Fiscal Policy

Sales tax revenues have recovered. Fiscal year 2019, which started in July, should be a good year thanks to Federal disaster aid. The real question though is what happens when Federal aid starts to fall.

The impact of the U.S. tax reform on the U.S. trade balance was a hot item of debate last December. There was an argument that reducing the headline tax rate—and creating an even lower tax for the export of intangibles—would reduce the incentive for firms to book profits abroad in offshore tax centers. Booking those profits at home would raise U.S. services exports—while the service “exports” of countries like Ireland and Luxembourg (really re-exports of intellectual property created in the U.S) would fall. This would have no overall effect on the balance of payments. The rise in the recorded exports of intellectual property from the U.S. would be offset by a fall in the offshore income of U.S. firms. For example, Google (U.S.) would show a bigger profit as offshore sales would be booked as exports of IP held in the U.S. (a service export) while Google (Bermuda) would show a smaller profit —and that would translate both into a smaller trade deficit and a smaller surplus on foreign direct investment income.*  But shifting paper profits around would bring down the measured trade deficit—a potential win for Trump. It is obviously too soon to assess the full impact of the tax reform. But it isn’t too soon to start looking for some clues. The q1 balance of payments data doesn’t suggest that firms have lost their appetite for booking profits abroad, or their appetite for booking the bulk of their offshore profits in low tax jurisdictions. This shouldn’t be a surprise—the lowest rate in the new U.S. tax code is the new global minimum rate on intangibles. What changed?  As expected, firms stopped “reinvesting” their earnings abroad (“reinvestment” allowed the firms to defer paying corporate tax under the old tax code and wait for a repatriation holiday to free up their "trapped" profits abroad) and raised their dividend payments back to headquarters. No surprise there: the reform ended the incentive to legally hold profits offshore so as to defer tax, as there is no incremental U.S. tax on funds repatriated to headquarters. To be clear, the “reinvestment” abroad was a matter of accounting. The profits weren’t actually held abroad. Apple (Ireland) couldn’t put its funds in Apple’s main bank account, or lend directly to Apple (U.S.). But it could put money on deposit in a U.S. bank, buy U.S. Treasury bonds and buy the bonds issued by other companies. Now though there is no need to maintain the fiction that the funds are offshore. Over $300 billion was notionally sent back to the U.S. in q1 alone (an annualized pace of $1.2 trillion). That is literally off the charts… Still, the stock of accumulated funds legally held abroad in order to defer payment of U.S. tax was huge, and even the massive dividend payments in q1 have only made a small dent in the accumulated stock. Around $3 trillion has been reinvested abroad since the infamous Homeland Investment Act of 2004  (The number from the balance of payments matches reasonably well with other estimates).  The details of the balance of payments suggest the bulk of that was “reinvested” in tax havens and thus almost certainly wasn’t invested in physical assets.** Of course, tax structures take time to set up and time to unwind. The data from the first quarter may not be indicative of how the balance of payments will evolve as firms and their accountants digest all the implications of the new law. As interesting, if not more so, are the first reports of the tax rates that profit-shifting firms will pay under the new tax law. And, well, those reports don’t suggest that the firms have any real incentive to shift either their intellectual property or actual manufacturing back to the U.S. For example, a large pharmaceutical firm that has placed its intellectual property in Bermuda and seems to produce primarily in Puerto Rico (a part of the U.S., but outside the U.S. for tax purposes) and Ireland estimates that it will now pay a tax rate of 9%. That’s a lot lower than the tax rate it would pay if it located its intellectual property and physical production in the U.S. It is also lower than the global minimum tax rate of 10.5% on intangibles. The tax structure is pretty direct—put your IP in a really low tax jurisdiction, and sweep all the profits there, so that they don’t stay in the fairly low tax jurisdictions where manufacturing takes place, let alone the location of most sales.   Michael Erman and Tom Bergin of Reuters report: “analysts and academics say corporate filings often show that drug companies frequently reduce their taxes by parking patents in a low-tax haven…and then have their affiliates - which manufacture or market the drug - pay the tax haven subsidiary royalty fees for the right to use the patent. This arrangement sees a drug sold into a target market, like the United States, at a high price, with the U.S. distribution arm getting a sales margin as low as 5 percent. Sometimes the U.S. distribution profit is not enough to cover group costs incurred in the United States.” And Richard Waters of the Financial Times has indicated that the bulk of the big technology firms aren’t going to unwind their tax structures either. Not a surprise really—“ tax reform” was not designed to raise revenues, but rather to cut corporate America’s tax bill. Including, it seems, the taxes of companies that were engaged in aggressive forms of tax shifting (e.g. showing operating losses in the U.S. operations even though the firm was globally very profitable). So there aren’t likely to be big changes in the locations where paper profits are booked.  Nor will there be a sudden fall in the U.S. trade deficit. */ U.S. firms earn more abroad than foreign firms report to earn in the U.S., even though the stock of foreign direct investment in both directions, measured at market value, is roughly equal. **/ These previously tax deferred offshore profits were subject to a one-time tax as the U.S. transitioned to a new system for taxing offshore income last December:  the accumulated stock of tax deferrred offshore profits was taxed at 15.5% if the profits were held in cash, and 8% if firms really has invested in tangible assets abroad—and firms have to pay this to settle their deferred liability no matter whether they legally repatriate the profits or not.  

