Andrew Yang’s Proposed $1,000 per Month Grant: Issues Raised in the Democratic Debate

A.  Introduction

This is the second in a series of posts on this blog addressing issues that have come up during the campaign of the candidates for the Democratic nomination for president, and which specifically came up in the October 15 Democratic debate.  As flagged in the previous blog post, one can find a transcript of the debate at the Washington Post website, and a video of the debate at the CNN website.

This post will address Andrew Yang’s proposal of a $1,000 per month grant for every adult American (which I will mostly refer to here as a $12,000 grant per year).  This policy is called a universal basic income (or UBI), and has been explored in a few other countries as well.  It has received increased attention in recent years, in part due to the sharp growth in income inequality in the US of recent decades, that began around 1980.  If properly designed, such a $12,000 grant per adult per year could mark a substantial redistribution of income.  But the degree of redistribution depends directly on how the funding would be raised.  As we will discuss below, Yang’s specific proposals for that are problematic.  There are also other issues with such a program which, even if well designed, calls into question whether it would be the best approach to addressing inequality.  All this will be discussed below.

First, however, it is useful to address two misconceptions that appear to be widespread.  One is that many appear to believe that the $12,000 per adult per year would not need to come from somewhere.  That is, everyone would receive it, but no one would have to provide the funds to pay for it.  That is not possible.  The economy produces so much, whatever is produced accrues as incomes to someone, and if one is to transfer some amount ($12,000 here) to each adult then the amounts so transferred will need to come from somewhere.  That is, this is a redistribution.  There is nothing wrong with a redistribution, if well designed, but it is not a magical creation of something out of nothing.

The other misconception, and asserted by Yang as the primary rationale for such a $12,000 per year grant, is that a “Fourth Industrial Revolution” is now underway which will lead to widespread structural unemployment due to automation.  This issue was addressed in the previous post on this blog, where I noted that the forecast job losses due to automation in the coming years are not out of line with what has been the norm in the US for at least the last 150 years.  There has always been job disruption and turnover, and while assistance should certainly be provided to workers whose jobs will be affected, what is expected in the years going forward is similar to what we have had in the past.

It is also a good thing that workers should not be expected to rely on a $12,000 per year grant to make up for a lost job.  Median earnings of a full-time worker was an estimated $50,653 in 2018, according to the Census Bureau.  A grant of $12,000 would not go far in making up for this.

So the issue is one of redistribution, and to be fair to Yang, I should note that he posts on his campaign website a fair amount of detail on how the program would be paid for.  I make use of that information below.  But the numbers do not really add up, and for a candidate who champions math (something I admire), this is disappointing.

B.  Yang’s Proposal of a $1,000 Monthly Grant to All Americans

First of all, the overall cost.  This is easy to calculate, although not much discussed.  The $12,000 per year grant would go to every adult American, who Yang defines as all those over the age of 18.  There were very close to 250 million Americans over the age of 18 in 2018, so at $12,000 per adult the cost would be $3.0 trillion.

This is far from a small amount.  With GDP of approximately $20 trillion in 2018 ($20.58 trillion to be more precise), such a program would come to 15% of GDP.  That is huge.  Total taxes and revenues received by the federal government (including all income taxes, all taxes for Social Security and Medicare, and everything else) only came to $3.3 trillion in FY2018.  This is only 10% more than the $3.0 trillion that would have been required for Yang’s $12,000 per adult grants.  Or put another way, taxes and other government revenues would need almost to be doubled (raised by 91%) to cover the cost of the program.  As another comparison, the cost of the tax cuts that Trump and the Republican leadership rushed through Congress in December 2017 was forecast to be an estimated $150 billion per year.  That was a big revenue loss.  But the Yang proposal would cost 20 times as much.

With such amounts to be raised, Yang proposes on his campaign website a number of taxes and other measures to fund the program.  One is a value-added tax (VAT), and from his very brief statements during the debates but also in interviews with the media, one gets the impression that all of the program would be funded by a value-added tax.  But that is not the case.  He in fact says on his campaign website that the VAT, at the rate and coverage he would set, would raise only about $800 billion.  This would come only to a bit over a quarter (27%) of the $3.0 trillion needed.  There is a need for much more besides, and to his credit, he presents plans for most (although not all) of this.

So what does he propose specifically?:

a) A New Value-Added Tax:

First, and as much noted, he is proposing that the US institute a VAT at a rate of 10%.  He estimates it would raise approximately $800 billion a year, and for the parameters for the tax that he sets, that is a reasonable estimate.  A VAT is common in most of the rest of the world as it is a tax that is relatively easy to collect, with internal checks that make underreporting difficult.  It is in essence a tax on consumption, similar to a sales tax but levied only on the added value at each stage in the production chain.  Yang notes that a 10% rate would be approximately half of the rates found in Europe (which is more or less correct – the rates in Europe in fact vary by country and are between 17 and 27% in the EU countries, but the rates for most of the larger economies are in the 19 to 22% range).

A VAT is a tax on what households consume, and for that reason a regressive tax.  The poor and middle classes who have to spend all or most of their current incomes to meet their family needs will pay a higher share of their incomes under such a tax than higher-income households will.  For this reason, VAT systems as implemented will often exempt (or tax at a reduced rate) certain basic goods such as foodstuffs and other necessities, as such goods account for a particularly high share of the expenditures of the poor and middle classes.  Yang is proposing this as well.  But even with such exemptions (or lower VAT rates), a VAT tax is still normally regressive, just less so.

