Weekly Economic Commentary by Scott J. Brown, Ph.D.


February 20 – 24, 2017

President Trump is expected to announce a revised tax cut plan soon. In the meantime, it’s worth revisiting how the sausage gets made in Washington. By law, tax code changes must originate in the House of Representatives, and the Senate will have its say. A central focus will be on revising how the foreign earnings of U.S. firms will be taxed. Here, there are likely to be large economic disruptions even if Washington gets it right – and heaven help us if they get it wrong.

“I love rumors! Facts can be so misleading, but rumors, true or false, are often revealing.”

– Col. Hans Landa (Inglorious Basterds)

While it’s getting difficult for investors to tell fake news from the really fake news, there have been a number of interesting leaks reported to have come out of the current administration. One is that a certain someone was surprised to learn that a $1 trillion infrastructure spending program in fact costs $1 trillion. Now that may be false, but it gets to the heart of the situation. We are unlikely to see a major infrastructure spending program anytime soon. House members aren’t going to favor adding to the deficit, at least through higher spending.

Trump’s spending and tax cut proposals from the campaign were widely blasted as “budget-busting.” Last May, the non-partisan Committee for a Responsible Budget calculated that Trump’s plan would add $12.1 trillion to the national debt by 2026. Other estimates are smaller, but still very large. Treasury Secretary Mnuchin has suggested that tax cuts will be revenue neutral, which seems to strain credulity. One possibility is to allow dynamic scoring. Tax cuts should lift growth to some extent, and one could factor that into revenue projections. However, nobody believes that tax cuts can pay for themselves. In Paul Ryan’s Blueprint for American, tax cuts are offset by unspecified future cuts in spending, but if you don’t touch Social Security and Medicare, you want to increase defense spending, and can’t do anything about interest payments on the debt, there isn’t enough left to cut to get the budget to balance. Democrats fear that there will be cuts to entitlements, and calling it “reform” doesn’t change that.

Let’s review the expected mechanics on the Hill. A tax reform bill, preferred by some Republicans in the Senate, would require 60 votes to pass in the Senate, which means that Republicans would have to get eight Democrats on board (given the 52-48 mix). That’s not out of the question, especially if there is an emphasis on business tax cuts. Tax cuts could be done through budget reconciliation, which would require a simple majority in the Senate, but you can do only one extra thing per year through budget reconciliation and Republicans have their sights on the repeal and replacement (or possibly “repair”) of the Affordable Care Act. The budget resolution approved by both chambers of Congress last month (budget resolutions do not require presidential approval) was reported to “pave the way” for ACA repeal. Yet, if you actually look at the budget resolution, there’s no mention of the ACA. That could mean that Congress can shift its priorities, putting tax cuts ahead of the ACA repeal (makes sense since there is no replacement in mind), but there’s been no indication of that so far.

One area that clearly needs reform is how we tax U.S. firms’ foreign earnings. Just about everyone agrees that the current system is “badly flawed,” leading firms to keep large amounts of foreign earnings (seen at somewhere around $2.6 trillion) offshore. Fixing it would lead to a repatriation of capital, and some short-term rise in tax receipts, but that seems unlikely to boost business fixed investment (as firms are generally flush with cash and currently have relatively easy access to credit).

Reducing the corporate tax rate from 35% to 20% would likely reduce tax revenue by about $200 billion per year. Added revenue from a border adjustment tax (BAT) could offset about half of that loss, and reduce distortions in corporate behavior. However, there are costs and benefits to moving to such a plan. Exporters would not be taxed, but consumers and businesses would face higher costs. U.S. manufacturing is critically dependent on global supply chains and disruptions would likely be large. Moreover, exchange rate adjustments and global capital flows could be destabilizing. The Bank for International Settlements recently reported that daily US$ forex volumes average more than $4 trillion (far exceeding trade flows). Implementation of a BAT would likely violate current trade agreements. Last week, the European Union indicated that it would file a complaint with the World Trade Organization if we move to a BAT. It would be the largest such complaint by far. While U.S. exporters would not be taxed, they would likely have a harder time through retaliatory efforts taken by the countries to which they export. The uncertainty of all these changes and conflicts could itself be a negative for business investment.

When asking for directions in Maine, the usual response is “well, I wouldn’t start from here.” That is a good summary of U.S. tax policy. If you started from scratch, you could have an efficient tax system – but nobody wants to give up their specific tax breaks. One proposal would eliminate all deductions except for mortgages and charitable giving. Good luck with that. A BAT proposal would pit importers against exporters. Congress is already getting an earful from their constituents (and more importantly, their donors). Hence, the odds of meaningful tax reform remain relatively low despite single-party control.

Most economists are in favor of moving to a value-added tax (with some adjustments), but that isn’t even being discussed.

Rebel Yell(en)

February 13 – 17, 2017

Fed Chair Janet Yellen will present her monetary policy testimony to Congress on Tuesday and Wednesday. We may not learn much new regarding the pace of future rate increases (which will remain data-dependent) and she’s certain to avoid getting into any discussion of fiscal policy. However, the Fed is now the chief supervisor of the financial system and, even if she is viewed as a lame duck (her term as Fed chair ends February 3, 2018), she ought to have a lot to say about financial regulation.

After some second-guessing in recent weeks, stock market participants remain generally enthusiastic. The Trump trade is back in gear. However, most economists are less enthusiastic. Expectations of near-term economic growth have been raised, but there are constraints ahead in the labor market, fiscal policy changes have to come through a contentious and difficult process, and there is a danger of a major mistake on global trade. It’s uncertain how these two conflicting views will be resolved. Yellen may not provide much clarity, but it will interesting to hear the Fed’s views on the outlook, as well as the risks and uncertainties. Remember, she’s there to present the view of all Fed policymakers, not just to give her own opinions.

