting there what had been US jobs.

Trump reacted angrily to Harley-Davidson’s response to his trade policies.  He threatened that “they will be taxed like never before!”.  Yet what Harley-Davidson is doing should not have been a surprise, had any thought been given to what would happen once Trump started imposing tariffs on essential inputs needed in the manufacture of motorcycles (steel and aluminum), coming from our major trade partners (and often closest allies).  And it is positively scary that a president should even think that he should use the powers of the state to threaten an individual private company in this way.  Today it is Harley-Davidson.  Who will it be tomorrow?

There are many other examples of the problems that have already been created by Trump’s new tariffs.  To cite a few, and just briefly:

a)  The National Association of Home Builders estimated that the 20% tariff imposed in 2017 on imports of softwood lumber from Canada added nearly $3,600 to the cost of building an average single-family home in the US and would, over the course of a year, reduce wages of US workers by $500 million and cost 8,200 full-time US jobs.

b)  The largest nail manufacturer in the US said in late June that it has already had to lay off 12% of its workforce due to the new steel tariffs, and that unless it is granted a waiver, it would either have to relocate to Mexico or shut down by September.

c)  As of early June, Reuters estimated that at least $2.5 billion worth of investments in new utility-scale solar installation projects had been canceled or frozen due to the tariffs Trump imposed on the import of solar panel assemblies.  This is far greater than new investments planned for the assembly of such panels in the US.  Furthermore, the jobs involved in such assembly work are generally low-skill and repetitive, and can be automated should wages rise.

So there are consequences from such tariffs.  They might be unintended, and possibly not foreseen, but they are real.

But would the imposition of tariffs necessarily reduce the trade deficit, as Trump evidently believes?  No.  As noted above, the trade deficit would only fall if the tariffs would, for some reason, increase domestic savings or reduce domestic investment.  But tariffs do not enter directly into those factors.  Indirectly, one could map out some chains of possible causation, but these changes in some set of tariffs (even if broadly applied to a wide range of imports) would not have a major effect on overall domestic savings or investment.  They could indeed even act in the opposite direction.

Households, to start, will face higher prices from the new tariffs.  To try to maintain their previous standard of living (in real terms) they would then need to spend more on what they consume and hence would save less.  This, by itself, would reduce domestic savings and hence would increase the trade deficit to the extent there was any impact.

The impacts on firms are more various, and depend on whether the firm will be a net winner or loser from the government actions and how they might then respond.  If a net winner, they have been able to raise their prices and hence increase their profits.  If they then save the extra profits (retained earnings), domestic savings would rise and the trade deficit would fall.  But if they increase their investments in what has now become a more profitable activity (and that is indeed the stated intention behind imposing the tariffs), that response would lead to an increase in the trade deficit.  The net effect will depend on whether their savings or their investment increases by more, and one does not know what that net change might be.  Different firms will likely respond differently.

One also has to examine the responses of the firms who will be the net losers from the newly imposed tariffs.  They will be paying more on their inputs and will see a reduction in their profits.  They will then save less and will likely invest less.  Again, the net impact on the trade deficit is not clear.

The overall impact on the trade deficit from these indirect effects is therefore uncertain, as one has effects that will act in opposing directions.  In part for this reason, but also because the tariffs will affect only certain industries and with responses that are likely to be limited (as a tariff increase today can be just as easily reversed tomorrow), the overall impact on the trade balance from such indirect effects are likely to be minor.

Increases in individual tariffs, such as those being imposed now by Trump, will not then have a significant impact on the overall trade balance.  But tariffs still do matter.  They change the mix of what is produced, from where items will be imported, and from where items will be produced for export (as the Harley-Davidson case shows).  They will create individual winners and losers, and hence it is not surprising to see the political lobbying as has grown in Washington under Trump.  Far from “draining the swamp”, Trump’s trade policy has made it critical for firms to step up their lobbying activities.

But such tariffs do not determine what the overall trade balance will be.

D.  What Role Does Foreign Investment Play in the Determination of the Trade Balance?

While tariffs will not have a significant effect on the overall trade balance, foreign investment (into the US) will.  To see this, we need to return to the basic macro balance derived in Section B above, but generalize it a bit to include all foreign financial flows.

The trade balance is the balance between exports and imports.  It is useful to generalize this to take into account two other sources of current flows in the national income and product accounts which add to (or reduce) the net demand for foreign exchange.  Specifically, there will be foreign exchange earned by US nationals working abroad plus that earned by US nationals on investments they have made abroad.  Economists call this “factor services income”, or simply factor income, as labor and capital are referred to as factors of production.  This is then netted against such income earned in the US by foreign nationals either working here or on their investments here.  Second, there will be unrequited transfers of funds, such as by households to their relatives abroad, or by charities, or under government aid programs.  Again, this will be netted against the similar transfers to the US.

Adding the net flows from these to the trade balance will yield what economists call the “current account balance”.  It is a measure of the net demand for dollars (if positive) or for foreign exchange (if a deficit) from current flows.  To put some numbers on this, the US had a foreign trade deficit of $571.6 billion in 2017.  This was the balance between the exports and imports of goods and services (what economists call non-factor services to be more precise, now that we are distinguishing factor services from non-factor services).  It was negative – a deficit.  But the US also had a surplus in 2017 from net factor services income flows of $216.8 billion, and a deficit of $130.2 billion on net transfers (mostly from households sending funds abroad).  The balance on current account is the sum of these (with deficits as negatives and surpluses as positives) and came to a deficit of $485.0 billion in 2017, or 2.5% of GDP.  As a share of GDP, this deficit is significant but not huge.  The UK had a current account deficit of 4.1% of GDP in 2017 for example, while Canada had a deficit of 3.0%.

The current account for foreign transactions, basically a generalization of the trade balance, is significant as it will be the mirror image of the capital account for foreign transactions.  That is, when the US had a current account deficit of $485.0 billion (as in 2017), there had to be a capital account surplus of $485.0 billion to match this, as the overall purchases and sales of dollars in foreign exchange transactions will have to balance out, i.e. sum to zero.  The capital account incorporates all transactions for the purchase or sale of capital assets (investments) by foreign entities into the US, net of the similar purchase or sale of capital assets by US entities abroad.  When the capital account is a net positive (as has been the case for the US in recent decades), there is more such investment going into the US than is going out.  The investments can be into any capital assets, including equity shares in companies, or real estate, or US Treasury or other bonds, and so on.

But while the two (the current account and the capital account) have to balance out, there is an open question of what drives what.  Look at this from the perspective of a foreigner, wishing to invest in some US asset.  They need to get the dollars for this from somewhere.  While this would be done by means of the foreign exchange markets, which are extremely active (with trillions of dollars worth of currencies being exchanged daily), a capital account surplus of $485 billion (as in 2017) means that foreign entities had to obtain, over the course of the year, a net of $485 billion in dollars for their investments into the US.  The only way this could be done is by the US importing that much more than it exported over the course of the year.  That is, the US would need to run a current account deficit of that amount for the US to have received such investment.

If there is an imbalance between the two (the current account and the capital account), one should expect that the excess supply or demand for dollars will lead to changes in a number of prices, most directly foreign exchange rates, but also interest rates and other asset prices.  These will be complex and we will not go into here all the interactions one might then have.  Rather, the point to note is that a current account deficit, even if seemingly large, is not a sign of disequilibrium when there is a desire on the part of foreign investors to invest a similar amount in US markets.  And US markets have traditionally been a good place to invest.  The US is a large economy, with markets for assets that are deep and active, and these markets have normally been (with a few exceptions) relatively well regulated.

Foreign nationals and firms thus have good reason to invest a share of their assets in the US markets.  And the US has welcomed this, as all countries do.  But the only way they can obtain the dollars to make these investments is for the US to run a current account deficit.  Thus a current account deficit should not necessarily be taken as a sign of weakness, as Trump evidently does.  Depending on what governments are doing in their market interventions, a current account deficit might rather be a sign of foreign entities being eager to invest in the country.  And that is a good sign, not a bad one.

E.  An “Exorbitant Privilege”

The dollar (and hence the US) has a further, and important, advantage.  It is the world’s dominant currency, with most trade contracts (between all countries, not simply between some country and the US) denominated in dollars, as are contracts for most internationally traded commodities (such as oil).  And as noted above, investments in the US are particularly advantageous due to the depth and liquidity of our asset markets.  For these reasons, foreign countries hold most of their international reserves in dollar assets.  And most of these are held in what have been safe, but low yielding, short-term US Treasury bills.

As noted in Section D above, those seeking to make investments in dollar assets can obtain the dollars required only if the US runs a current account deficit.  This is as true for assets held in dollars as part of a country’s international reserves as for any other investments in US dollar assets.  Valéry Giscard d’Estaing in the 1960s, then the Minister of Finance of France, described this as an “exorbitant privilege” for the US (although this is often mistakenly attributed Charles de Gaulle, then his boss as president of France).

And it certainly is a privilege.  With the role of the dollar as the preferred reserve currency for countries around the world, the US is able to run current account deficits indefinitely, obtaining real goods and services from those countries while providing pieces of paper generating only a low yield in return.  Indeed, in recent years the rate of return on short-term US Treasury bills has generally been negative in real terms (i.e. after inflation).  The foreign governments buying these US Treasury bills are helping to cover part of our budget deficits, and are receiving little to nothing in return.

