It’s a bit less than a year since Congress passed the Trump tax cut, but we are far enough along that we can be fairly confident about its impact on the economy. There are three main lessons we can learn:
The tax cut is to not leading to the promised investment boom;
The additional demand generated by the tax cut is spurring growth and reducing the unemployment rate;
The Federal Reserve Board’s interest rate hikes are slowing the economy in a way that is unnecessary given current inflation risks.
The Investment Boom: Just Like Jared Kushner’s Hidden Genius, No One Can See It
Taking these in turn, it is pretty clear at this point that we will not see the investment boom promised by proponents of the tax cut. This point really has to be front and center in any discussion of the benefits of the tax cut. By far, the largest chunk of the tax cut was the reduction in the corporate tax rate from 35 percent to 21 percent, along with various other measures lowering corporate taxes.
The immediate impact of a corporate tax cut is to give more money to the richest people in the country since stock ownership is highly skewed towards the top 10 percent of the income distribution and especially the top one percent.
However, giving more money to the wealthy could be justified if it led to greater prosperity for the rest of the population as well. The story here was that the tax cuts will lead to a huge increase in investment (around 30 percentage points more than baseline growth). The increase in investment would mean higher productivity, which would, in turn, translate into higher wages. The Trump administration predicted that the average worker would see their income rise by $4,000 over the baseline growth path in just four years due to this effect.
The data for the first three quarters of 2018 indicate that this is not likely to happen. Investment is up modestly, but we’re clearly not seeing the promised boom. In the first three-quarters of 2018 investment was 6.7 percent higher than in the same period last year. By comparison, investment rose by 6.9 percent in 2014 and increased at a 9.1 percent annual rate from 2010 to 2012.
Much of the growth we have seen this year is not from tax cuts, but higher world energy prices spurring a boom in oil and gas drilling. If we pull out energy-related sectors, the rise in investment would be even less.
There is also no evidence of the promised investment boom in any of the various surveys showing business plans for the future. For example, the Commerce Department reported last week that new orders for non-defense capital goods, the largest component of investment, were up by less than 1.0 percent from their year-ago levels.
In short, at this point, it certainly looks like the skeptics were right. Cuts in corporate tax rates are not an effective way to boost investment, they are an effective way to give more money to rich people.
Larger Budget Deficits Can Boost Growth and Employment
The second point is that the tax cuts did boost demand. This meant more growth and more jobs than we would have otherwise. This is a very good story; the 3.7 percent unemployment rate is the lowest we have seen in almost 50 years. The Congressional Budget Office is projecting the unemployment rate will bottom out at 3.2 percent next year. Its pre-tax cut forecast had the unemployment rate at 4.2 percent in 2019.
When we get to low levels of unemployment the people who are getting jobs are overwhelmingly workers who are disadvantaged in the labor market, blacks, Hispanics, people with disabilities, and people with criminal records. The chance to get a foot in the labor market can make an enormous difference in their lives. We don’t have any social programs that can make as much difference for these people as say, lowering the unemployment rate from 4.5 percent to 3.5 percent.
In addition to giving people jobs, the tighter labor market also gives workers in the middle and bottom of the wage distribution the bargaining power to achieve real wage gains. While the rate of real wage growth has been disappointing given the low levels of unemployment, workers at the middle and bottom have been seeing real wage gains the last four years in contrast to earlier in the recovery when their wages were stagnant or declining. It is likely that the rate of real wage growth will pick up if the unemployment remains this low or goes lower.
While boosting growth with a larger deficit offers clear and substantial benefits, tax breaks to the rich were hardly the best way to do it. If we had spent the money on infrastructure, education, or even tax breaks to low and moderate income households, it would have boosted demand by even more. And, we would have seen a longer-term dividend of a more productive economy if we spent the money on infrastructure and education.
Obviously, the Republicans’ priority was giving more money to rich people and, given their control of the White House and Congress, it was inevitable that a tax cut for the rich would be the outcome. The Republican Congress blocked efforts by Obama to have any stimulus in his second term, but he really did not push the case. Many of Obama’s top economic advisers were fearful of deficits and were not anxious to see additional spending that was not offset with either tax increases or spending cuts in other areas.
We see from the economy’s response to the tax cut — increased growth, lower unemployment, and no evidence of accelerating inflation — that the economy could benefit from a larger budget deficit. It is unfortunate that we were only able to get this boost by giving still more money to rich people.
The Fed, Higher Interest Rates, and Slower Growth
This brings us to the Federal Reserve Board. The Fed has been continuing on a path of rate hikes, which it has likely accelerated in response to the boost to growth from the tax cuts. The rationale for raising rates is slowing the economy to prevent inflation. As a result of the Fed’s increase in the federal funds rate, interest rates have risen across the board with the most obvious effect on mortgage interest rates. The 30-year mortgage interest rate was hovering near 3.9 percent last fall. It is now just under 5.0 percent.