Furthermore, households will in the end be paying the tax, as prices will rise to reflect the new tax.  Yang asserts that some of the cost of the VAT will be shifted to businesses, who would not be able, he says, to pass along the full cost of the tax.  But this is not correct.  In the case where the VAT applies equally to all goods, the full 10% will be passed along as all goods are affected equally by the now higher cost, and relative prices will not change.  To the extent that certain goods (such as foodstuffs and other necessities) are exempted, there could be some shift in demand to such goods, but the degree will depend on the extent to which they are substitutable for the goods which are taxed.  If they really are necessities, such substitution is likely to be limited.

A VAT as Yang proposes thus would raise a substantial amount of revenues, and the $800 billion figure is a reasonable estimate.  This total would be on the order of half of all that is now raised by individual income taxes in the US (which was $1,684 billion in FY2018).  But one cannot avoid that such a tax is paid by households, who will face higher prices on what they purchase, and the tax will almost certainly be regressive, impacting the poor and middle classes the most (with the extent dependent on how many and which goods are designated as subject to a reduced VAT rate, or no VAT at all).  But whether regressive or not, everyone will be affected and hence no one will actually see a net increase of $12,000 in purchasing power from the proposed grant  Rather, it will be something less.

b)  A Requirement to Choose Either the $12,000 Grants, or Participation in Existing Government Social Programs

Second, Yang’s proposal would require that households who currently benefit from government social programs, such as for welfare or food stamps, would be required to give up those benefits if they choose to receive the $12,000 per adult per year.  He says this will lead to reduced government spending on such social programs of $500 to $600 billion a year.

There are two big problems with this.  The first is that those programs are not that large.  While it is not fully clear how expansive Yang’s list is of the programs which would then be denied to recipients of the $12,000 grants, even if one included all those included in what the Congressional Budget Office defines as “Income Security” (“unemployment compensation, Supplemental Security Income, the refundable portion of the earned income and child tax credits, the Supplemental Nutrition Assistance Program [food stamps], family support, child nutrition, and foster care”), the total spent in FY2018 was only $285 billion.  You cannot save $500 to $600 billion if you are only spending $285 billion.

Second, such a policy would be regressive in the extreme.  Poor and near-poor households, and only such households, would be forced to choose whether to continue to receive benefits under such existing programs, or receive the $12,000 per adult grant per year.  If they are now receiving $12,000 or more in such programs per adult household member, they would receive no benefit at all from what is being called a “universal” basic income grant.  To the extent they are now receiving less than $12,000 from such programs (per adult), they may gain some benefit, but less than $12,000 worth.  For example, if they are now receiving $10,000 in benefits (per adult) from current programs, their net gain would be just $2,000 (setting aside for the moment the higher prices they would also now need to pay due to the 10% VAT).  Furthermore, only the poor and near-poor who are being supported by such government programs will see such an effective reduction in their $12,000 grants.  The rich and others, who benefit from other government programs, will not see such a cut in the programs or tax subsidies that benefit them.

c)  Savings in Other Government Programs 

Third, Yang argues that with his universal basic income grant, there would be a reduction in government spending of $100 to $200 billion a year from lower expenditures on “health care, incarceration, homelessness services and the like”, as “people would be able to take better care of themselves”.  This is clearly more speculative.  There might be some such benefits, and hopefully would be, but without experience to draw on it is impossible to say how important this would be and whether any such savings would add up to such a figure.  Furthermore, much of those savings, were they to follow, would accrue not to the federal government but rather to state and local governments.  It is at the state and local level where most expenditures on incarceration and homelessness, and to a lesser degree on health care, take place.  They would not accrue to the federal budget.

d)  Increased Tax Revenues From a Larger Economy

Fourth, Yang states that with the $12,000 grants the economy would grow larger – by 12.5% he says (or $2.5 trillion in increased GDP).  He cites a 2017 study produced by scholars at the Roosevelt Institute, a left-leaning non-profit think tank based in New York, which examined the impact on the overall economy, under several scenarios, of precisely such a $12,000 annual grant per adult.

There are, however, several problems:

i)  First, under the specific scenario that is closest to the Yang proposal (where the grants would be funded through a combination of taxes and other actions), the impact on the overall economy forecast in the Roosevelt Institute study would be either zero (when net distribution effects are neutral), or small (up to 2.6%, if funded through a highly progressive set of taxes).

ii)  The reason for this result is that the model used by the Roosevelt Institute researchers assumes that the economy is far from full employment, and that economic output is then entirely driven by aggregate demand.  Thus with a new program such as the $12,000 grants, which is fully paid for by taxes or other measures, there is no impact on aggregate demand (and hence no impact on economic output) when net distributional effects are assumed to be neutral.  If funded in a way that is not distributionally neutral, such as through the use of highly progressive taxes, then there can be some effect, but it would be small.

In the Roosevelt Institute model, there is only a substantial expansion of the economy (of about 12.5%) in a scenario where the new $12,000 grants are not funded at all, but rather purely and entirely added to the fiscal deficit and then borrowed.  And with the current fiscal deficit now about 5% of GDP under Trump (unprecedented even at 5% in a time of full employment, other than during World War II), and the $12,000 grants coming to $3.0 trillion or 15% of GDP, this would bring the overall deficit to 20% of GDP!

Few economists would accept that such a scenario is anywhere close to plausible.  First of all, the current unemployment rate of 3.5% is at a 50 year low.  The economy is at full employment.  The Roosevelt Institute researchers are asserting that this is fictitious, and that the economy could expand by a substantial amount (12.5% in their scenario) if the government simply spent more and did not raise taxes to cover any share of the cost.  They also assume that a fiscal deficit of 20% of GDP would not have any consequences, such as on interest rates.  Note also an implication of their approach is that the government spending could be on anything, including, for example, the military.  They are using a purely demand-led model.

iii)  Finally, even if one assumes the economy will grow to be 12.5% larger as a result of the grants, even the Roosevelt Institute researchers do not assume it will be instantaneous.  Rather, in their model the economy becomes 12.5% larger only after eight years.  Yang is implicitly assuming it will be immediate.