So is the US a “piggybank that everybody is robbing”, as Trump asserted to necessarily be the case when the US is has a current account deficit?  Not at all.  Indeed, it is the precise opposite.  The current account deficit is the mirror image of the foreign investment inflows coming into the US.  To obtain the dollars needed to do this those countries must export more real goods to the US than they import from the US.  The US gains real resources (the net exports), while the foreign entities then invest in US markets.  And for governments obtaining dollars to hold as their international reserves, those investments are primarily in the highly liquid and safe, short-term US Treasury bills, despite those assets earning low or even negative returns.  This truly is an “exorbitant privilege”, not a piggybank being robbed.

Indeed, the real concern is that with the mismanagement of our budget (tax cuts increasing deficits at a time when deficits should be reduced) plus the return to an ideologically driven belief in deregulating banks and other financial markets (such as what led to the financial and then economic collapse of 2008), the dollar may lose its position as the place to hold international reserves.  The British pound had this position in the 1800s and then lost it to the dollar due to the financial stresses of World War I.  The dollar has had the lead position since.  But others would like it, most openly by China and more quietly Europeans hoping for such a role for the euro.  They would very much like to enjoy this “exorbitant privilege”, along with the current account deficits that privilege conveys.

F.  Summary and Conclusion

Trump’s beliefs on the foreign trade deficit, on the impact of hiking tariffs, and on who will “win” in a trade war, are terribly confused.  While one should not necessarily expect a president to understand basic economics, one should expect that a president would appoint and listen to advisors who do.  But Trump has not.

To sum up some of the key points:

a)  The foreign trade balance will always equal the difference between domestic savings and domestic investment.  Or with government accounts split out, the trade balance will equal the difference between domestic private savings and domestic private investment, plus the government budget balance.  The foreign trade balance will only move up or down when there is a change in the balance between domestic savings and domestic investment.

b)  One way to change that balance would be for the government budget balance to increase (i.e. for the government deficit to be reduced).  Yet Trump and the Republican Congress have done the precise opposite.  The massive tax cuts of last December, plus (to a lesser extent) the increase in government spending now budgeted (primarily for the military), will increase the budget deficit to record levels for an economy in peacetime at full employment.  This will lead to a bigger trade deficit, not a smaller one.

c)  One could also reduce the trade deficit by making the US a terrible place to invest in.  This would reduce foreign investment into the US, and hence the current account deficit.  In terms of the basic savings/investment balance, it would reduce domestic investment (whether driven by foreign investors or domestic ones).  If domestic savings was not then also reduced (a big if, and dependant on what was done to make the US a terrible place to invest in), this would lead to a similar reduction in the trade deficit.  This is of course not to be taken seriously, but rather illustrates that there are tradeoffs.  One should not simplistically assume that a lower trade deficit achieved by any means possible is good.

d)  It is also not at all clear that one should be overly concerned about the size of the trade and current account deficits, at where they are today.  The US had a trade deficit of 2.9% of GDP in 2017 and a current account deficit of 2.5% of GDP.  While significant, these are not huge.  Should they become much larger (due, for example, to the forecast increases in government budget deficits to record levels), they might rise to problematic levels.  But at the current levels for the current account deficit, we have seen the markets for foreign exchange and for interest rates functioning pretty well and without overt signs of concern.  The dollars being made available through the current account deficit have been bought up and used for investments in US markets.

e)  Part of the demand for dollars to be invested and held in the US markets comes from the need for international reserves by governments around the world.  The dollar is the dominant currency in the world, and with the depth and liquidity of the US markets (in particular for short-term US Treasury bills) most of these international reserves are held in dollars.  This has given the US what has been called an “exorbitant privilege”, and permits the US to run substantial current account deficits while providing in return what are in essence paper assets yielding just low (or even negative) returns.

f)  The real concern should not be with the consequences of the dollar playing such a role in the system of international trade, but rather with whether the dollar will lose this privileged status.  Other countries have certainly sought this, most openly by China but also more quietly for the euro, but so far the dollar has remained dominant.  But there are increasing concerns that with the mismanagement of the government budget (the recent tax cuts) plus ideologically driven deregulation of banks and the financial markets (as led to the 2008 financial collapse), countries will decide to shift their international reserves out of the dollar towards some alternative.

g)  What will not reduce the overall trade deficit, however, is selective increases in tariff rates, as Trump has started to do.  Such tariff increases will shift around the mix of countries from where the imports will come, and/or the mix of products being imported, but can only reduce the overall trade deficit to the extent such tariffs would lead somehow to either higher domestic savings and/or lower domestic investment.  Tariffs will not have a direct effect on such balances, and indirect effects are going to be small and indeed possibly in the wrong direction (if the aim is to reduce the deficits).

h)  What such tariff policies will do, however, is create a mess.  And they already have, as the Harley-Davidson case illustrates.  Tariffs increase costs for US producers, and they will respond as best they can.  While the higher costs will possibly benefit certain companies, they will harm those using the products unless some government bureaucrat grants them a special exemption.

But what this does lead to is officials in government picking winners and losers.  That is a concern.  And it is positively scary to have a president lashing out and threatening individual firms, such as Harley-Davidson, when the firms respond to the mess created as one should have expected.

The Mismanagement of Fiscal Policy Under Trump: Deficits When There Should be Surpluses

A.  Introduction

Since World War II, the US has never run such high fiscal deficits in times of full employment as it will now.  With the tax cuts pushed through by the Republican Congress and signed into law by Trump in December, and to a lesser extent the budget passed in March, it is expected that the US will soon be running a fiscal deficit of over $1.0 trillion a year, exceeding 5% of GDP.  This is unprecedented.

We now have good estimates of how high the deficits will grow under current policy and in a scenario which assumes (optimistically) that the economy will remain at full employment, with no downturn.  The Congressional Budget Office (CBO) published on April 9 its regular report on “The Budget and Economic Outlook”, this year covering fiscal years 2018 to 2028.  In this report to Congress and to the public, the CBO assesses the implications of federal budget and tax policy, as set out under current law.  The report normally comes out in January or February of each year but was delayed this year in order to reflect the tax bill approved in December and also the FY18 budget, which was only approved in March (even though the fiscal year began last October).

The forecast is that the deficits will now balloon.  This should not be a surprise given the magnitude of the tax cuts pushed through Congress in December and then signed into law by Trump, but recall that the Republicans pushing through the tax bill asserted deficits would not increase as a result.  The budget approved in March also provides for significant increases in legislated spending – especially for the military but also for certain domestic programs.  But as will be discussed below, government spending (other than on interest) over the next decade is in fact now forecast by the CBO to be less than what it had forecast last June.

The CBO assessment is the first set of official estimates of what the overall impact will be.  And they are big.  The CBO forecasts that even though the economy is now at full employment (and assumed to remain there for the purposes of the scenario used), deficits are forecast to grow to just short of $1 trillion in FY2019, and then continue to increase, reaching over $1.5 trillion by FY2028.  In dollar terms, it has never been that high – not even in 2009 at the worst point in the recession following the 2008 collapse of the economy.

That is terrible fiscal policy.  While high fiscal deficits are to be expected during times of high unemployment (as tax revenues are down, while government spending is the only stabilizing element for the economy when both households and corporations are cutting back on spending due to the downturn), standard policy would be to limit deficits in times of full employment in order to bring down the public debt to GDP ratio.  But with the tax cuts and spending plans this is not going to happen under Trump, even should the economy remain at full employment.  And it will be far worse when the economy once again dips into a recession, as always happens eventually.

This blog post will first discuss the numbers in the new CBO forecasts, then the policy one should follow over the course of the business cycle in order to keep the public debt to GDP under control, and finally will look at the historical relationship between unemployment and the fiscal deficit, and how the choices made on the deficit by Trump and the Republican-controlled Congress are unprecedented and far from the historical norms.

B.  The CBO Forecast of the Fiscal Deficits

The forecasts made by the CBO of the fiscal accounts that would follow under current policies are always eagerly awaited by those concerned with what Congress is doing.  Ten-year budget forecasts are provided by the CBO at least annually, and typically twice or even three times a year, depending on the decisions being made by Congress.

The CBO itself is non-partisan, with a large professional staff and a director who is appointed to a four-year term (with no limits on its renewal) by the then leaders in Congress.  The current director, Keith Hall, took over on April 1, 2015, when both the House and the Senate were under Republican control.  He replaced Doug Elmensdorf, who was widely respected as both capable and impartial, but who had come to the end of a term.  Many advocated that he be reappointed, but Elmensdorf had first taken the position when Democrats controlled the House and the Senate.  Hall is a Republican, having served in senior positions in the George W. Bush administration, and there was concern that his appointment signaled an intent to politicize the position.

