US fiscal policy Ghosts of the past

5 min
Alexis Garatti
Alexis Garatti Head of Macroeconomic Research
  • Over the last five months, President Trump has initiated an ambitious program of tax cuts and higher fiscal spending, with the promise that positive dynamic effects on growth will be strong enough to avoid any increase of the public debt
  • We estimate that the impact on GDP growth should be moderate with a 0.7 pp boost in 2018 and 0.6 pp in 2019
  • The rapid worsening of the fiscal situation, embodied by a public deficit at 4.5% of GDP in 2019 compared with 3.4% in 2017, will evidence rather weak multiplier effects in a late phase of the cycle and call for rapid changes in the orientation of the US economic policy


The US economic policy at a crossroad

Over the last five months, President Trump has initiated an ambitious program of tax cuts and higher fiscal spending, with the promise that positive dynamic effects on growth will be strong enough to avoid any increase of the public debt. Taking into account the specificities of these fiscal packages, we estimate that the impact on GDP growth should be moderate with a 0.7 pp boost in 2018 and 0.6% pp in 2019. The rapid worsening of the fiscal situation, embodied by a public deficit at 4.5% of GDP in 2019 compared with 3.4% in 2017, is evidence of rather weak multiplier effects in a late phase of the cycle.

History can tell us a lot, especially the smell of the 80s, concerning the fiscal actions. In this paper, we will look at the three building blocks of President Trump’s fiscal policy, i.e. a radical program of tax cuts (USD 1.4 trillion over ten years), a tax holiday on foreign profits (targeting a pool of USD 2.4 trillion of funds detained abroad) and a significant acceleration of public spending (USD440bn over 2 years).

Similarities and differences from the past suggest that the bet of higher growth and stable debt may not materialize. Mid-term elections will probably play the role of a wake-up call as debt sustainability will come back at the forefront of concerns among conservative leaders.


A sizeable tax bill with limited effects, especially if/when the fiscal hawks are back

Donald Trump has announced one of the largest tax cut programs ever in the US.Losses on fiscal revenues, without taking account of macroeconomic positive feedback effects, are estimated at USD 1.45 trillion over ten years.It represents an average stimulus of USD140bn per year. The estimated size of the tax cut boost ranks fourth in the hierarchy of past tax cut programs, behind 1981 Reagan’s program (Table 1).

Table 1 Revenue effects of major US bills enacted since 1968 (Constant 2012 USD bn)


Sources: Office of Tax Analysis, Allianz, Euler Hermes

The TCJA mainly deals with tax cuts and reduction of tax loopholes, which aim at simplifying the US tax system (see the details in Table 2).

Besides the size of the stimulus, the composition and targets of the “Tax Cuts and Jobs Act” point toward limited impact on growth. In order to calculate the impact of the US fiscal reform on US GDP growth, we adopt a differentiated approach of multipliers by categories of agents and by categories of measures.

CBO research has provided a low and high estimate of different categories of multipliers. We adopt a middle range in order to get a reasonable estimate of the total multiplier impact.

We therefore assume an average multiplier of 0.9 for tax cuts benefitting to lower income households and a multiplier of 0.35 for higher income households. Regarding tax cuts on profits, the average estimated size of the multiplier reaches 0.2.

These types of multipliers are somewhat lower compared with other types of stimulus measures such as infrastructure spending or direct purchase of goods and services by the government with estimated values of 1.3 and 1.5 respectively.

Individuals of the lower income group, that we define as those perceiving less than USD 100K per year, will benefit from USD39.2bn of cuts in income taxes in 2019 (28% of total individual tax cuts), while those winning more than USD 100K will benefit from the bulk of the tax cuts (72% representing USD102.8bn).

Households in the highest categories of revenues have a lower propensity to spend when observing a rise of their disposable income. Applying the CBO’s multiplier to those tax cuts sharing by income categories and assuming that the effects take place within one year, we obtain an impulse of 0.4 pp on GDP growth in 2018 and 0.3 pp in 2019. On the business side, we can estimate that USD112bn of tax cuts will occur in 2018 and USD118bn in 2019. By applying a multiplier of 0.2 we obtain an impact amounting 0.1 pp of domestic aggregate demand in both 2018 and 2019.

In total, cumulating the impact of individual tax cuts and corporate tax cuts, we reach a positive outcome representing a boost of 0.5% of GDP in 2018 and 0.4% of GDP in 2019.