Germany seems to have ruled out all the mechanisms for eurozone fiscal expansion that the IMF liked…

Irish tax distortions have a material impact on aggregate eurozone economic data.

Will there be a mismatch between what the U.S. wants to sell (Treasuries) and what the world wants to buy?

It looks like a combination of tax cuts and spending increases will raise the U.S. fiscal deficit by about 2 percentage points of GDP (that’s the number Krugman used; Goldman’s US economics team puts the increase in the fiscal deficit between fiscal 2017 and fiscal 2019 at 1.7 percent of GDP). The IMF’s standard coefficient relating changes in the fiscal balance to changes in the external balance would imply that the U.S. current account deficit will increase by about a percentage point of GDP—so rise to around 4 percent of GDP. There are a few reasons to think that this might be a bit high. The U.S. is globally speaking, a relatively closed economy. Imports have increased at about a quarter of the pace of domestic demand over the course of the recovery from the global (or north Atlantic) crisis. So the external spillovers from a U.S. fiscal stimulus might be smaller than the global norm. * A high portion of the tax cut will go toward buybacks, special dividend payments, and the like, and a high portion of those payments may be saved not spent. This isn’t a fiscal stimulus designed for maximum impact on demand. And, well, the IMF’s coefficients have a whole lot of implicit assumptions baked into them—assumptions that may not hold this time. In most cases a fiscal loosening changes the stance of monetary policy, and those changes in the stance of monetary policy in turn drive some change in the exchange rate. But, if the Fed doesn’t end up tightening more, or if the dollar doesn’t in fact appreciate as the Fed tightens, the impact of the fiscal expansion on the trade deficit may be smaller than the simple application of the IMF’s model would predict. But there are a couple of factors that could work the other way too. The closer the economy is to operating at capacity, the more the demand created by the stimulus may bleed out to the rest of the world. That is arguably what happened in q4 of 2017. Domestic demand growth accelerated, with the contribution from demand to GDP growth rising from around 2.5 percent to above 3.5 percent. But an unusually big chunk of that was spent on imports—over 50 percent. ** If that pattern continues, The U.S. would get stuck with the debt while the United States’ big trading partners would get the stimulus. A poorly timed fiscal expansion thus could end up making China, Korea, Japan, Germany, and the other big exporting economies great. Aside from trade there is an “income” channel. Or more specifically, a “higher interest rate on a big stock of external debt” channel. The U.S. now has a large stock of external debt, so a higher nominal interest rate in the U.S. mechanically leads to higher interest payments on that external debt (interest payments are big part of the income balance in the current account, along with the dividend income on foreign direct investment). The United States’ external debt has quietly increased to about 50 percent of GDP, so a 1 percentage point increase in the nominal interest rate translates into half a percentage point of GDP increase in the amount of interest the U.S. will need to pay to the world. *** This swing is easy to forecast even if the change will come slowly: effectively, the central banks of the world’s biggest (former?) currency manipulators stand to gain over time as they rollover their maturing treasuries into higher-yielding bonds, raising the cash return on their excess reserves. There are many ironies here of course. But the most important, perhaps, is that Trump’s trade goals will likely be set back by his biggest policy success: the tax bill. Had Congress been unable to agree on a large tax cut—or had the Trump administration insisted on a budget-neutral tax plan—there is a strong argument that the trade deficit would now be set to fall. European demand growth is (finally!) strong and the Eurozone’s output gap is falling. With the market looking forward to the end of the ECB’s asset purchases and speculating about the beginning of a tightening cycle, the euro is rising. The combination of China’s stimulus in 2016, the controls put on in 2017, and the euro’s rise against the dollar has led China’s currency to strengthen against the dollar. While Korea continues to resist calls to expand its system of social insurance and bring its fiscal surplus down [PDF], the won—and many other Asian currencies—are now facing pressure to appreciate. With a bit of U.S. pressure on key countries to limit their intervention (both through the front door and through the back door), currencies like the Korean won, the new Taiwan dollar, and the Thai baht could all rise—supporting global adjustment. Canada’s dollar is rising, and the U.S. trades a lot with Canada. A deal on NAFTA would likely lead the Mexican peso to rise too. Basically, many of the conditions were in place for some of the deterioration in the non-petrol balance that occurred after the dollar rose in 2014 to reverse. But that would have required patience on the part of the Trump Administration—and refraining from policies that juice U.S. demand just as the rest of the world is starting to look better.   Very wonky endnote: I wanted to do the very rough math needed to plug the demand stimulus into a standard partial equilibrium model for the U.S. trade balance (something akin to the Fed’s international transactions model). Such models have their critics (they don’t model savings and investment, they are partial equilibrium not general equilibrium models, etc.) but I have generally found them a useful guide for thinking about the trade balance. Let’s stipulate that U.S. demand growth would be expected to contribute about 2.5 percentage points of GDP to U.S. growth in the absence of a major shift in fiscal policy in the next couple of years (that’s the average pace of increase in the last 12 quarters of data, though it arguably is a bit stronger than what the U.S. should be able to generate over the long-term. And let’s stipulate that growth in U.S. trading partners will be between 3 and 3.5 percent (roughly, the IMF’s forecast for global growth). The Fed puts the income elasticity of U.S. imports at around 2—so 2.5 percent demand growth