But as much as his party background, a key consideration appeared to have been Hall’s support for the view that tax cuts would, through their impact on incentives, lead to more rapid growth, with that more rapid growth then generating more tax revenue which would partially or even fully offset the losses from the lower tax rates.  I do not agree.  An earlier post on this blog discussed that that argument is incomplete, and does not take into account that there are income as well as substitution effects (as well as much more), which limit or offset what the impact might be from substitution effects alone.  And another post on this blog looked at the historical experience after the Reagan and Bush tax cuts, in comparison to the experience after the (more modest) increases in tax rates on higher income groups under Clinton and Obama.  It found no evidence in support of the argument that growth will be faster after tax cuts than when taxes are raised.  What the data suggest, rather, is that there was little to no impact on growth in one direction or the other.  Where there was a clear impact, however, was on the fiscal deficits, which rose with the tax cuts and fell with the tax increases.

Given Hall’s views on taxes, it was thus of interest to see whether the CBO would now forecast that an acceleration in GDP growth would follow from the new tax cuts sufficient to offset the lower tax revenues following from the lower tax rates.  The answer is no.  While the CBO did forecast that GDP would be modestly higher as a result of the tax cuts (peaking at 1.0% higher than would otherwise be the case in 2022 before then diminishing over time, and keep in mind that these are for the forecast levels of GDP, not of its growth), this modestly higher GDP would not suffice to offset the lower tax revenues following from the lower tax rates.

Taking account of all the legislative changes in tax law since its prior forecasts issued in June 2017, the CBO estimated that fiscal revenues collected over the ten years FY2018 to FY2027 would fall by $1.7 trillion from what it would have been under previous law.  However, after taking into account its forecast of the resulting macroeconomic effects (as well as certain technical changes it made in its forecasts), the net impact would be a $1.0 trillion loss in revenues.  This is almost exactly the same loss as had been estimated by the staff of the Joint Committee on Taxation for the December tax bill, which also factored in an estimate of a (modest) impact on growth from the lower tax rates.

Fiscal spending projections were also provided, and the CBO estimated that legislative changes alone (since its previous estimates in June 2017) would raise spending (excluding interest) by $450 billion over the ten year period.  However, after taking into account certain macro feedbacks as well as technical changes in the forecasts, the CBO is now forecasting government spending will in fact be $100 billion less over the ten years than it had forecast last June.  The higher deficits over those earlier forecast are not coming from higher spending but rather totally from the tax cuts.

Finally, the higher deficits will have to be funded by higher government borrowing, and this will lead to higher interest costs.  Interest costs will also be higher as the expansionary fiscal policy at a time when the economy is already at full employment will lead to higher interest rates, and those higher interest rates will apply to the entire public debt, not just to the increment in debt resulting from the higher deficits.  The CBO forecasts that higher interest costs will add $650 billion to the deficits over the ten years.

The total effect of all this will thus be to increase the fiscal deficit by $1.6 trillion over the ten years, over what it would otherwise have been.  The resulting annual fiscal deficits, in billions of dollars, would be as shown in the chart at top of this post.  Under the assumed scenario that the economy will remain at full employment over the entire period, the fiscal deficit will still rise to reach almost $1 trillion in FY19, and then to over $1.5 trillion in FY28.  Such deficits are unprecedented for when the economy is at full employment.

The deficits forecast would then translate into these shares of GDP, given the GDP forecasts:

The CBO is forecasting that fiscal deficits will rise to a range of 4 1/2 to 5 1/2% of GDP from FY2019 onwards.  Again, this is unprecedented for the US economy in times of full employment.

C.  Fiscal Policy Over the Course of the Business Cycle

As noted above, fiscal policy has an important role to play during economic downturns to stabilize conditions and to launch a recovery.  When something causes an economic downturn (such as the decision during the Bush II administration not to regulate banks properly in the lead up to the 2008 collapse, believing “the markets” would do this best), both households and corporations will reduce their spending.  With unemployment increasing and wages often falling even for those fortunate enough to remain employed, as well as with the heightened general concerns on the economy, households will cut back on their spending.  Similarly, corporations will seek to conserve cash in the downturns, and will cut back on their spending both for the inputs they would use for current production (they cannot sell all of their product anyway) and for capital investments (their production facilities are not being fully used, so why add to capacity).

Only government can sustain the economy in such times, stopping the downward spiral through its spending.  Fiscal stimulus is needed, and the Obama stimulus program passed early in his first year succeeded in pulling the economy out of the freefall it was in at the time of his inauguration.  GDP fell at an astounding 8.2% annual rate in the fourth quarter of 2008 and was still crashing in early 2009 as Obama was being sworn in.  It then stabilized in the second quarter of 2009 and started to rise in the third quarter.  The stimulus program, as well as aggressive action by the Federal Reserve, accounts for this turnaround.

But fiscal deficits will be high during such economic downturns.  While any stimulus programs will add to this, most of the increase in the deficits in such periods occur automatically, primarily due to lower tax revenues in the downturn.  Incomes and employment are lower, so taxes due will be lower.  There is also, but to a much smaller extent, some automatic increase in government spending during the downturns, as funds are paid out in unemployment insurance or for food stamps for the increased number of the poor.  The deficits will then add to the public debt, and the public debt to GDP ratio will rise sharply (exacerbated in the short run by the lower GDP as well).

One confusion, sometimes seen in news reports, should be clarified.  While fiscal deficits will be high in a downturn, for the reasons noted above, and any stimulus program will add further to those deficits, one should not equate the size of the fiscal deficit with the size of the stimulus.  They are two different things.  For example, normally the greatest stimulus, for any dollar of expenditures, will come from employing directly blue-collar workers in some government funded program (such as to build or maintain roads and other such infrastructure).  A tax cut focused on the poor and middle classes, who will spend any extra dollar they receive, will also normally lead to significant stimulus (although probably less than via directly employing a worker).  But a tax cut focused on the rich will provide only limited stimulus as any extra dollar they receive will mostly simply be saved (or used to pay down debt, which is economically the same thing).  The rich are not constrained in how much they can spend on consumption by their income, as their income is high enough to allow them to consume as much as they wish.

Each of these three examples will add equally to the fiscal deficit, whether the dollar is used to employ workers directly, to provide a tax cut to the poor and middle classes, or to provide a tax cut to the rich.  But the degree of stimulus per dollar added to the deficit can be dramatically different.  One cannot equate the size of the deficit to the amount of stimulus.

Deficits are thus to be expected, and indeed warranted, in a downturn.  But while the resulting increase in public debt is to be expected in such conditions, there must also come a time for the fiscal deficits to be reduced to a level where at least the debt to GDP ratio, if not the absolute level of the debt itself, will be reduced.  Debt cannot be allowed to grow without limit.  And the time to do this is when the economy is at full employment.  It was thus the height of fiscal malpractice for the tax bills and budget passed by Congress and signed into law by Trump not to provide for this, but rather for the precise opposite.  The CBO estimates show that deficits will rise rather than fall, even under a scenario where the economy is assumed to remain at full employment.

It should also be noted that the deficit need not be reduced all the way to zero for the debt to GDP ratio to fall.  With a growing GDP and other factors (interest rates, the rate of inflation, and the debt to GDP ratio) similar to what they are now, a good rule of thumb is that the public debt to GDP ratio will fall as long as the fiscal deficit is around 3% of GDP or less.  But the budget and tax bills of Trump and the Congress will instead lead to deficits of around 5% of GDP.  Hence the debt to GDP ratio will rise.

[Technical note for those interested:  The arithmetic of the relationship between the fiscal deficit and the debt to GDP ratio is simple.  A reasonable forecast, given stated Fed targets, is for an interest rate on long-term public debt of 4% and an inflation rate of 2%.  This implies a real interest rate of 2%.  With real GDP also assumed to grow in the CBO forecast at 2% a year (from 2017 to 2028), the public debt to GDP ratio will be constant if what is called the “primary balance” is zero (as the numerator, public debt, will then grow at the same rate as the denominator, GDP, each at either 2% a year in real terms or 4% a year in nominal terms) .  The primary balance is the fiscal deficit excluding what is paid in interest on the debt.  The public debt to GDP ratio, as of the end of FY17, was 76.5%.  With a nominal interest rate of 4%, this would lead to interest payments on the debt of 3% of GDP.  A primary balance of zero would then imply an overall fiscal deficit of 3% of GDP.  Hence a fiscal deficit of 3% or less, with the public debt to GDP ratio roughly where it is now, will lead to a steady debt to GDP ratio.

More generally, the debt to GDP ratio will be constant whenever the rate of growth of real GDP matches the real interest rate, and the primary balance is zero.  In the case here, the growth in the numerator of debt (4% in nominal terms, or 2% in real terms when inflation is 2%) matches the growth in the denominator of GDP (2% in real terms, or 4% in nominal terms), and the ratio will thus be constant.]

Putting this in a longer-term context:

Federal government debt rose to over 100% of GDP during World War II.  The war spending was necessary.  But it did not then doom the US to perpetual economic stagnation or worse.  Rather, fiscal deficits were kept modest, the economy grew well, and over the next several decades the debt to GDP ratio fell.