Ghost of the Past: President Trump's fiscal reform produces a sense of déjà vu when compared with President Reagan’s Economic Recovery Tax Act of 1981 and the Tax Reform Act of 1986

The net increase of public debt should reach a level of USD 1 trillion over ten years as dynamic effects on growth are generally estimated at USD 400bn, less than offsetting the USD 1.4 trillion of losses in terms of fiscal revenues. In fact, this expected surge in public debt is a common feature with Reagan’s era as it increased from 31% of GDP to 51% of GDP between 1980 and 1988 following the implementation of different tax cut programs. President Reagan proposed two series of tax cuts: the Economic Recovery Tax Act of 1981 (Enacted reduction in marginal income tax rates by 25% over 3 years, with the top rate falling from 70% to 50% and the bottom rate dropping from 14% to 11%, reduced maximum capital gains to 20%, trimmed taxes paid by corporations by USD150bn over a five year period) and the Tax Reform Act of 1986 (Top individual tax rate was reduced to 28.5% from 50%, increased home mortgage deductions, reduced tax loopholes). President Reagan slightly increased public expenditure, notably defence spending, from 29% of GDP to 31% of GDP between 1980 and 1988. However, the double dip recession of 1982 had eroded fiscal revenues and required some 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. The Tax Equity and Fiscal Responsibility Act (TEFRA), then signifi-cantly counterbalanced the tax cuts decided in 1981 with the ERTA. President Reagan raised taxes 11 times over the course of his presidency thereafter.

November 2018 mid-term elections could be a turning point for fiscal policy

As a symbol of a lack of confidence in winning the next Mid-Term Elections, and gradual division among Republicans, the House Speaker Paul Ryan announced on April 11th, 2018 that he would retire from January 2019. This announcement is first of all an obstacle to the current campaign of fund raising as he is a prominent figure of the GOP counterbalancing the image of President Trump. It brings to 38 the number of Republicans not seeking re-election, embodying a form of discouragement in the Republican side. It is now estimated that Democrats have a chance to win back the House (they need 23 seats). The current rate of approval of President Trump is currently significantly lower compared with all prior US Presidents. At last, the Republican Chairman of the Senate Judiciary Committee proposed a bill to protect Special Counsel Robert Mueller from being dismissed after President Trump’s communication suggested that this possibility was real. A growing division is clearly visible meaning that fiscal hawks, those advocating for prioritizing the stabilization of public debt, could re-take the lead after November 2018. Similarly with President Reagan’s era, in the case of no rapid success of the fiscal policy in boosting growth, the current US President could be pushed to back-pedal in order to stabilize debt.

Earnings repatriation suggests small boon for investment

Above calculations of the multiplier takes into account repatriated foreign profits flowing into investment. One of the highlights of President Trump’s tax plan is the reform of taxation of income perceived by foreign affiliates of US companies. As it stands the US taxes foreign corporate income at a rate of 35% if/when earnings are repatriated. The latest iteration of President Trump’s tax plan has two key features: (i) foreign income would be subject to a 0% territorial regime with a minimum rate for intangible income and (ii) a one-time tax on untaxed foreign profits of 15.5% for assets held in cash and liquid assets and 8% for the rest. With respect to growth, estimating how much of these earnings will be distributed in the form of dividends versus being re-invested is key. 

Ghost of the past: The 2004 Homeland Investment Act (HIA) which revised section 965 of the internal revenue code (IRC) such that US corporations with foreign subsidiaries could bring overseas profits at a reduced tax rate of 5.25%.

In the immediate aftermath of the HIA, US corporations repatriated 25% of their total estimated overseas earning or USD300bn in 2005 alone, up from USD82bn in 2004 (see figure 1). Researchers have shown that this tax holiday did not result in increased domestic investment, employment or R&D. Instead, a $1 increase in repatriations was associated with nearly as much an increase in payouts to shareholders.

According to analysts, S&P 500 companies account for USD2.5 of USD2.9 trillion in earnings reinvested overseas including USD920bn is in the form of cash. Assuming firms fund their tax burden from overseas cash that leaves USD652bn dollars available. Assuming that the magnitude of tax repatriation is the same as in the wake of the HIA, S&P 500 firms could repatriate (net of taxes) as much as USD163bn in 2018 with the rest remaining overseas to fund international operations.

Chart 1 Repatriated earnings rose sharply during the HIA tax holiday

Sources: CBO, Allianz, Euler Hermes

US corporates which repatriate foreign earnings will have the choice of returning it to shareholders via (i) share buybacks and dividends or (ii) investing for growth in the form of capital expenditure, research and development and cash backed merger and acquisitions. Based on history, we could assume that 80% of the USD167bn will fund share buybacks and dividends, the other USD 33bn remaining could be used for investment. Nevertheless, US companies have already announced USD 151bn of share buybacks YTD (more than doubling the level of 2017 at this stage) with the prospect that this amount will exceed total 2017 level by far (USD 800bn expected compared with USD530bn in 2017). That’s why we can reasonably estimate that the general impact on investment will finally be negligible.