There are therefore several problems in the interpretation and use of the Roosevelt Institute study.  Their scenario for 12.5% growth is not the one that follows from Yang’s proposals (which is funded, at least to a degree), nor would GDP jump immediately by such an amount.  And the Roosevelt Insitute model of the economy is one that few economists would accept as applicable in the current state of the economy, with its 3.5% unemployment.

But there is also a further problem.  Even assuming GDP rises instantly by 12.5%, leading to an increase in GDP of $2.5 trillion (from a current $20 trillion), Yang then asserts that this higher GDP will generate between $800 and $900 billion in increased federal tax revenue.  That would imply federal taxes of 32 to 36% on the extra output.  But that is implausible.  Total federal tax (and all other) revenues are only 17.5% of GDP.  While in a progressive tax system the marginal tax revenues received on an increase in income will be higher than at the average tax rate, the US system is no longer very progressive.  And the rates are far from what they would need to be twice as high at the margin (32 to 36%) as they are at the average (17.5%).  A more plausible estimate of the increased federal tax revenues from an economy that somehow became 12.5% larger would not be the $800 to $900 billion Yang calculates, but rather about half that.

Might such a universal basic income grant affect the size of the economy through other, more orthodox, channels?  That is certainly possible, although whether it would lead to a higher or to a lower GDP is not clear.  Yang argues that it would lead recipients to manage their health better, to stay in school longer, to less criminality, and to other such social benefits.  Evidence on this is highly limited, but it is in principle conceivable in a program that does properly redistribute income towards those with lower incomes (where, as discussed above, Yang’s specific program has problems).  Over fairly long periods of time (generations really) this could lead to a larger and stronger economy.

But one will also likely see effects working in the other direction.  There might be an increase in spouses (wives usually) who choose to stay home longer to raise their children, or an increase in those who decide to retire earlier than they would have before, or an increase in the average time between jobs by those who lose or quit from one job before they take another, and other such impacts.  Such impacts are not negative in themselves, if they reflect choices voluntarily made and now possible due to a $12,000 annual grant.  But they all would have the effect of reducing GDP, and hence the tax revenues that follow from some level of GDP.

There might therefore be both positive and negative impacts on GDP.  However, the impact of each is likely to be small, will mostly only develop over time, and will to some extent cancel each other out.  What is likely is that there will be little measurable change in GDP in whichever direction.

e)  Other Taxes

Fifth, Yang would institute other taxes to raise further amounts.  He does not specify precisely how much would be raised or what these would be, but provides a possible list and says they would focus on top earners and on pollution.  The list includes a financial transactions tax, ending the favorable tax treatment now given to capital gains and carried interest, removing the ceiling on wages subject to the Social Security tax, and a tax on carbon emissions (with a portion of such a tax allocated to the $12,000 grants).

What would be raised by such new or increased taxes would depend on precisely what the rates would be and what they would cover.  But the total that would be required, under the assumption that the amounts that would be raised (or saved, when existing government programs are cut) from all the measures listed above are as Yang assumes, would then be between $500 and $800 billion (as the revenues or savings from the programs listed above sum to $2.2 to $2.5 trillion).  That is, one might need from these “other taxes” as much as would be raised by the proposed new VAT.

But as noted in the discussion above, the amounts that would be raised by those measures are often likely to be well short of what Yang says will be the case.  One cannot save $500 to $600 billion in government programs for the poor and near-poor if government is spending only $285 billion on such programs, for example.  A more plausible figure for what might be raised by those proposals would be on the order of $1 trillion, mostly from the VAT, and not the $2.2 to $2.5 trillion Yang says will be the case.

C.  An Assessment

Yang provides a fair amount of detail on how he would implement a universal basic income grant of $12,000 per adult per year, and for a political campaign it is an admirable amount of detail.  But there are still, as discussed above, numerous gaps that prevent anything like a complete assessment of the program.  But a number of points are evident.

To start, the figures provided are not always plausible.  The math just does not add up, and for someone who extolls the need for good math (and rightly so), this is disappointing.  One cannot save $500 to $600 billion in programs for the poor and near-poor when only $285 billion is being spent now.  One cannot assume that the economy will jump immediately by 12.5% (which even the Roosevelt Institute model forecasts would only happen in eight years, and under a scenario that is the opposite of that of the Yang program, and in a model that few economists would take as credible in any case).  Even if the economy did jump by so much immediately, one would not see an increase of $800 to $900 billion in federal tax revenues from this but rather more like half that.  And other such issues.

But while the proposal is still not fully spelled out (in particular on which other taxes would be imposed to fill out the program), we can draw a few conclusions.  One is that the one group in society who will clearly not gain from the $12,000 grants is the poor and near-poor, who currently make use of food stamp and other such programs and decide to stay with those programs.  They would then not be eligible for the $12,000 grants.  And keep in mind that $12,000 per adult grants are not much, if you have nothing else.  One would still be below the federal poverty line if single (where the poverty line in 2019 is $12,490) or in a household with two adults and two or more children (where the poverty line, with two children, is $25,750).  On top of this, such households (like all households) will pay higher prices for at least some of what they purchase due to the new VAT.  So such households will clearly lose.

Furthermore, those poor or near-poor households who do decide to switch, thus giving up their eligibility for food stamps and other such programs, will see a net gain that is substantially less than $12,000 per adult.  The extent will depend on how much they receive now from those social programs.  Those who receive the most (up to $12,000 per adult), who are presumably also most likely to be the poorest among them, will lose the most.  This is not a structure that makes sense for a program that is purportedly designed to be of most benefit to the poorest.