For the fiscal balances over this period (with fiscal deficits as negative and fiscal surpluses as positive):

Fiscal balances were mostly but modestly in deficit (and occasionally in surplus) through the 1950s, 60s, and 70s.  The 3% fiscal deficit rule of thumb worked well, and one can see that as long as the fiscal deficit remained below 3% of GDP, the public debt to GDP ratio fell, to a low of 23% of GDP in FY1974.  It then stabilized at around this level for a few years, but reversed and started heading in FY1982 after Reagan took office.  And it kept going up even after the economy had recovered from the 1982 recession and the country was back to full employment, as deficits remained high following the Reagan tax cuts.

The new Clinton budgets, along with the tax increase passed in 1993, then stabilized the accounts, and the economy grew strongly.  The public debt to GDP ratio, which had close to doubled under Reagan and Bush I (from 25% of GDP to 48%), was reduced to 31% of GDP by the year Clinton left office.   But it then started to rise again following the tax cuts of Bush II (plus with the first of the two recessions under Bush II).  And it exploded in 2008/2009, at the end of Bush II and the start of Obama, as the economy plunged into the worst economic downturn since the Great Depression.

The debt to GDP ratio did stabilize, however, in the second Obama term, and actually fell slightly in FY2015 (when the deficit was 2.4% of GDP).  But with the deficits now forecast to rise to the vicinity of 5% of GDP (and to this level even with the assumption that there will not be an economic downturn at some point), the public debt to GDP ratio will soon be approaching 100% of GDP.

This does not have to happen.  As noted above, one need not bring the fiscal deficits all the way down to zero.  A fiscal deficit kept at around 3% of GDP would suffice to stabilize the public debt to GDP ratio, while something less than 3% would bring it down.

D.  Historical Norms

What stands out in these forecasts is how much the deficits anticipated now differ from the historical norms.  The CBO report has data on the deficits going back to FY1968 (fifty years), and these can be used to examine the relationship with unemployment.  As discussed above, one should expect higher deficits during an economic downturn when unemployment is high.  But these deficits then need to be balanced with lower deficits when unemployment is lower (and sufficiently low when the economy is at or near full employment that the public debt to GDP ratio will fall).

A simple scatter-plot of the fiscal balance (where fiscal deficits are a negative balance) versus the unemployment rate, for the period from FY1968 to now and then the CBO forecasts to FY2028, shows:

While there is much going on in the economy that affects the fiscal balance, this scatter plot shows a surprisingly consistent relationship between the fiscal balance and the rate of unemployment.  The red line shows what the simple regression line would be for the historical years of FY1968 to FY2016.  The scatter around it is surprisingly tight.  [Technical Note:  The t-statistic is 10.0, where anything greater than 2.0 is traditionally considered significant, and the R-squared is 0.68, which is high for such a scatter plot.]

An interesting finding is that the high deficits in the early Obama years are actually very close to what one would expect given the historical norm, given the unemployment rates Obama faced on taking office and in his first few years in office.  That is, the Obama stimulus programs did not cause the fiscal deficits to grow beyond what would have been expected given what the US has had in the past.  The deficits were high because unemployment was high following the 2008 collapse.

At the other end of the line, one has the fiscal surpluses in the years FY1998 to 2000 at the end of the Clinton presidency.  As noted above, the public debt to GDP ratio stabilized soon after Clinton took office (in part due to the tax increases passed in 1993), with the fiscal deficits reduced to less than 3% of GDP.  Unemployment fell to below 5% by mid-1997 and to a low of 3.8% in mid-2000, as the economy grew well.  By FY1998 the fiscal accounts were in surplus.  And as seen in the scatter plot above, the relationship between unemployment and the fiscal balance was close in those years (FY1998 to 2000) to what one would expect given the historical norms for the US.

But the tax cuts and budget passed by Congress and signed by Trump will now lead the fiscal accounts to a path far from the historical norms.  Instead of a budget surplus (as in the later Clinton years, when the unemployment rate was similar to what the CBO assumes will hold for its scenario), or even a deficit kept to 3% of GDP or less (which would suffice to stabilize the debt to GDP ratio), deficits of 4 1/2 to 5 1/2 % of GDP are foreseen.  The scatter of points for the fiscal deficit vs. unemployment relationship for 2018 to 2028 is in a bunch by itself, down and well to the left of the regression line.  One has not had such deficits in times of full employment since World War II.

E.  Conclusion

Fiscal policy is being mismanaged.  The economy reached full employment by the end of the Obama administration, fiscal deficits had come down, and the public debt to GDP ratio had stabilized.  There was certainly more to be done to bring down the deficit further, and with the aging of the population (retiring baby boomers), government expenditures (for Social Security and especially for Medicare and other health programs) will need to increase in the coming years.  Tax revenues to meet such needs will need to rise.

But the Republican-controlled Congress and Trump pushed through measures that will do the opposite.  Taxes have been cut dramatically (especially for corporations and rich households), while the budget passed in March will raise government spending (especially for the military).  Even assuming the economy will remain at full employment with no downturn over the next decade (which would be unprecedented), fiscal deficits will rise to around 5% of GDP.  As a consequence, the public debt to GDP ratio will rise steadily.

This is unprecedented.  With the economy at full employment, deficits should be reduced, not increased.  They need not go all the way to zero, even though Clinton was able to achieve that.  A fiscal deficit of 3% of GDP (where it was in the latter years of the Obama administration) would stabilize the debt to GDP ratio.  But Congress and Trump pushed through measures to raise the deficit rather than reduce it.

This leaves the economy vulnerable.  There will eventually be another economic downturn.  There always is one, eventually.  The deficit will then soar, as it did in 2008/2009, and remain high until the economy fully recovers.  But there will then be pressure not to allow the debt to rise even further.  This is what happened following the 2010 elections, when the Republicans gained control of the House.  With control over the budget, they were able to cut government spending even though unemployment was still high.  Because of this, the pace of the recovery was slower than it need have been.  While the economy did eventually return to full employment by the end of Obama’s second term, unemployment remained higher than should have been the case for several years as a consequence of the cuts.

At the next downturn, the fiscal accounts will be in a poor position to respond as they need to in a crisis.  Public debt, already high, will soar to unprecedented levels, and there will be arguments from conservatives not to allow the debt to rise even further.  Recovery will then be even more difficult, and many will suffer as a result.

Impact of the 1994 Assault Weapons Ban on Mass Shootings: An Update, Plus What To Do For a Meaningful Reform

A.  Introduction

An earlier post on this blog (from January 2013, following the horrific shooting at Sandy Hook Elementary School in Connecticut), looked at the impact of the 1994 Federal Assault Weapons Ban on the number of (and number of deaths from) mass shootings during the 10-year period the law was in effect.  The data at that point only went through 2012, and with that limited time period one could not draw strong conclusions as to whether the assault weapons ban (with the law as written and implemented) had a major effect.  There were fewer mass shootings over most of the years in that 1994 to 2004 period, but 1998 and 1999 were notable exceptions.

There has now been another horrific shooting at a school – this time at Marjory Stoneman Douglas High School in Parkland, Florida.  There are once again calls to limit access to the military-style semiautomatic assault weapons that have been used in most of these mass shootings (including the ones at Sandy Hook and Stoneman Douglas).  And essentially nothing positive had been done following the Sandy Hook shootings.  Indeed, a number of states passed laws which made such weapons even more readily available than before.  And rather than limiting access to such weapons, the NRA response following Sandy Hook was that armed guards should be posted at every school.  There are, indeed, now more armed guards at our schools.  Yet an armed guard at Stoneman Douglas did not prevent this tragedy.

With the passage of time, we now have five more years of data than we had at the time of the Sandy Hook shooting.  With this additional data, can we now determine with more confidence whether the Assault Weapons Ban had an impact, with fewer shootings incidents and fewer deaths from such shootings?

This post will look at this.  With the additional five years of data, it now appears clear that the 1994 to 2004 period did represent a change in the sadly rising trend, with a reduction most clearly in the number of fatalities from and total victims of those mass shootings.  This was true even though the 1994 Assault Weapons Ban was a decidedly weak law, with a number of loopholes that allowed continued access to such weapons for those who wished to obtain them.  Any new law should address those loopholes, and I will discuss at the end of this post a few such measures so that such a ban would be more meaningful.

B.  The Number of Mass Shootings by Year

The Federal Assault Weapons Ban (formally the “Public Safety and Recreational Firearms Use Protection Act”, and part of a broader crime control bill) was passed by Congress and signed into law on September 13, 1994.  The Act banned the sale of any newly manufactured or imported “semiautomatic assault weapon” (as defined by the Act), as well as of newly manufactured or imported large capacity magazines (holding more than 10 rounds of ammunition).  The Act had a sunset provision where it would be in effect for ten years, after which it could be modified or extended.

However, it was a weak ban, with many loopholes.  First of all, there was a grandfather clause that allowed manufacturers and others to sell all of their existing inventory.  Not surprisingly, manufacturers scaled up production sharply while the ban was being debated, as those inventories could later then be sold, and were.  Second and related to this, there was no constraint on shops or individuals on the sale of weapons that had been manufactured before the start date, provided just that they were legally owned at the time the law went into effect.  Third, “semiautomatic assault weapons” (which included handguns and certain shotguns, in addition to rifles such as the AR-15) were defined quite precisely in the Act.  But with that precision, gun manufacturers could make what were essentially cosmetic changes, with the new weapons then not subject to the Act.  And fourth, with the sunset provision after 10 years (i.e. to September 12, 2004), the Republican-controlled Congress of 2004 (and President George W. Bush) simply could allow the Act to expire, with nothing done to replace it.  And they did.