Fed officials did not formally update their economic projections at the recent policy meeting, so Yellen may simply rehash the mid-December outlook. At that meeting, some officials, but not all, incorporated fiscal stimulus into their forecasts. Most Fed officials see the economy as being near full employment. Hence, fiscal stimulus may not add much to the growth outlook. Still, Yellen should take note that the size, composition, and timing of fiscal stimulus is uncertain. The Fed is not going to base monetary policy decisions on what Congress might do. There’s a strong belief that the central bank has the ability to wait to see what Congress does. There’s little danger of the Fed falling behind the curve.

The Fed’s economic outlook is likely to be a mixed bag. Job growth is expected to remain relatively strong in the near term, but will slow as labor market constraints become more binding. Wage growth, while uneven from month to month, is trending gradually higher. Yet, while nominal wage growth is gently moving up, inflation-adjusted wage growth has slowed significantly (reflecting the firming in gasoline prices). Hence, consumer spending growth ought to remain moderate – not weak, but not especially strong either. In contrast, beginning last summer, business fixed investment appeared to be emerging from a slow patch. The global economy, while not booming, is looking better. Thus, capital spending should add to overall economic growth in the near term. However, the consumer sector is a much larger part of the economy, so the upside prospects for growth are likely to be more limited than stock market participants seem to be anticipating.

The Fed has two goals, maximum sustainable employment and stable prices (in practice, this is taken to be low inflation – 2% per year in the PCE Price Index). Over the long term, these are often viewed as one goal. That is, keeping inflation low will lead to better job growth over time. Inflation is a monetary phenomenon, but its approach is visible through pressure in resource markets. The labor market is the widest channel for inflation pressure. Most Fed officials fear that wage inflation will be passed along in higher price inflation. However, that depends on the ability of firms to raise prices. Higher wage inflation could lead to a more efficient allocation of labor, boosting productivity growth. The Greenspan Fed took a risk in the late 1990s, allowing the unemployment rate to fall below a level many thought to be consistent with full employment. That period coincided with rapid technology change and a misallocation of capital (the dot-com bubble). It’s hard to separate the effects (Fed policy vs. technology), but we saw major changes in the job market (a high level of job destruction and a high level of job creation, but net gains). It’s unlikely that the Fed will repeat that experiment.

The financial crisis was due in part to the absence of a systemic regulator (no one overseeing the financial system as a whole). The Federal Reserve has that role now. Since the election, financial stocks have rallied on the expectation of a rollback of regulations. However, there’s little evidence that regulation has been a major constraint on bank lending. On Friday, Daniel Tarullo, the key Fed governor on regulation and supervision, announced his resignation (effective April 5). President Trump will nominate his replacement (in addition to filling two currently vacant Fed governor slots and choosing Yellen’s replacement as Fed chair). This week, expect Yellen to emphasize the importance of central bank independence and the Fed’s critical role in regulating the financial system.

A clouded, but optimistic outlook

February 6 – 10, 2017

January economic data are relatively unreliable, but recent figures paint a fairly consistent picture of where we are headed in the near term. While there is reason to be optimistic, it’s still a mixed bag, with some concerns about what we’ll see coming out of Washington over the next several months.

The economy shed nearly three million jobs in January, a bit less than we saw a year ago. Construction fell by 241,000, retail by 546,000, couriers by 184,000, and education (public and private) by 683,000. None of this seems out of line. The bigger question is what will happen over the next few months. The hiring outlook is strong, but may be restrained.

Labor force participation picked up in January, but one should take that with a grain of salt. Judging by the employment/population ratio, there is likely some slack remaining in the job market. However, demographic changes and increased educational enrollment make it difficult to compare where we are now with where we were a decade ago.

Fed officials see an economy that is nearing full employment. We should hear more of that when Fed Chair Janet Yellen delivers her monetary policy testimony to Congress on February 15. Note that tight labor markets are usually reflected in faster wage growth. Average hourly earnings rose a meager 0.1% in January, up just 2.5% from a year earlier (the same pace as we saw in the 12 months ending January 2016). However, the monthly figures are often uneven, seasonal adjustment is difficult, and there appeared to be an odd quirk in finance (-1.0% m/m, perhaps as income was shifted into 1Q17 to take advantage of an expected drop in personal tax rates).

For the household sector, real (that is, inflation adjusted) income is what matters. The impact of lower gasoline prices is fading, leaving much slower growth in real wages. Moreover, the middle class has faced higher rents and healthcare costs.

The personal income and spending figures for December showed good momentum at the end of the year. However, unit motor vehicle sales fell in January, and the softening in real wage growth suggests more moderate gains in consumer spending into the early part of 2017. Increased consumer confidence isn’t going to help if the household sector doesn’t have the cash (or ability to borrow) to spend.

In contrast, orders and shipments of capital goods appear to be picking up. Business fixed investment should add to overall economic growth in the near term, likely enough to offset a moderate slowing in consumer spending growth.

Financial market participants will focus on Washington. Tax cuts and a rollback of regulations are encouraging for investors, but the timing, size, and character of tax cuts are uncertain. Business leaders are concerned about trade policy. There’s a clear need to rework how foreign earnings are taxed, but there are major risks if Washington gets it wrong – especially at a time when the global economy appears poised for improvement.

The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.

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