For middle and higher-income households the net gain (or loss) from the program will depend on the full set of taxes that would be needed to fund the program.  One cannot say who will gain and who will lose until the structure of that full set of taxes is made clear.  This is of course not surprising, as one needs to keep in mind that this is a program of redistribution:  Funds will be raised (by taxes) that disproportionately affect certain groups, to be distributed then in the $12,000 grants.  Some will gain and some will lose, but overall the balance has to be zero.

One can also conclude that such a program, providing for a universal basic income with grants of $12,000 per adult, will necessarily be hugely expensive.  It would cost $3 trillion a year, which is 15% of GDP.  Funding it would require raising all federal tax and other revenue by 91% (excluding any offset by cuts in government social programs, which are however unlikely to amount to anything close to what Yang assumes).  Raising funds of such magnitude is completely unrealistic.  And yet despite such costs, the grants provided of $12,000 per adult would be poverty level incomes for those who do not have a job or other source of support.

One could address this by scaling back the grant, from $12,000 to something substantially less, but then it becomes less meaningful to an individual.  The fundamental problem is the design as a universal grant, to all adults.  While this might be thought to be politically attractive, any such program then ends up being hugely expensive.

The alternative is to design a program that is specifically targeted to those who need such support.  Rather than attempting to hide the distributional consequences in a program that claims to be universal (but where certain groups will gain and certain groups will lose, once one takes fully into account how it will be funded), make explicit the redistribution that is being sought.  With this clear, one can then design a focussed program that addresses that redistribution aim.

Finally, one should recognize that there are other policies as well that might achieve those aims that may not require explicit government-intermediated redistribution.  For example, Senator Cory Booker in the October 15 debate noted that a $15 per hour minimum wage would provide more to those now at the minimum wage than a $12,000 annual grant.  This remark was not much noted, but what Senator Booker said was true.  The federal minimum wage is currently $7.25 per hour.  This is low – indeed, it is less (in real terms) than what it was when Harry Truman was president.  If the minimum wage were raised to $15 per hour, a worker now at the $7.25 rate would see an increase in income of $15.00 – $7.25 = $7.75 per hour, and over a year of 40 hour weeks would see an increase in income of $7.75 x 40 x 52 = $16,120.00.  This is well more than a $12,000 annual grant would provide.

Republican politicians have argued that raising the minimum wage by such a magnitude will lead to widespread unemployment.  But there is no evidence that changes in the minimum wage that we have periodically had in the past (whether federal or state level minimum wages) have had such an adverse effect.  There is of course certainly some limit to how much it can be raised, but one should recognize that the minimum wage would now be over $24 per hour if it had been allowed to grow at the same pace as labor productivity since the late 1960s.

Income inequality is a real problem in the US, and needs to be addressed.  But there are problems with Yang’s specific version of a universal basic income.  While one may be able to fix at least some of those problems and come up with something more reasonable, it would still be massively disruptive given the amounts to be raised.  And politically impossible.  A focus on more targeted programs, as well as on issues such as the minimum wage, are likely to prove far more productive.

The Growing Fiscal Deficit, the Keynesian Stimulus Policies of Trump, and the FY20/21 Budget Agreement

A.  The Growing Fiscal Deficit Under Trump

Donald Trump, when campaigning for office, promised that he would “quickly” drive down the fiscal deficit to zero.  Few serious analysts believed that he would get it all the way to zero during his term in office, but many assumed that he would at least try to reduce the deficit by some amount.  And this clearly should have been possible, had he sought to do so, when Republicans were in full control of both the House and the Senate, as well as the presidency.

That has not happened.  The deficit has grown markedly, despite the economy being at full employment, and is expected to top $1 trillion this year, reaching over 5% of GDP.  This is unprecedented in peacetime.  Never before in US history, other than during World War II, has the federal deficit hit 5% of GDP with the economy at full employment.  Indeed, the fiscal deficit has never even reached 4% of GDP at a time of full employment (other than, again, World War II).

The chart at the top of this post shows what has happened.  The deficit is the difference between what the government spends (shown as the line in blue) and the revenues it receives (the line in green).  The deficit grew markedly following the financial and economic collapse in the last year of the Bush administration.  A combination of higher government spending and lower taxes (lower both because the economy was depressed but also from legislated tax cuts) were then necessary to stabilize the economy.  As the economy recovered the fiscal deficit then narrowed.  But it is now widening again, and as noted above, is expected to top $1 trillion dollars in FY2019 (which ends on September 30).

More precisely, the US Treasury publishes monthly a detailed report on what the federal government received in revenues and what was spent in outlays for that month and for up to that point in the fiscal year.  See here for the June report, and here for previous monthly reports.  It includes a forecast of what will be received and spent for the fiscal year as a whole, and hence what the deficit will be, based on the budget report released each spring, usually in March.  For FY2019, the forecast was of a deficit of $1.092 trillion.  But these are forecasts, and comparing the forecasts made to the actuals realized over the last three fiscal years (FY2016 to18), government outlays were on average overestimated by 2.0% and government revenues by 2.2%.  These are similar, and scaling the forecasts of government outlays and government revenues down by these ratios, the deficit would end up at $1.075 trillion.  I used these scaled figures in the chart above.

The widening in the deficit in recent years is evident.  The interesting question is why.  For this one needs counterfactuals, of what the figures would have been if some alternative decisions had been made.

For government revenues (taxes of various kinds), the curve in orange show what they would have been had taxes remained at the same shares of the relevant income (depending on the tax) as they were in FY2016.  Specifically, individual income taxes were kept at a constant share of personal income (as defined and estimated in the National Income and Product Accounts, or NIPA accounts, assembled by the Bureau of Economic Analysis, or BEA, of the US Department of Commerce); corporate profit taxes were kept at a constant share of corporate profits (as estimated in the NIPA accounts); payroll taxes (primarily Social Security taxes) were kept at a constant share of compensation of employees (again from the NIPA accounts); and all other taxes were kept at a constant share of GDP.  The NIPA accounts (often referred to as the GDP accounts) are available through the second quarter of CY2019, and hence are not yet available for the final quarter of FY2019 (which ends September 30, and hence includes the third quarter of CY2019).  For this, I extrapolated the final quarter’s figures based on what growth had been over the preceding four quarters.