The ban was therefore weak.  But it is still of interest to see whether even such a weak law might have had an impact on the number of, and severity of, mass shootings during the period it was in effect.

The data used for this analysis were assembled by Mother Jones, the investigative newsmagazine and website.  The data are available for download in spreadsheet form, and is the most thorough and comprehensive such dataset publicly available.  Sadly, the US government has not assembled and made available anything similar.  A line in the Mother Jones spreadsheet is provided for each mass shooting incident in the US since 1982, with copious information on each incident (as could be gathered from contemporaneous news reports) including the weapons used when reported.  I would encourage readers to browse through the spreadsheet to get a sense of mass shootings in America, the details of which are all too often soon forgotten.  My analysis here is based on various calculations one can then derive from this raw data.

This dataset (through 2012) was used in my earlier blog post on the impact of the Assault Weapons Ban, and has now been updated with shootings through February 2018 (as I write this).  To be included, a mass shooting incident was defined by Mother Jones as a shooting in a public location (and so excluded incidents such as in a private home, which are normally domestic violence incidents), or in the context of a conventional crime (such as an armed robbery, or from gang violence), and where at least four people were killed (other than the killer himself if he also died, and note it is almost always a he).  While other possible definitions of what constitutes a “mass shooting” could be used, Mother Jones argues (and I would agree) that this definition captures well what most people would consider a “mass shooting”.  It only constitutes a small subset of all those killed by guns each year, but it is a particularly horrific set.

There was, however, one modification in the updated file, which I adjusted for.  Up through 2012, the definition was as above and included all incidents where four or more people died (other than the killer).  In 2013, the federal government started to refer to mass shootings as those events where three or more people were killed (other than the killer), and Mother Jones adopted this new criterion for the mass shootings it recorded for 2013 and later.  But this added a number of incidents that would not have been included under the earlier criterion (of four or more killed), and would bias any analysis of the trend.  Hence I excluded those cases in the charts shown here.  Including incidents with exactly three killed would have added no additional cases in 2013, but one additional in 2014, three additional in 2015, two additional in 2016, and six additional in 2017 (and none through end-February in 2018).  There would have been a total of 36 additional fatalities (three for each of the 12 additional cases), and 80 additional victims (killed and wounded).

What, then, was the impact of the assault weapons ban?  We will first look at this graphically, as trends are often best seen by eye, and then take a look at some of the numbers, as they can provide better precision.

The chart at the top of this post shows the number of mass shooting events each year from 1982 through 2017, plus for the events so far in 2018 (through end-February).  The numbers were low through the 1980s (zero, one, or two a year), but then rose.  The number of incidents per year was then generally less during the period the Assault Weapons Ban was in effect, but with the notable exceptions of 1998 (three incidents) and especially 1999 (five).  The Columbine High School shooting was in 1999, when 13 died and 24 were wounded.

The number of mass shootings then rose in the years after the ban was allowed to expire.  This was not yet fully clear when one only had data through 2012, but the more recent data shows that the trend is, sadly, clearly upward.  The data suggest that the number of mass shooting incidents were low in the 1980s but then began to rise in the early 1990s; that there was then some fallback during the decade the Assault Weapons Ban was in effect (with 1998 and 1999 as exceptions); but with the lifting of the ban the number of mass shooting incidents began to grow again.  (For those statistically minded, a simple linear regression for the full 1982 to 2017 period indicates an upward trend with a t-statistic of a highly significant 4.6 – any t-statistic of greater than 2.0 is generally taken to be statistically significant.)

C.  The Number of Fatalities and Number of Victims in Mass Shooting Incidents 

These trends are even more clear when one examines what happened to the total number of those killed each year, and the total number of victims (killed and wounded).

First, a chart of fatalities from mass shootings over time shows:

 

Fatalities fluctuated within a relatively narrow band prior to 1994, but then, with the notable exception of 1999, fell while the Assault Weapons Ban was in effect.  And they rose sharply after the ban was allowed to expire.  There is still a great deal of year to year variation, but the increase over the last decade is clear.

And for the total number of victims:

 

One again sees a significant reduction during the period the Assault Weapons Ban was in effect (with again the notable exception of 1999, and now 1998 as well).  The number of victims then rose in most years following the end of the ban, and went off the charts in 2017.  This was due largely to the Las Vegas shooting in October, 2017, where there were 604 victims of the shooter.  But even excluding the Las Vegas case, there were still 77 victims in mass shooting events in 2017, more than in any year prior to 2007 (other than 1999).

D.  The Results in Tables

One can also calculate the averages per year for the pre-ban period (13 years, from 1982 to 1994), the period of the ban (September 1994 to September 2004), and then for the post-ban period (again 13 years, from 2005 to 2017):

Number of Mass Shootings and Their Victims – Averages per Year

Avg per Year

Shootings

Fatalities

Injured

Total Victims

1982-1994

1.5

12.4

14.2

26.6

1995-2004

1.5

9.6

10.1

19.7

2005-2017

3.8

38.6

71.5

110.2

Note:  One shooting in December 2004 (following the lifting of the Assault Weapons Ban in September 2004) is combined here with the 2005 numbers.  And the single shooting in 1994 was in June, before the ban went into effect in September.

The average number of fatalities per year, as well as the number injured and hence the total number of victims, all fell during the period of the ban.  They all then jumped sharply once the ban was lifted.  While one should acknowledge that these are all correlations in time, where much else was also going on, these results are consistent with the ban having a positive effect on reducing the number killed or wounded in such mass shootings.

The number of mass shootings events per year also stabilized during the period the ban was in effect (at an average of 1.5 per year).  That is, while the number of mass shooting events was the same (per year) as before, their lethality was less.  Plus the number of mass shooting events did level off, and fell back if one compares it to the previous half-decade rather than the previous 13 year period.  They had been following a rising trend before.  And the number of mass shootings then jumped sharply after the ban was lifted.

The data also allow us to calculate the average number of victims per mass shooting event, broken down by the type of weapon used:

Average Number of Victims per Mass Shooting, by Weapon Used

Number of Shootings

Fatalities

Injured

Total Victims

Semiauto Rifle Used

26

13.0

34.6

47.6

Semiauto Rifle Not Used

59

7.5

5.6

13.1

Semiauto Handgun Used

63

10.0

17.5

27.5

Semiauto Handgun (but Not Semiautomatic Rifle) Used

48

7.7

6.0

13.7

No Semiauto Weapon Used

11

6.6

4.0

10.6

There were 26 cases where the dataset Mother Jones assembled allowed one to identify specifically that a semiautomatic rifle was used.  (Some news reports were not clear, saying only that a rifle was used.  Such cases were not counted here.)  This was out of a total of 85 mass shooting events where four or more were killed.  But the use of semiautomatic rifles proved to be especially deadly.  On average, there were 13 fatalities per mass shooting when one could positively identify that a semiautomatic rifle was used, versus 7.5 per shooting when it was not.  And there were close to 48 total victims per mass shooting on average when a semiautomatic rifle was used, versus 13 per shooting when it was not.

The figures when a semiautomatic handgun was used (from what could be identified in the news reports) are very roughly about half-way between these two.  But note that there is a great deal of overlap between mass shootings where a semiautomatic handgun was used and where a semiautomatic rifle was also used.  Mass shooters typically take multiple weapons with them as they plan out their attacks, including semiautomatic handguns along with their semiautomatic rifles.  The fourth line in the table shows the figures when a semiautomatic handgun was used but not also a semiautomatic rifle.  These figures are similar to the averages in all of the cases where a semiautomatic rifle was not used (the second line in the table).

The fewest number of fatalities and injured are, however, when no semiautomatic weapons are used at all.  Unfortunately, in only 11 of the 85 mass shootings (13%) were neither a semiautomatic rifle nor a semiautomatic handgun used.  And these 11 might include a few cases where the news reports did not permit a positive identification that a semiautomatic weapon had been used.

E.  What Would Be Needed for a Meaningful Ban

It thus appears that the 1994 Assault Weapons Ban, as weak as it was, had a positive effect on saving lives.  But as noted before, it was flawed, with a number of loopholes which meant that the “ban” was far from a true ban.  Some of these might have been oversights, or issues only learned with experience, but I suspect most reflected compromises that were necessary to get anything approved by Congress.  That will certainly remain an issue.