should translate into a 5 percent increase in import volumes. And the income elasticity of U.S. exports is more like 1.5, so 3 percent growth abroad translates into a 4.5 percent increase in export volumes. Exports are a bit smaller than imports as a share of GDP (17 versus 20 percent of GDP or so), so all things equal the expected differential in volume growth would lead the real trade deficit to widen a bit. Now throw in the stimulus. Krugman estimates that a 2 percentage point of GDP fiscal impulse over the next two years would boost growth by about half that (or 1 percentage point). Technically, I should turn that into an estimated demand impulse—as U.S. demand growth, not overall U.S. growth, is what drives imports. So to be overly precise, let’s assume that the impetus to domestic demand is more like 1.25 percentage points of GDP over two years. If all that came in a single year, import volume would be expected to grow by 7.5 percent. In practice, the impulse is likely to be spread over the next two years. No matter: absent an acceleration in global growth, the additional impulse to U.S. demand would clearly be expected to raise the U.S. trade deficit (very roughly, an additional 2.5 percentage points of import growth over two years versus baseline means about 50 basis points of GDP in extra imports over that period). Now for the part I find much harder: the impact of the dollar. The Fed’s model implied that a 10 percent increase (decrease) in the dollar reduces (raises) U.S. exports by close to 7 percent over 3 years. And a 10 percent increase in the dollar raises imports by about 4 percent over two years. Seems straightforward. But remember the lags—the model implies that the impact of a dollar rise in the second year after the change (quarters 5 through 8) is almost as big as the effect in the first year. For 2018 exports, the three year lag implies changes in the dollar in 2016, and 2017 matter as well as changes in the first quarter of 2018. And for imports, moves in late 2016 and 2017 still matter. A plot of the lagged dollar shows this well—if you look at the trailing three year sum (an imperfect measure of the exchange rate impulse for exports) the dollar is rising not falling. In other words, don’t count on a boost to exports from the dollar’s recent weakening right now. In fact, the average level of the dollar in 2016 was significantly above its average level in 2015—and the dollar’s average level in 2017 was about at its 2016 level. The dollar’s impulse to exports would only really be expected to be positive in 2019. If the dollar stays at its current level the roughly 5 percent depreciation in the broad real dollar from its 2017 average should push up the pace of export growth by about 3.5 percentage points relative to a baseline over 2018, 2019 and 2020 and also do a bit to hold down the pace of import growth. But remember that the baseline includes some lagged impact from the dollar’s strength in late 2016, and thus the depreciation baseline would show a slowdown in export growth. My ballpark math thus suggests that the exchange rate won’t do much to offset the projected widening of the real trade deficit in 2018, but could help stabilize the real trade balance in 2019. Note that this is just the forecast for the real trade balance. The price of oil matters too (still). And the U.S. interest bill is likely to rise along with U.S. interest rates, pushing the current account up even if the trade deficit is constant. Now for a few even wonkier caveats. The Fed’s trade model is based on historical relationships, and those may not hold perfectly. For example, the dollar’s 2003 to 2008 depreciation boosted exports by a bit less than would have been expected based on the models used at the time, while the dollar’s 2014-2016 rise has had more or less the expected negative impact on exports. I personally worry that the positive effect of dollar depreciation on exports is not quite as strong as the negative effect of dollar appreciation. And, well, the dollar’s 2014 to 2016 rise does not seem to have led to the expected increase in imports—which is a bit of a puzzle (an inventory adjustment in 2015 clearly played a role). That creates a bit of risk too: if there is a bit of catchup to forecast, imports might rise by even more than the basic model would suggest. Even with the dollar’s recent depreciation, it is still substantially stronger than it was from 2008 to 2013. Finally, the estimated historical income elasticity is also subject to challenge—there is some evidence that income elasticities have fallen recently. But this still rough math convinced me of two things: 1) The dollar’s current weakening won’t have an impact for a while; 2) The Trump administration should hope that the income elasticity of imports has fallen and the rise in the trade deficit that accompanied the acceleration of demand growth in the fourth quarter is a one-off and not a sign of things to come. * The average spillover to the rest of the world from imports since the end of 2009 has been a little over 20 percent of the increase in U.S. demand. Until the dollar’s 2014 appreciation, that was typically offset by the spillover of growth in the rest of the world to the U.S. ** I am curious how others react to this graph. I added exports to demand—but also plotted the increase of imports against domestic demand. This is an effort to try to capture the different ways trade can impact growth. Ideally, export demand would rise as domestic demand falls. That though clearly wasn’t the case in 2015—hence the slowdown in overall U.S. growth. Conversely, in the fourth quarter of 2017—unlike in q2 or q3—the bulk of the increase in U.S. demand ended up supporting global rather than U.S. output. That’s why overall growth slowed even as demand growth accelerated. *** Tim Duy, among others, has noted that higher rates now have the advantage of giving the U.S. more scope to cut should growth falter in the future. No disagreement from me. I only would note that, for the U.S., the advantages a higher nominal rate path provides for monetary policy have to be balanced against the disadvantages higher rates always pose to a net debtor. The stock of U.S. external debt, measured relative to U.S. GDP, has essentially doubled since the last Fed rate hiking cycle. A return to a world of 4 percent nominal/2 percent real rates thus has a larger mechanical cost to the U.S. than in the past.

