North America: Ghosts of the past

5 min
Alexis Garatti
Alexis Garatti Head of Macroeconomic Research

The US fiscal reform is likely to have low multiplier effects on growth and nurture debt over the long-term

Trying to follow Reagan’s footsteps

On December the 22nd 2017, Donald Trump signed into law the “Tax Cuts and Jobs Act”, while he invoked Reagan’s legacy so as to rally a greater support to his tax reform bill.

The two presidents indeed share the ambition to free up market forces through a reduction of the government’s weight and a greater deregulation. Reagan managed to pass two major tax reforms: the Economic Recovery Tax Act in 1981 and the Tax Reform Act in 1986.

If the new bill’s magnitude is similar to the 1981 fast tax reduction, the prevailing logic is closer to the 1986 bill which aimed to simplify the federal tax system and prevent fiscal dumping.

The lessons of history are sometimes cruel. During the Reagan’s era, cuts in tax rates were not accompanied by reductions in public expenditures. Reagan in fact slightly increased public expenditure, notably defense spending, to 31% of GDP from 29% of GDP between 1980 and 1988.

Ironically, the ‘Reagan recovery’ began weeks after the 1982 tax increase called the Tax Equity and Fiscal Responsibility Act (TEFRA), which significantly counterbalanced the 1981 ERTA tax cuts.

Reagan raised taxes 11 times over the course of his presidency. The double dip recession of 1982 eroded fiscal revenues, in turn requiring support in terms of public expenditures. As a result, public debt ballooned, inciting the Congress to push for tax hikes in order to restore its sustainability.

Following midterm elections, to be held in November 2018, we consider that there is a good chance for tax cuts to be reversed for debt sustainability purpose, as we don’t expect the current fiscal package to have a significant impact on growth and generate enough fiscal revenues to put US debt on stable footing.

Past tax cut programs suggest low multiplier effects

Contrary to President Trump’s argument for the largest program of tax cuts in US history, the TCJA will rank fourth in history of tax cuts program, behind the 1981 ERTA and Obama’s stimulus programs (2010 and 2013) after the subprime crisis.

These tax packages were followed by a sharp increase of public expenditures, which seems unlikely today given the fiscal hawks around Trump (e.g. the Tea Party), making President’s Trump initiatives in terms of infrastructure spending unlikely to materialize.

This could reduce investment incentives as companies will anticipate a negative contribution of the public sector to domestic demand and therefore reduce the multiplier effects of recent tax cuts.

In terms of individual tax cuts the two highest deciles of US income distribution will concentrate over 70% of the corresponding gains.

Yet higher-income households have a lower propensity to consume, therefore weakening the size of the multiplier effect.

On the corporate side, tax cuts on corporations’ cash flows have also lower multiplier effects compared to infrastructure projects, which traditionally boost in a larger extent investment.

CBO’s calculations on US multipliers by category of fiscal initiative allow us to give out an average estimate of the tax reform’s impact on US growth.

We obtain a total impact on real GDP growth between 0.1-1.0 pp, taking into account the repatriation of foreign profits. The latter are expected to generate a limited impulse on domestic investment as repatriated profits are expected to be held in cash deposits, fund dividends and share buybacks as well as reduce corporate debt levels.

The spectre of debt because of partisanship

Beside the short-term multiplier impact, we attach a higher importance to the context of instability surrounding budgetary issues in the US. Partisan discussions on immigration issues blocked the voting of a continuing resolution (read: temporary fix of public finances) on budget in the US Congress.

As a result, a government shutdown (closure of non-essential federal offices) took place from December 19th 2017, and then was temporary fixed until February 8, 2018.

A government shutdown, observed several times in the past, represents a negative shock to annualized quarterly real GDP growth of 0.1-0.15 pp per week. Partisanship has reached a record high level during first year of Donald Trump’s Presidency.

Yet the IMF has demonstrated a positive relation between political fragmentation and the level of public debt.

Typically, countries with highly partisan political systems (Japan, Greece, Spain, Italy, France, US) have higher public debt compared with countries capable of bipartisanship in public affairs via a tradition of broad coalition governments (Germany, Netherlands, Finland, Sweden, Denmark).

General Government Debt, Total, % of GDP,2015

Source: OECD