But if one were to draft a law addressing these issues, what are some of the measures one would include?  I will make a few suggestions here, but this list should not be viewed as anything close to comprehensive:

a)  First, there should not be a 10-year (or any period) sunset provision.  A future Congress could amend the law, or even revoke it, as with any legislation, but this would then require specific action by that future Congress.  But with a sunset provision, it is easy simply to do nothing, as the Republican-controlled Congress did in 2004.

b)  Second, with hindsight one can see that the 1994 law made a mistake by defining precisely what was considered a “semiautomatic” weapon.  This made it possible for manufacturers later to make what were essentially cosmetic changes to the weapons, and then make and sell them.  Rather, a semiautomatic weapon should be defined in any such law by its essential feature, which is that one can fire such a weapon repeatedly simply by pulling the trigger once for each shot, with the weapon loading itself.

c)  Third, fully automatic weapons (those which fire continuously as long as the trigger is pulled) have been banned since 1986 (if manufactured after May 19, 1986, the day President Reagan signed this into law).  But “bump stocks” have not been banned.  Bump stocks are devices that effectively convert a semiautomatic weapon into a fully automatic one.  Following the horrific shooting in Las Vegas on October 1, 2017, in which 58 were killed and 546 injured, and where the shooter used a bump stock to convert his semiautomatic rifles (he had many) into what were effectively fully automatic weapons, there have been calls for bump stocks to be banned.  This should be done, and indeed it is now being recognized that a change in existing law is not even necessary.  Attorney General Jeff Sessions said on February 27 that the Department of Justice is re-examining the issue, and implied that there would “soon” be an announcement by the department of regulations that recognize that a semiautomatic weapon equipped with a bump stock meets the definition of a fully automatic weapon.

d)  Fourth, a major problem with the 1994 Assault Weapons Ban, as drafted, was it only banned the sale of newly manufactured (or imported) semiautomatic weapons from the date the act was signed into law – September 13, 1994.  Manufacturers and shops could sell legally any such weapons produced before then.  Not surprisingly, manufacturers ramped up production (and imports) sharply in the months the Act was being debated in Congress, which provided then an ample supply for a substantial period after the law technically went into effect.

But one could set an earlier date of effectiveness, with the ban covering weapons manufactured or imported from that earlier date.  This is commonly done in tax law.  That is, tax laws being debated during some year will often be made effective for transactions starting from the beginning of the year, or from when the new laws were first proposed, so as not to induce negative actions designed to circumvent the purpose of the new law.

e)  Fifth, the 1994 Assault Weapons Ban allowed the sale to the public of any weapons legally owned before the law went into effect on September 13, 1994 (including all those in inventory).  This is related to, but different from, the issue discussed immediately above.  The issue here is that all such weapons, including those manufactured many years before, could then be sold and resold for as long as those weapons existed.  This could continue for decades.  And with millions of such weapons now in the US, it would be many decades before the supply of such weapons would be effectively reduced.

To accelerate this, one could instead create a government-funded program to purchase (and then destroy) any such weapons that the seller wished to dispose of.  And one would couple this with a ban on the sale of any such weapons to anyone other than the government.  There could be no valid legal objection to this as any sales would be voluntary (although I have no doubt the NRA would object), and would be consistent with the ban on the sale of any newly manufactured semiautomatic weapon.  One would also couple this with the government buying the weapons at a generous price – say the original price paid for the weapon (or the list price it then had), without any reduction for depreciation.

Semiautomatic weapons are expensive.  An assault rifle such as the AR-15 can easily cost $1,000.  And one would expect that as those with such weapons in their households grow older and more mature over time, many will recognize that such a weapon does not provide security.  Rather, numerous studies have shown (see, for example, here, here, here, and here) that those most likely to be harmed by weapons in a household are either the owners themselves or their loved ones.  As the gun owners mature, many are likely to see the danger in keeping such weapons at home, and the attractiveness of disposing of them legally at a good price.  Over time, this could lead to a substantial reduction in the type of weapons which have been used in so many of the mass shootings.

F.  Conclusion

Semiautomatic weapons are of no use in a civilian setting other than to massacre innocent people.  They are of no use in self-defense:  One does not walk down the street, or while shopping in the aisles of a Walmart or a Safeway, with an AR-15 strapped to your back.  One does not open the front door to your house each time the doorbell rings aiming an AR-15 at whoever is there.  Nor are such weapons of any use in hunting.  First, they are not terribly accurate.  And second, if one succeeded in hitting the animal with multiple shots, all one would have is a bloody mess.

Such weapons are used in the military precisely because they are good at killing people.  But for precisely the same reason as fully automatic weapons have been banned since 1986 (and tightly regulated since 1934), semiautomatic weapons should be similarly banned.

The 1994 Assault Weapons Ban sought to do this.  However, it was allowed to expire in 2004.  It also had numerous loopholes which lessened the effectiveness it could have had.  Despite this, the number of those killed and injured in mass shootings fell back substantially while that law was in effect, and then jumped after it expired.  And the number of mass shooting events per year leveled off or fell while it was in effect (depending on the period it is being compared to), and then also jumped once it expired.

There are, however, a number of ways a new law banning such weapons could be written to close off those loopholes.  A partial list is discussed above.  I fully recognize, however, that the likelihood of such a law passing in the current political environment, where Republicans control both the Senate and the House as well as the presidency, are close to nil.  One can hope that at some point in the future the political environment will change to the point where an effective ban on semiautomatic weapons can be passed.  After all, President Reagan, the hero of Republican conservatives, did sign into law the 1986 act that banned fully automatic weapons.  Sadly, I expect many more school children will die from such shootings before this will happen.

What a Real Tax Reform Could Look Like – III: A Carbon Tax to Address Climate Change

Source:  James Hansen, Global Temperatures, update of December 18, 2017

 

A.  Introduction

The final element of a comprehensive tax reform would be a tax to address climate change.  Previous posts have looked at what a true reform of corporate and individual income taxes could look like, plus what could be done to ensure Social Security benefits can continue to be paid in accord with current formulae, and indeed enhanced.  This post will look at a tax on greenhouse gas emissions (commonly called a carbon tax, as carbon dioxide is the primary contributor) to address global warming.

There is no doubt the planet is warming –  the chart above shows the most recent estimates.  And this is primarily due to our economies pouring into the air carbon dioxide and certain other gases (such as methane) that lead to heat being retained by the atmosphere.  These greenhouse gases have warmed the planet, leading to an increased frequency of extreme weather events such as the series of remarkably intense hurricanes that hit the US this August and September.  The cost, already being incurred, has been staggering.  Early estimates of the cost of just Hurricanes Harvey (which hit Texas) and Irma (which hit Florida) reach $290 billion.  Hurricane Maria (which hit Puerto Rico) may have cost Puerto Rico as much as $95 billion according to an early estimate (and this excludes the cost to other Caribbean nations it hit).

As I am writing this (January 3, 2018), record-breaking cold has swept over much of the eastern half of the US.  And it is forecast to get worse over the next few days.  Trump has, not surprisingly, tweeted that this cold shows that global warming is not true.  But this illustrates well his ignorance.  First, there is more to the world than the eastern US.  There is also today unseasonably warm weather in the western US (especially Alaska, relative to what is normal there), as well as in Europe, Russia, and especially Siberia.  Overall, the average global surface temperature today is 0.5 degrees Celsius above the 1979 to 2000 average for this time of year, and 0.9 degrees Celsius above that average in the Northern Hemisphere.  But second, that blast of cold hitting the eastern US should not be taken as a surprising outcome of global warming.  Warming leads to greater volatility in atmospheric currents, including in the jet streams that allow (or block) cold air to come down from the Arctic.

One cannot, of course, attribute with certainty any particular severe weather event (whether hurricanes, extreme hot or cold temperatures, drought or floods, and more) to climate change.  We had severe weather events before global warming became significant.  But the same is true of lung cancer and smoking:  One cannot attribute any individual’s death from lung cancer to his or her smoking.  People died of lung cancer before smoking became common.  The issue, rather, is that smoking increases the likelihood of getting lung cancer.  Similarly, global warming increases the likelihood and hence frequency of severe weather events.

And that is precisely what we have seen.  Severe weather events have increased in number in recent years as the planet has warmed and as climate change models have predicted.  A database maintained by the National Oceanic and Atmospheric Administration (NOAA, the home of the National Weather Service) has kept track since 1980 of the number of weather and climate disasters in the US which each cost $1 billion or more (in 2017 prices).  Over that close to 37 year period the 7 worst years (in terms of the number of such disasters) have all come in the last 10 years (including 2017, which as of end September already had tied the worst full year so far, and will exceed it once fourth quarter data is included).

Global warming, arising from man-made emissions of carbon dioxide (CO2), methane (natural gas), and certain other gases (together, greenhouse gases or GHGs, for the greenhouse effect they cause), is thus imposing a huge cost already on society, and one which will get worse as the planet warms further.  It is thus a mark of confusion to say, as Trump and many Republican politicians have, that we cannot “afford” to address the causes of the warming planet.  We are already bearing the costs, and those costs will get far worse if nothing is done.  The question is whether steps will be taken to reduce those costs by addressing the underlying causes.

The issue is that the costs such GHG emissions cause are not being borne by those who emit those gases.  The emitters of GHGs are in effect being subsidized, and encouraged to burn fossil fuels rather than make use of a cleaner alternative.  And when a producer is not bearing the full cost of what he is producing, it will be badly done.  The key is to charge a tax or fee on such production equal to the cost being imposed on others, so that the producer faces the full cost of what he is making.  The producer will then have a reason to make suitable choices on how the product can be made at the least cost to all.  And consumers, facing the full costs of what they are buying, can then make suitable choices on whether to buy one product or another.