Note also that the base year here (FY2016) already shows a flattening in tax revenues.  If I had used the tax shares of FY2015 as a base for the comparison, the tax losses in the years since then would have been even greater.  Various factors account for the flattening of tax revenues in FY2016, including (according to an analysis by the Congressional Budget Office) passage by Congress of Public Law 114-113 in December 2015, that allowed for a more rapid acceleration of depreciation allowances for investment by businesses.  This had the effect of reducing corporate profit taxes substantially in FY2016.

Had taxes remained at the shares of the relevant income as they were in FY2016, tax revenues would have grown, following the path of the orange curve.  Instead, they were flat in nominal dollar amount (the green curve), indicating they were falling in real terms as well as a share of income.  The largest loss in revenues stemmed from the major tax cut pushed through Congress in December 2017, which took effect on January 1, 2018.  Hence it applied over three of the four quarters in FY2018, and for all of FY2019.

An increase in government spending is also now leading, in FY2019, to a widening of the deficit.  Again, one needs to define a counterfactual for the comparison.  For this I assumed that government spending during Trump’s term in office so far would have grown at the same rate as it had during Obama’s eight years in office (the rate of increase from FY2008 to 16).  That rate of increase during Obama’s two terms was 3.2% a year (in nominal terms), and was substantially less than during Bush’s two terms (which was a 6.6% rate of growth per year).

The rate of growth in government spending in the first two years of Trump’s term (FY2017 and 2018) then almost exactly matched the rate of growth under Obama.  But this has now changed sharply in FY19, with government spending expected to jump by 8.0% in just one year.

The fiscal deficit is then the difference, as noted above, between the two curves for spending and revenues.  Its change over time may be clearer in a chart of just the deficit itself:

The curve in black shows what the deficit has been, and what is expected for FY2019.  The deficit narrowed to $442 billion in FY2015, and then started to widen.  Primarily due to flat tax revenues in FY2016 (spending was following the path it had been following before, after several years of suppression), the deficit grew in FY2016.  And it then continued to grow until at least through FY2019.  The curve in red shows what the deficit would have been had government spending continued to grow under Trump at the pace it had under Obama.  This would have made essentially no difference in FY2017 and FY2018, but would have reduced the deficit in FY2019 from the expected $1,075 billion to $877 billion instead.  Not a small deficit by any means, but not as high.

But more important has been the contribution to the higher deficit from tax cuts.  The combined effect is shown in the curve in blue in the chart.  The deficit would have stabilized and in fact reduced by a bit.  For FY2019, the deficit would have been $528 billion, or a reasonable 2.5% of GDP.  Instead, at an expected $1,075 billion, it will be over twice as high.  And it is a consequence of Trump’s policies.

B.  Have the Tax Cuts Led to Higher Growth?

The Trump administration claimed that the tax cuts (and specifically the major cuts passed in December 2017) would lead to such a more rapid pace of GDP growth that they would “pay for themselves”.  This clearly has not happened – tax revenues have fallen in real terms (they were flat in nominal terms).  But a less extreme argument was that the tax cuts, and in particular the extremely sharp cut in corporate profit taxes, would lead to a spurt of new corporate investment in equipment, which would raise productivity and hence GDP.  See, for example, the analysis issued by the White House Council of Economic Advisors in October 2017.

But this has not happened either.  Growth in private investment in equipment has in fact declined since the first quarter of 2018 (when the law went into effect):

The curve in blue shows the quarter to quarter changes (at an annual rate), while the curve in red smooths this out by showing the change over the same quarter of a year earlier.  There is a good deal of volatility in the quarter to quarter figures, while the year on year changes show perhaps some trends that last perhaps two years or so, but with no evidence that the tax cut led to a spurt in such investment.  The growth has in fact slowed.

Such investment is in fact driven largely by more fundamental factors, not by taxes.  There was a sharp fall in 2008 as a result of the broad economic and financial collapse at the end of the Bush administration, it then bounced back in 2009/10, and has fluctuated since driven by various industry factors.  For example, oil prices as well as agricultural prices both fell sharply in 2015, and the NIPA accounts indicate that equipment investment in just these two sectors reduced private investment in equipment by more than 2% points from what the total would have been in 2015.  This continued into 2016, with a reduction of a further 1.3% points.  What matters are the fundamentals.  Taxes are secondary, at best.

What about GDP itself?:

Here again there is quarter to quarter volatility, but no evidence that the tax cuts have spurred GDP growth.  Over the past three years, real GDP growth on a quarter to quarter basis peaked in the fourth quarter of 2017, before the tax cuts went into effect, and has declined modestly since then.  And that peak in the fourth quarter of 2017 was not anything special:  GDP grew at a substantially faster pace in the second and third quarters of 2014, and the year on year rate in early 2015 was higher than anything reached in 2017-19.  Rather, what we see in real GDP growth since late 2009 is significant quarter to quarter volatility, but around an average pace of about 2.3% a year.  There is no evidence that the late 2017 tax cut has raised this.