This has had a serious effect on the housing market. New and existing home sales have fallen, as has construction of new homes. This both slows growths and also has the perverse effect of putting upward pressure on inflation, by causing rents to rise. The Fed is hoping to slow inflation by raising rates, but to some extent, they are pushing in the opposite direction by worsening the shortage of housing in many cities. This is also bad news for workers in high rent cities who are unlikely to see any reduction in rents without a big boost in construction.
Higher interest rates also slow the economy through other channels, most importantly by pushing up the value of the dollar relative to other currencies. A higher dollar makes US goods and services less competitive internationally, leading to a larger trade deficit. In September’s data, the trade deficit in goods was up by $70 billion from the year-ago level.
In short, there is good reason to believe that higher interest rates are slowing the economy. As the boost from the tax cuts wears off, the drop in housing and the rise in the trade deficit are likely to push growth down to 2.0 percent or even lower.
This raises the question of whether the Fed’s rate hikes are necessary, or at least whether future hikes will be necessary. Most immediately, the Fed is widely expected to raise the federal funds rate that it directly controls by another quarter point in December. There is a good argument that it should hold off on this hike until it sees further evidence of inflationary pressures.
The Fed has set a target of a 2.0 percent inflation rate in the core personal consumption expenditure deflator (PCE). Many economists (including me) have argued that this target is too low or even questioned whether a hard inflation target was a good idea. But even if we accept this target, the Fed is arguably being too tight with its rate hikes.
It is important to remember that the 2.0 percent inflation target is an average, not a ceiling, a point that has been explicitly stated many times by former Fed chair Janet Yellen and many other Fed officials. This means that there must be periods in which the inflation rate is above 2.0 percent, especially given the long period post-recession in which the inflation rate was below 2.0 percent. To be consistent with its own target the Fed has to allow the inflation rate to rise somewhat above 2.0 percent.
This isn’t just a question of fighting over a few tenths of a percentage point of inflation. If being somewhat looser in monetary policy allows the unemployment rate to fall another 0.2–0.3 percentage points, we’re talking about jobs for another 400,000 to 600,000 people. And again, these are the most disadvantaged people in the labor market.
That seems like a huge gain, and of course, it could well be larger if it turns out unemployment can fall even more than we expect. (That has proven to be the case thus far — very few economists thought the unemployment rate could fall below 4.0 percent without sending inflation sharply higher.)
The supposed downside is that if the Fed doesn’t continue on its path of raising rates is that it will cause inflationary expectations to be dislodged. The argument here is that people have come to expect that the Fed will act aggressively to keep inflation under control. If it slips from the anticipated course of rate hikes, then people will no longer take the Fed seriously as an inflation-fighting central bank. This means they will come to expect higher inflation and we therefore see a big jump in long-term interest rates, as investors seek to compensate for this risk.
This story on inflationary expectations being dislodged is very similar to the “confidence fairy” story about austerity earlier in the recovery. People may recall back in 2010–2012 that many economists insisted that the US and other governments should cut back spending and reduce their budget deficits even though the economy was operating far below anyone’s estimate of full employment.
The argument was that the commitment to low deficits would give investors and consumers confidence in the government’s fiscal management. This would lead to a burst of investment and consumption spending, which would rapidly boost economies out of recession.
As it turned out, there was no confidence fairy. The countries that pursued austerity and reduced their budget deficits saw slower growth and higher unemployment. There is every reason to believe we are seeing the same story with the Fed’s concern about dislodging inflationary expectations. If it continues to hike interest rates, even when inflation remains below its target, it will needlessly be keeping workers from getting jobs and reducing the bargaining power of tens of millions of workers who do have jobs.
There is one last point to be made about the latest economic data. Value-added in the nonfarm business sector, the numerator for the productivity data, rose at a 4.1 percent annual rate in the third quarter. With hours rising at close to a 1.0 percent rate, we should see productivity growth of close to 3.0 percent for the quarter, which follows second quarter growth of 2.9 percent.
Productivity data are hugely erratic, so this may just be a blip. But it is possible that the tight labor market is forcing employers to find ways to better use their workers. More rapid productivity growth would be a great outcome, it would provide a basis for more rapid gains in wages and living standards. It would also reduce budget deficits from projected levels, if it is sustained.
But it is important to point out that this is not a tax cut story. Nonresidential investment is up just 6.4 percent from the prior year, an amount that could only explain a tiny boost in productivity. So if we are actually on a higher productivity growth path it is the tight labor market that deserves credit, not the Trump tax cut.