I sat down with the FT's Matt Klein for an Alphachat podcast on the international provisions in the December tax reform.

“Thanks to the Tax Cuts And Jobs Act, Walmart—America’s largest employer—is raising wages,” tweeted House Speaker Paul Ryan on January 11. Walmart CEO Doug McMillon was only too happy to embrace the narrative. “[T]he President and Congress have approved a lower business tax rate,” he told employees. “So, we’re pleased to tell you that we’re raising our starting wage to $11 an hour.” As economists, we are admittedly prone to being cynical. But when a CEO whose compensation depends on happy shareholders says he’s giving more of their profits to employees just because those profits are about to get bigger, we go beyond cynicism. We go for the data. As shown in the graphic above, this is the third wage hike that Walmart has announced in the past two years. Each one was preceded by a period of accelerating private retail wage growth—which is precisely what a cynical economist would expect. Firms raise wages when they need to attract and retain workers. But that makes for crummy PR. Much better to share credit for rising wages with lawmakers who cut your taxes. Gives them motivation to keep the goodies coming. It also helps bury the bigger story, which emerged by leak a few hours after the wage announcement: Walmart would be closing 63 Sam’s Club stores, affecting an estimated 9,400 employees. Don’t you just hate cynical economists?

In Foreign Affairs online last month, we used our own implied earnings growth (IEG) estimates from stock prices around the world to evaluate President Trump’s impact on the U.S. market. We found that it was virtually nil until at least September 2017, when GOP congressional leaders announced their tax-reform initiative. Laying aside the question of the president’s role in the reform, U.S. IEG has outperformed its developed-market peers by 0.3 percent since then—as shown in the inset graphic above. An important item of sharp recent debate is what effect the tax reform will have on U.S. GDP growth, which will determine—among other things—the extent of the additional debt burden. The Trump Treasury forecasts a 0.7 percent increase in GDP growth on average per year over the next decade, primarily as a result of corporate tax cuts. The Treasury analysis has been scathingly challenged by Jason Furman and Larry Summers, among others. One way to estimate the tax reform’s growth effects is to look at the historical relationship between corporate earnings and GDP. From 1990-2015, U.S. corporate earnings grew with GDP at a ratio of almost 3:2, although after 2007 the ratio fell to 1:1. If either of these trends were to persist, our implied earnings growth estimate from stock prices suggests an average annual GDP growth boost of 0.20-0.30 percent, as shown in our main graphic. This estimate is slightly higher than that produced with a very different methodology by the Tax Foundation, although it is only about a third of what Treasury is forecasting. In short, even upbeat stock market investors appear to be projecting far less growth from tax reform than the Trump Administration.