The argument that tax cuts will spur private investment, and hence productivity and hence GDP, is a supply-side argument.  There is no evidence in the numbers to support this.  But there may also be a demand-side argument, which is basically Keynesian.  The argument would be that tax cuts lead to higher (after-tax) incomes, and that these higher incomes led to higher consumption expenditures by households.  There might be some basis to this, to the extent that a portion of the tax cuts went to low and middle-income households who will spend more upon receiving it.  But since the tax cut law passed in December 2017 went primarily to the rich, whose consumption is not constrained by their current income flows (they save the excess), the impact of the tax cuts on household consumption would be weak.  It still, however, might be something.

But this still did not lead to a more rapid pace of GDP growth, as we saw above.  Why?  One needs to recognize that GDP is a measure of production in the domestic economy (GDP is Gross Domestic Product), and not of demand.  GDP is commonly measured by adding up the components of demand, with any increase or decrease in the stock of inventories then added (or subtracted, if negative) to tell us what production must have been.  But this is being done because the data is better (and more quickly available) for the components of GDP demand.  One must not forget that GDP is still an estimate of production, and not of total domestic demand.

And what the economy can produce when at full employment is constrained by whatever capacity was at that point in time.  The rate of unemployment has fallen steadily since hitting its peak in 2009 during the downturn:

Aside from the “squiggles” in these monthly figures (the data are obtained from household surveys, and will be noisy), unemployment fell at a remarkably steady pace since 2009.  One can also not discern any sharp change in that pace before and after January 2017, when Trump took office.  But the rate of unemployment is now leveling off, as it must, since there will always be some degree of frictional unemployment when an economy is at “full employment”.

With the economy at full employment, growth will now be constrained by the pace of growth of the labor force (about 0.5% a year) plus the growth in productivity of the average labor force member (which analysts, such as at the Congressional Budget Office, put at about 1.5% a year in the long term, and a bit less over the next decade).  That is, growth in GDP capacity will be 2% a year, or less, on average.

In such situations, Keynesian demand expansion will not raise the growth in GDP beyond that 2% rate.  There will of course be quarter to quarter fluctuations (GDP growth estimates are volatile), but on average over time, one should not expect growth in excess of this.

But growth can be less.  In a downturn, such as that suffered in 2008/09, GDP growth can drop well below capacity.  Unemployment soars, and Keynesian demand stimulus is needed to stabilize the economy and return it to a growth path.  Tax cuts (when focused on low and middle income households) can be stimulative.  But especially stimulative in such circumstances is direct government spending, as such spending leads directly to people being hired and put to work.

Thus the expansion in government spending in 2008/09 (see the chart at the top of this post) was exactly what was needed in those circumstances.  The mistake then was to hold government spending flat in nominal terms (and hence falling in real terms) between 2009 and 2014, even though unemployment, while falling, was still relatively high.  That cut-back in government spending was unprecedented in a period of recovery from a downturn (over at least the past half-century in the US).  And an earlier post on this blog estimated that had government spending been allowed to increase at the same pace as it had under Reagan following the 1982 downturn, the US economy would have fully recovered by 2012.

But the economy is now at full employment.  In these circumstances, extra demand stimulus will not increase production (as production is limited by capacity), but will rather spill over into a drawdown in inventories (in the short term, but there is only so much in inventories that one can draw down) or an increase in the trade deficit (more imports to satisfy the domestic demand, or exports diverted to meet the domestic demand).  One saw this in the initial estimates for the GDP figures for the second quarter of 2019.  GDP is estimated to have grown at a 2.1% rate.  But the domestic final demand components grew at a pace that, by themselves, would have accounted for a 3.6% point increase in GDP.  The difference was accounted for by a drawdown in inventories (accounting for 0.7% points of GDP) and an increase in the trade deficit (accounting for a further reduction of 0.8% points of GDP).  But these are just one quarter of figures, they are volatile, and it remains to be seen whether this will continue.

It is conceivable that domestic demand might fall back to grow in line with capacity.  But this then brings up what should be considered the second arm of Trump’s Keynesian stimulus program.  While tax cuts led to growing deficits in FY2017 and 18, we are now seeing in FY2019, in addition to the tax cuts, an extraordinary growth in government spending.  Based on US Treasury forecasts for FY2019 (as adjusted above), federal government spending this fiscal year is expected to grow by 8.0%.  This will add to domestic demand growth.  And there has not been such growth in government spending during a time of full employment since George H. W. Bush was president.

C.  The Impact of the Bipartisan Budget Act of 2019

Just before leaving for its summer recess, the House and the Senate in late July both passed an important bill setting the budget parameters for fiscal years 2020 and 2021.  Trump signed it into law on August 2.  It was needed as, under the budget sequester process forced on Obama in 2011, there would have otherwise been sharp cutbacks in the discretionary budgets for what government is allowed to spend (other than for programs such as Social Security or Medicare, where spending follows the terms of the programs as established, or for what is spent on interest on the public debt).  The sequesters would have set sharp cuts in government spending in fiscal years 2020 and 2021, and if allowed, such sudden cuts could have pushed the US economy into a recession.

The impact is clear on a chart:

The figures are derived from the Congressional Budget Office analysis of the impact on government spending from the lifting of the caps.  Without the change in the spending caps, discretionary spending would have been sharply reduced.  At the new caps, spending will increase at a similar pace as it had before.

Note the sharp contrast with the cut-backs in discretionary budget outlays from FY2011 to FY2015.  Unemployment was high then, and the economy struggled to recover from the 2008/09 downturn while confronting these contractionary headwinds.  But the economy is now at full employment, and the extra stimulus on demand from such spending will not, in itself and in the near term, lead to an increase in capacity, and hence not lead to a faster rate of growth than what we have seen in recent years.

But I should hasten to add that lifting the spending caps was not a mistake.  Government spending has been kept too limited for too long – there are urgent public needs (just look at the condition of our roads).  And a sharp and sudden cut in spending could have pushed the economy into a recession, as noted above.