A suitable tax on greenhouse gas emissions would bring prices in line with the total costs being incurred.  A comprehensive tax reform should include this.  And it would be straightforward to implement.  There is indeed a well worked out plan being promoted by a group of traditional Republican conservatives, the Climate Leadership Council, with the active involvement and endorsements of several Treasury Secretaries in past Republican administrations (Hank Paulson, James Baker, and George Schultz); as well as of individuals such as Michael Bloomberg and liberal and conservative economists such as Larry Summers, Martin Feldstein, and Gregory Mankiw; companies such as ExxonMobil, General Motors, and Shell; and environmental organizations such as The Nature Conservancy and Conservation International.

It is a good plan, and I would suggest basically just copying it.  The proposal will be explained below.  A one-page summary of the Climate Leadership Council’s specific proposal is available here, while a more complete description is available here.  A very similar proposal has also been assessed by the US Treasury, with a brief summary of the Treasury analysis available on the Climate Leadership Council website here, while the complete Treasury analysis is available here on the Treasury website (assuming the Trump administration has not taken it down).  The Treasury assessment is excellent, as it reviews precisely how one could implement such a tax, including the practicalities, and arrives at specific quantitative estimates of the impact on different income groups.  The analysis below will basically follow the variant of the plan as assessed by the Treasury.

This post will first provide a description of that plan, how it could be implemented, and what the impact on prices might be.  Importantly, clean alternatives exist for many of the processes which emit GHGs, particularly from the burning of fossil fuels, which thus can be substituted for processes emitting those gases.  This would limit the price impact and smooth the way to sharp reductions in GHG emissions.  Furthermore, a key feature of this plan is that the revenues that would be collected by the carbon tax would all be rebated to the American population.  The final section will discuss this and the distributional implications.  The plan would be revenue neutral – the aim is to change prices so that they fully reflect the costs being incurred, not to raise revenues.  And the rebates would be distributionally positive, with the bottom seven deciles of the population (the bottom 70%) coming out ahead after the rebates.  Only the top three deciles (top 30%) would see a net loss, as a direct consequence of their disproportionate share in consumption of goods that cause the GHG emissions in the first place.

B.  A Carbon Tax to Address Climate Change

In brief, under this proposal a tax would be charged for each unit of GHG pollution emitted.  The Climate Leadership Council would set the tax to start at $40 per ton of CO2, with the taxes on other GHGs set in proportion based on their global warming impact per ton relative to that of CO2.  This is often called simply a carbon tax, although it is in fact a tax on CO2 (carbon dioxide) emissions and on other GHGs in proportion to their global warming impact.  The tax would then rise in real terms over time.  The start date would presumably have been 2018, although this was not explicit (the proposal came out in early 2017).  The Treasury variant examined a price of $49 per ton of CO2-equivalent starting in 2019 (with some phasing in of the goods to which it would apply until 2021), and then increasing at a rate of 2% a year in real terms from 2019.

Importantly, all revenues collected would be returned directly to the American population.  The impact on the federal budget thus would be revenue neutral.  There would also be border adjustments for imports and exports (discussed below).  The Treasury estimates that at $49 per ton, the carbon tax would lead to a rebate in the first year (2019) of $583 per person, or $2,332 for a family of four.  Scaling this in proportion, a $40 per ton carbon tax would lead to a rebate of $476 per person, or $1,904 for a family of four.  And the tax would be highly progressive.  The Treasury estimated that there would on average be net income gains for the bottom 70% of the population.  That is, their rebates would be greater than the higher amounts they would need to spend on goods and services to reflect the cost of the carbon tax.

In more detail, under this plan a price (whether $40 or $49 to start) would be charged which reflects the cost to society of the GHGs being emitted as part of the production process for the good or service being produced.  This is called the “social cost of carbon”, and while the concept is clear, it is difficult in practice to estimate precisely.  Its value will depend on factors which are difficult to know at this point in time, including the full cost to our economies (starting now and extending many decades into the future) as a consequence of climate change, the cost of technologies to limit GHG emissions (again starting now, and then for decades into the future), and the appropriate values for parameters such as the proper discount rate to use to put the costs and benefits over this range of time all into the prices of today.  A fundamental difficulty of GHG emissions is that their impact is not just in the near term, but can extend for centuries.  They remain in the atmosphere for a very long time.

Thus while starting at a reasonable cost of carbon (whether $40 or $49) is important, probably more important is how this price should be adjusted over time to reflect actual experience.  Some predictability in the path is also valuable, so firms can make their investment decisions accordingly.  Thus the Climate Leadership Council plan would have the price rise in real terms over time at some unspecified pace, while the Treasury assessment assumed concretely a rise of 2% a year in real terms.  Such a 2% real increase is reasonable.

One should, however, also recognize the inherent uncertainty, as the proper price on carbon is difficult to know before we have any experience with such a plan.  Thus one should allow for reassessment and adjustment, perhaps every five years or so, with the pace of price adjustment increased or decreased depending on the observed response.  The pace would be raised if we find that GHG emissions are not falling at the pace needed, or reduced if we find GHGs are falling at a more rapid pace than anticipated and needed.  Past experience with market mechanisms to reduce pollution (in particular the use of trading schemes to reduce sulfur dioxide and nitrogen oxides pollution) worked surprisingly well, with costs well below what had been anticipated and what would have been incurred through traditional regulatory regimes.  The same would be likely, in my view, if we would start to price GHG emissions.

Pricing GHG emissions is also relatively straightforward administratively for the bulk of GHG sources.  Fully 76% of GHG emissions in the US come from the burning of fossil fuels.  This rises to 83% if one adds in the emission of GHGs in the production of the fossil fuels themselves (at the mine or well-head) plus from the non-energy use of fossil fuels.  The carbon tax thus could be applied at the level of the limited number of power plants that still burn coal; at the level of petroleum refineries where substantially all crude oil must be processed; and at the level of gas pipelines as substantially all natural gas is transported via pipelines.  A limited number of industrial plants then account for a significant share of the remainder.  These include from the use of coking coals in the production of iron and steel; from the production of petrochemicals such as plastics; and GHGs resulting from the production of cement, glass, limestone, and similar products.  For these, it would be straightforward to apply a carbon tax at the factory or plant level.  There would remain GHG emissions from a range of resources, including in particular in agriculture (accounting for about 8% of GHG emissions in the US), and the Treasury analysis assumes the carbon tax would not apply to those sources.  But they are a small share of the total, and an issue one could address in the future.

A key part of the plan is that there would also be a border tax adjustment, where exports would receive a rebate for the carbon taxes paid on their production, while imports would be charged a carbon tax based on the GHGs emitted in their production.  The rebate for exports means that US production would not be disadvantaged by being located here, and there would be no incentive from this source to move such plants abroad.  This addresses the Trump criticism (and confusion) that such carbon taxes will make US industry uncompetitive.  And imports would be charged a carbon tax based on their GHG emissions to the extent such imports do not already reflect such charges (which would likely be the case, as they too would likely be given rebates in their home countries on carbon taxes paid, just as US exports would be).

A feature of this border tax adjustment is that revenues for the US would be generated (and rebated to the US population) in the case where other countries are not themselves charging a carbon tax (or the equivalent, such as in a cap and trade system), but also (given the US trade structure) even when they are.  In the first case, where other countries are not at first themselves charging such a tax, imposing the carbon tax on such imports will generate revenues which would be distributed to the US population.  This would provide a strong incentive for those other countries to join the US and start to charge a similar carbon tax.  And such a border adjustment for the carbon tax would be compliant with WTO rules on trade, as the tax would simply be ensuring that imported goods are being taxed the same as their domestic equivalents are (just as is true for a value-added tax).  This is not discrimination against imports, but rather equal treatment.

In the second case, where trading partners are themselves all charging a similar carbon tax (let’s assume), the US would still come out ahead in carbon tax revenues due to our trade structure.  US imports of goods are about 50% higher than its exports of goods, and it is primarily in the production of goods that GHGs are emitted.  Partially offsetting this in the overall trade balance, US exports of services are about 50% higher than its imports of services.  But services are a smaller share of trade, plus services are not as intensive as goods in the GHGs emitted.  Overall, the US has a current account deficit (more imports of goods and services than exports), matched by capital inflows being invested in the US.  With such a trade structure, the carbon taxes charged on imports will substantially exceed whatever is rebated on exports.  The US population would come out ahead.  Put another way, producers of goods being sold in the US are currently being provided a subsidy by not charging them for the cost we are incurring due to the greenhouse gases being emitted in their production.  Given the US trade structure, a substantial share of this subsidy is going to foreign producers.  A tax on such GHG emissions is simply the removal of this subsidy.

C.  Price Impacts, and the Viability of Clean Alternatives

Applying the carbon tax will lead producers to raise their prices if they do not otherwise adjust their processes.  For transportation fuels, for example, the Treasury analysis estimated that at $49 per ton of CO2 (and its equivalent for other GHGs), the tax would equal 44 cents per gallon for gasoline, or 50 cents per gallon for diesel fuel.  While significant, such increases are not huge.  There have been far greater fluctuations in such fuel prices in recent years in response to the price of crude oil rising or falling, and consumers and the economy have been able to accommodate such changes.

