Tag Archives: fiscal deficit

Taxes on Corporate Profits Have Continued to Collapse

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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

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“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

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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.