More fundamentally, keeping up a “high pressure” economy is not necessarily a mistake.  One will of course need to monitor what is happening to inventories and the trade deficit, but the pressure on the labor market from a low unemployment rate has been bringing into the labor force workers who had previously been marginalized out of it.  And while there is little evidence as yet that it has spurred higher wages, continued pressure to secure workers should at some point lead to this.  What one does not want would be to reach the point where this leads to higher inflation.  But there is no evidence that we are near that now.  Indeed, the Fed decided on July 31 to reduce interest rates (for the first time since 2008, in part out of concern that inflation has been too low.

D.  Summary, Implications, and Conclusion

Trump campaigned on the promise that he would bring down the government deficit – indeed bring it down to zero.  The opposite has happened.  The deficit has grown sharply, and is expected to reach over $1 trillion this fiscal year, or over 5% of GDP.  This is unprecedented in the US in a time of full employment, other than during World War II.

The increase in the deficit is primarily due to the tax cuts he championed, supplemented (in FY2019) by a sharp rise in government spending.  Without such tax cuts, and with government spending growth the same as it had been under Obama, the deficit in FY2019 would have been $530 billion.  It is instead forecast to be double that (a forecast $1.075 trillion).

The tax cuts were justified by the administration by arguing that they would spur investment and hence growth.  That has not happened.  Growth in private investment in equipment has slowed since the major tax cuts of December 2017 were passed.  So has the pace of GDP growth.

This should not be surprising.  Taxes have at best a marginal effect on investment decisions.  The decision to invest is driven primarily by more fundamental considerations, including whether the extra capacity is needed given demand for the products, by the technologies available, and so on.

But tax cuts (to the extent they go to low and middle income households), and even more so direct government spending, can spur demand in the economy.  At times of less than full employment, this can lead to a higher GDP in standard Keynesian fashion.  But when the economy is at full employment, the constraint is not aggregate demand but rather production capacity.  And that is set by the available labor force and how much each worker can produce (their productivity).  The economy can then grow only as fast as the labor force and productivity grow, and most estimates put that at about 2% or less per year in the US right now.

The spur to demand can, however, act to keep the economy from falling back into a recession.  With the chaos being created in the markets by the trade wars Trump has launched, this is not a small consideration.  Indeed, the Fed, in announcing its July 31 cut in interest rates, indicated that in addition to inflation tracking below its target rate of 2%, concerns regarding “global developments” (interpreted as especially trade issues) was a factor in making the cut.

There are also advantages to keeping high pressure on the labor markets, as it draws in labor that was previously marginalized, and should at some point lead to higher wages.  As long as inflation remains modest (and as noted, it is currently below what the Fed considers desirable), all this sounds like a good situation.  The fiscal policies are therefore providing support to help ensure the economy does not fall back into recession despite the chaos of the trade wars and other concerns, while keeping positive pressure in the labor markets.  Trump should certainly thank Nancy Pelosi for the increases in the government spending caps under the recently approved budget agreement, as this will provide significant, and possibly critical, support to the economy in the period leading up to the 2020 election.

So what is there not to like?

The high fiscal deficit at a time of full employment is not to like.  As noted above, a fiscal deficit of more than 5% of GDP during a time of full employment is unprecedented (other than during World War II).  Unemployment was similarly low in the final few years of the Clinton presidency, but the economy then had fiscal surpluses (reaching 2.3% of GDP in FY2000) as well as a public debt that was falling in dollar amount (and even more so as a share of GDP).

The problem with a fiscal deficit of 5% of GDP with the economy at full employment is that when the economy next goes into a recession (and there eventually always has been a recession), the fiscal deficit will rise (and will need to rise) from this already high base.  The fiscal deficit rose by close to 9 percentage points of GDP between FY2007 and FY2009.  A similar economic downturn starting from a base where the deficit is already 5% of GDP would thus raise the fiscal deficit to 14% of GDP.   And that would certainly lead conservatives to argue, as they did in 2009, that the nation cannot respond to the economic downturn with the increase in government spending that would be required to stabilize and then bring down unemployment.

Is a recession imminent?  No one really knows, but the current economic expansion, that began five months after Obama took office, is now the longest on record in the US – 121 months as of July.  It has just beaten the 120 month expansion during the 1990s, mostly when Clinton was in office.  Of more concern to many analysts is that long-term interest rates (such as on 10-year US Treasury bonds) are now lower than short-term interest rates on otherwise similar US Treasury obligations.  This is termed an “inverted yield curve”, as the yield curve (a plot of interest rates against the term of the bond) will normally be upward sloping.  Longer-term loans normally have to pay a higher interest rate than shorter ones.  But right now, 10-year US Treasury bonds are being sold in the market at a lower interest rate than the interest rate demanded on short-term obligations.  This only makes sense if those in the market expect a downturn (forcing a reduction in interest rates) at some point in the next few years.

The concern is that in every single one of the seven economic recessions since the mid-1960s, the yield curve became inverted prior to that downturn.  While this was typically two or three years before the downturn (and in the case leading up to the 1970 recession, about four years before), in no case was there an inverted yield curve without a subsequent downturn within that time frame.  Some argue that “this time is different”, and perhaps it will be.  But an inverted yield curve has been 100% accurate so far in predicting an imminent recession.

The extremely high fiscal deficit under Trump at a time of full employment is therefore leaving the US economy vulnerable when the next recession occurs.  And a growing public debt (it will reach $16.8 trillion, or 79% of GDP, by September 30 of this year, in terms of debt held by the public) cannot keep growing forever.

What then to do?  A sharp cut in government spending might well bring on the downturn that we are seeking to avoid.  Plus government spending is critically needed in a range of areas.  But raising taxes, and specifically raising taxes on the well-off who benefited disproportionately in the series of tax cuts by Reagan, Bush II, and then Trump, would have the effect of raising revenue without causing a contractionary impulse.  The well-off are not constrained in what they spend on consumption by their incomes – they consume what they wish and save the residual.