More broadly, and expressed in terms of percentage increases, the Treasury analysts estimated that if the cost increases from the carbon tax were all fully passed along, the price of gasoline would rise by 11.8%, home heating oil by 12.4%, and air transportation by 7.5%.  The price of natural gas would go up by 27.0% and the price of electricity by 16.9%, but note these are the prices of just the energy alone.  The delivered price to our homes also includes distribution and other charges.  For natural gas, for example, the energy component of my bill (in Washington, DC) was just 44% of my total bill over the last 12 months, so a 27% increase in the wholesale cost of natural gas would mean a 15% increase in my overall bill for gas.  There would be no reason for distribution and other such charges to go up by any significant amount, as their costs depend on the volume delivered and not on the wholesale cost of the gas being delivered (and similarly for electricity).  Overall, the Treasury analysis forecasts that prices in general would go up by 2.6% if the new carbon tax (at $49 per ton of CO2) were fully passed forward.

But the higher costs would provide incentives both to producers to change how they make things, and to consumers to take into account the total costs in their decisions on what to buy.  One would see this most importantly (given its share as a source of GHG emissions) in how electricity is produced.  Generating electricity by the burning of fossil fuels is now heavily subsidized, in effect, as nothing is charged for the cost of the damage done (hurricanes and other severe weather events, and more) by the resulting GHG emissions.  But even with such subsidies going to those who burn fossil fuels, solar and wind produced power is now competitive (even without the subsidies going to solar and wind – see below) for newly built power plants, and indeed has been for some years.  See the careful analysis of the relative costs that is undertaken annually by Lazard (see here for their November 2017 report).  Indeed, Lazard found in its 2017 analysis that at current costs, utility-scale solar and wind generation is now often cheaper than just the operating costs of coal or nuclear plants, thus encouraging such substitution even when the capital costs of coal and nuclear plants are treated as a sunk cost.

Furthermore, solar and wind technology is still developing, with costs falling rapidly, while at this point the further reduction in costs in traditional power generation is slow.  Lazard estimates the levelized cost of energy production at a new installation (in terms of dollars of overall costs, including capital costs, per megawatt hour of electricity generated, and excluding explicit subsidies on renewables) fell by 72% between 2009 and 2017 for utility-scale solar installations and by 47% for wind generation (to prices of $50 and $45 per megawatt hour, for solar and wind respectively; this is equivalent to 5 cents and 4.5 cents per kilowatt hour).  In contrast, the cost for power generated by coal fell by just 8% over this period (to $102 per megawatt hour) and by 28% for natural gas (to $60).  And the full levelized cost for nuclear power generation actually rose by 20% over the period (to $148).

There is, of course, wide variability in the cost of solar and wind across the country, depending on local conditions.  Existing coal and nuclear plants are also of various ages and efficiencies, and hence also of varying costs.  Thus overall averages tell only part of the story.  The cost competitiveness (on average) of new installations does not mean that all new installations will be solar or wind, much less that all generation would or could shift immediately.  But the now competitive costs have led to a bit over 50% of all new generation capacity built in the US over the last 10 years (2007 to 2016) to come from installations of solar, wind, or other renewables (with most of the solar coming only in the second half of that period).

No transition will be instantaneous, but should a significant carbon tax be imposed (of $40 or $49, for example), one should see an acceleration in the pace of such substitution of renewables for fossil fuels.  And with such substitution, the impact on higher power prices will be limited in time, and should soon decline.

The other major user of fossil fuels is transportation, and here one sees a similar dynamic.  Electric battery powered cars are now either competitive in cost or close to it (depending on how one values other attributes, such as better performance and inherently easier maintenance), and a carbon tax will accelerate the transition to such vehicles.  And battery-powered vehicles are not just limited to cars.  Tesla has announced plans to produce heavy trucks powered by batteries, with a range of up to 500 miles on a charge.  Costs would be more than competitive with traditional fueled heavy trucks, and a substantial number of pre-orders have indeed already come in from owners of large trucking fleets.  There is an interest at least in trying this.  And with battery-powered heavy trucks possible, the same is true for full-size buses.

Again, starting to charge for the costs borne by society from the CO2 and other GHGs emitted in transportation would accelerate the shift to less polluting vehicles.  It won’t happen overnight.  But that shift will limit the extent and duration of higher costs stemming from charging a carbon tax.

And while such a tax alone will not lead to zero GHG emissions with current technologies available, it would be a giant step in that direction.  It would also provide a strong incentive to develop the technologies that would carry this further and at a lower cost.

D.  Distributional Implications

Finally and importantly, the funds collected by the carbon tax would be fully rebated to all Americans, with the same amount rebated per person.  The Treasury analysis estimated that at $49 per ton of CO2 in 2019, the carbon tax would collect funds sufficient to provide a rebate of $583 per person (for the year), or $2,332 for a family of four.  The rebate could be provided annually or quarterly, or even monthly, and through the IRS or Social Security.

The rebates would also be distributionally positive.  The poor would indeed benefit on a net basis.  Being poor, they do not consume that much, and thus do not account for a high share of GHG emissions.  The rich, in contrast, not only consume more (they are rich, and can afford more), but the products they buy are also more polluting in greenhouse gases (big gas-guzzling cars rather than small fuel-efficient ones; jet travel for vacations but not public transit; large homes kept heated and air-conditioned rather than smaller homes and apartments; etc.).  Thus the rich will receive back less than what is paid in carbon taxes on the goods they consume, while the poor will receive back more.  Furthermore, because the poor are poor, a given dollar amount rebated to them will be a higher percentage of their (low) incomes, than the same dollar amount would be (in percentage terms) for the rich.

The impacts are significant.  The Treasury analysis (based on data they use for their tax simulation models) concluded that the impacts by family income decile would be:

Net Impact on Income from $49 per ton Carbon Tax, with $583 per Person Rebate, by Family Decile

Decile

% of Income

0 to 10

+8.9%

10 to 20

+4.7%

20 to 30

+3.1%

30 to 40

+2.0%

40 to 50

+1.2%

50 to 60

+0.6%

60 to 70

+0.1%

70 to 80

-0.3%

80 to 90

-0.7%

90 to 100

-1.0%

Families are ranked here by income decile, so the first decile (0 to 10%) is made up of the 10% of families (in number) who have the lowest incomes, the second decile (10 to 20%) is made up of the 10% of families with the next lowest incomes, and so on, up to the richest 10% of families (90 to 100%).

The results indicate that on a net basis (i.e. after taking account of the higher prices that would be paid on goods purchased, reflecting the carbon tax at $49 per ton), the lowest income decile families would see an increase in their real incomes of 8.9% following the $583 per person rebate.  This is quite substantial.  And the analysis found there would be a similar, positive, gain for all families up through the 7th decile, although at diminishing shares of their income.  The top 3 deciles would end up paying more on a net basis, due to their greater purchases of goods where greenhouse gases are emitted (both in total amount and in the mix of their goods).  But the net cost reaches just 1% of incomes for the richest decile.  It is only a small share in part because their incomes are of course the highest.  This tax is not unaffordable.

E.  Conclusion

To conclude, imposing a carbon tax is administratively practical, would bring prices and costs in line with the costs being borne by society when greenhouse gases are emitted, and even with current technologies would lead to a significant shift away from processes that are warming our planet.  It is a fundamental confusion to assert, as Trump and others have done, that “we cannot afford it”.  That is nonsense:  We are paying the costs already (in an increased frequency of severe weather events, in droughts in some areas and floods in others, and other such impacts), and they will get far worse if nothing is done.  Furthermore, such a carbon tax would not reduce our competitiveness when applied equally to imported items (and rebated for exports).  Indeed, with our current trade structure, the US would come out ahead financially by starting to charge for GHG emissions.

Such a tax also would be distributionally highly progressive, as the poor would come well ahead on a net basis with the revenues collected being rebated back to the population.  Indeed, it is estimated that the bottom 70% of the population would come out ahead on a net basis.  And while the rich would end up paying more, reflecting their greater consumption and the GHG intensity of the goods they buy, this would come just to 1% of the incomes of the richest 10% of the population.

Such a tax on GHG emissions would be the final component of what a comprehensive tax reform really should have looked like.  As discussed in the preceding posts on this blog, there should have been a reform to simplify corporate and individual income taxes (with all sources of income taxed similarly), plus action taken on Social Security taxes to ensure the system will be sustained for the foreseeable future.  None of this was done.  Nor was any action taken to address climate change, where the subsidy we are implicitly providing fossil fuels and other sources of greenhouse gas emissions (by not charging for the damage being done as a result of those emissions) could have been addressed by a tax on such emissions.

This is not surprising, unfortunately.  There are important vested interests in the fossil fuel industries (coal, oil, and gas) that benefit from not being charged for the damage their fuels are causing.  As a rationalization of this, Trump and much of the Republican Party continue to deny that climate change even exists.  But the result will be that the damage being done, already large, will grow over time.  Plus, once the doubters do finally recognize it, the actions that will then need to be taken will be more costly and disruptive than if action were taken now.

As discussed above, there is no practical or special administrative difficulty to addressing the climate change problem now.  It would be straightforward to implement a tax on GHG emissions.  And the sooner this is done, the better.