The impact on the deficit and hence on the debt could also be significant.  While now a bit dated, an analysis on this blog from September 2013 (using Congressional Budget Office figures) found that simply reversing in full the Bush tax cuts of 2001 and 2003 would lead the public debt to GDP ratio to fall and fall sharply (by about half in 25 years).  The Trump tax cuts of December 2017 have now made things worse, but a good first step would be to reverse these.

It was the Bush and now Trump tax cuts that have put the fiscal accounts on an unsustainable trajectory.  As was noted above, the fiscal accounts were in surplus at the end of the Clinton administration.  But we now have a large and unprecedented deficit even when the economy is at full employment.  In a situation like this, one would think it should be clear to acknowledge the mistake, and revert to what had worked well before.

Managing the fiscal accounts in a responsible way is certainly possible.  But they have been terribly mismanaged by this administration.

Taxes on Corporate Profits Have Continued to Collapse

 

The Bureau of Economic Analysis (BEA) released earlier today its second estimate of GDP growth in the fourth quarter ot 2018.  (Confusingly, it was officially called the “third” estimate, but was only the second as what would have been the first, due in January, was never done due to Trump shutting down most agencies of the federal government in December and January due to his border wall dispute.)  Most public attention was rightly focussed on the downward revision in the estimate of real GDP growth in the fourth quarter, from a 2.6% annual rate estimated last month, to 2.2% now.  And current estimates are that growth in the first quarter of 2019 will be substantially less than that.

But there is much more in the BEA figures than just GDP growth.  The second report of the BEA also includes initial estimates of corporate profits and the taxes they pay (as well as much else).  The purpose of this note is to update an earlier post on this blog that examined what happened to corporate profit tax revenues following the Trump / GOP tax cuts of late 2017.  That earlier post was based on figures for just the first half of 2018.

We now have figures for the full year, and they confirm what had earlier been found – corporate profit tax revenues have indeed plummeted.  As seen in the chart at the top of this post, corporate profit taxes were in the range of only $150 to $160 billion (at annual rates) in the four quarters of 2018.  This was less than half the $300 to $350 billion range in the years before 2018.  And there is no sign that this collapse in revenues was due to special circumstances of one quarter or another.  We see it in all four quarters.

The collapse shows through even more clearly when one examines what they were as a share of corporate profits:

 

The rate fell from a range of generally 15 to 16%, and sometimes 17%, in the earlier years, to just 7.0% in 2018.  And it was an unusually steady rate of 7.0% throughout the year.  Note that under the Trump / GOP tax bill, the standard rate for corporate profit tax was cut from 35% previously to a new headline rate of 21%.  But the actual rate paid turned out (on average over all firms) to come to just 7.0%, or only one-third as much.  The tax bill proponents claimed that while the headline rate was being cut, they would close loopholes so the amount collected would not go down.  But instead loopholes were not only kept, but expanded, and revenues collected fell by more than half.

If the average corporate profit tax rate paid in 2018 had been not 7.0%, but rather at the rate it was on average over the three prior fiscal years (FY2015 to 2017) of 15.5%, an extra $192.2 billion in revenues would have been collected.

There was also a reduction in personal income taxes collected.  While the proportional fall was less, a much higher share of federal income taxes are now borne by individuals than by corporations.  (They were more evenly balanced decades ago, when the corporate profit tax rates were much higher – they reached over 50% in terms of the amount actually collected in the early 1950s.)  Federal personal income tax as a share of personal income was 9.2% in 2018, and again quite steady at that rate over each of the four quarters.  Over the three prior fiscal years of FY2015 to 2017, this rate averaged 9.6%.  Had it remained at that 9.6%, an extra $77.3 billion would have been collected in 2018.

The total reduction in tax revenues from these two sources in 2018 was therefore $270 billion.  While it is admittedly simplistic to extrapolate this out over ten years, if one nevertheless does (assuming, conservatively, real growth of 1% a year and price growth of 2%, for a total growth of about 3% a year), the total revenue loss would sum to $3.1 trillion.  And if one adds to this, as one should, the extra interest expense on what would now be a higher public debt (and assuming an average interest rate for government borrowing of 2.6%), the total loss grows to $3.5 trillion.

This is huge.  To give a sense of the magnitude, an earlier post on this blog found that revenues equal to the original forecast loss under the Trump / GOP tax plan (summing to $1.5 trillion over the next decade, and then continuing) would suffice to ensure the Social Security Trust Fund would be fully funded forever.  As things are now, if nothing is done the Trust Fund will run out in about 2034.  And Republicans insist that the gap is so large that nothing can be done, and that the system will have to crash unless retired seniors accept a sharp reduction in what are already low benefits.

But with losses under the Trump / GOP tax bill of $3.1 trillion over ten years, less than half of those losses would suffice to ensure Social Security could survive at contracted benefit levels.  One cannot argue that we can afford such a huge tax cut, but cannot afford what is needed to ensure Social Security remains solvent.

In the nearer term, the tax cuts have led to a large growth in the fiscal deficit.  Even the US Treasury itself is currently forecasting that the federal budget deficit will reach $1.1 trillion in FY2019 (5.2% of GDP), up from $779 billion in FY2018.  It is unprecedented to have such high fiscal deficits at a time of full employment, other than during World War II.  Proper fiscal management would call for something closer to a balanced budget, or even a surplus, in those periods when the economy is at full employment, while deficits should be expected (and indeed called for) during times of economic downturns, when unemployment is high.  But instead we are doing the opposite.  This will put the economy in a precarious position when the next economic downturn comes.  And eventually it will, as it always has.

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.