Bi-partisan budget and Omnibus bill: USD430bn of additional spending over two years but 2000bn of additional debt

The “Bipartisan Budget Act of 2018” budget deal that finally emanated from the negotiations on February 9, 2018 and the subsequent adoption of the Omnibus Bill on March 23, 2018 have the following elements:

  •  It once again lifts the Budget Control Act’s spending caps , increasing them by about USD320bn over the next two years and devoting about 55 percent of that increase to defence spending,
  •  Democrats also obtained an increase in natural disaster spending, as the package contains USD84bn in disaster relief for communities affected by recent hurricanes and wildfires.
  • It retroactively extends a number of tax provisions, none of them particularly significant, which had expired at the beginning of 2018 for a total cost to Treasury of USD17bn.
  • The legislation suspends the debt ceiling until March 2019.
  • Last, the recently voted Omnibus spending bill which determines discretionary spending levels of programs funded by the federal government, added USD 110bn above these caps.

Overall, it is estimated that the package will add another USD 430bn to federal budget deficits over the next two years.

From a macroeconomic perspective, the most important aspect is the boost to demand coming from the lifting of budget caps for defence and non-defence spending.

With regard to the effects of the decided increases in public sector expenditure on economic activity, it should be noted first of all that the expenditure increases authorized by the budget for the next two years will be spent over a longer period of time. In fact, the corresponding estimates of the Congressional Budget Office for outlays show that by the end of the fiscal year 2019 only a good 2/3 of the budgeted authority will be spent and the remainder will be expended in successively reduced amounts by the fiscal year 2023.  A similar pattern, but over a 10-year horizon, is evident in the spending of disaster relief.

The second and probably more difficult aspect is the magnitude of government spending multiplier, taking account of the fact that the US economy is in a mature stage of the business cycle. Empirical studies commonly suggest that fiscal multipliers are lower if the economy is close to or above its potential output than when there is a large negative output gap. The effectiveness of additional public spending is limited in times of high overall economic capacity utilization as it crowds out private demand, in part because the central bank is reacting to rising demand pressure. Concretely, a CBO study finds that a dollar increase

(decrease) in demand will have effects over eight quarters, instead of four in a situation when output is below potential. Importantly, the cumulative effect on GDP over eight quarters is clearly below 1, ranging from 0.2 (“low estimate”) to 0.8 (“high estimate”), because output in quarters five through eight moves in in the opposite direction of its initial path. Using the low estimate value of the CBO's multiplier estimate and making the simplifying assumption that USD 130 bn of the additional outlays are spent in 2018 and USD 300 bn in 2019, we have attempted to determine the impact on aggregate demand over time. 

All in all, GDP growth is expected to increase by around 0.2 percentage points in 2018 and by 0.2 in 2019 as a result of the higher fiscal spending.

Ghost of the past: Debt to markedly increase amid partisanship, low growth and low inflation

As a result of lower fiscal revenues, higher public spending and a muted reaction of activity to these different impulses, we expect the US deficit to reach 4.5% of GDP at the horizon of 2019 compared with 3.4% of GDP in 2017.  Between October 2017 and March 2018, the US deficit has already reached USD599.7bn, representing a 14% increase compared with the same period last year. The CBO expects the level of public debt held by the public to reach 100% of GDP approaching 2030 if the current law is maintained until this time.

The drawbacks of partisanship

The recent budget deal in Congress quite clearly documents how overcoming a partisan standoff eventually contributes to piling up public debt. Since fiscal year 2017 ended last September, the federal government has been operating under a series of continuing resolutions to fund the government.  Negotiations have been complicated as – in addition to issues related to immigration policy – Republicans, in particular, desired a large increase in defense spending without the commensurate increase in nondefense spending. Partisan discussions on immigration issues blocked the voting of a continuing resolution (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 January 20, 2018, 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 %-point per week.

Partisanship has reached a record high level during first year of Donald Trump’s Presidency. In order to overcome these difficulties, many concessions have been done in terms of tax cuts and increase of public spending to satisfy the Republican and Democratic side. 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).

Chart  2 US public debt outstanding and CPI inflation

Sources: CBO, Euler Hermes, Allianz research

A regime of lower growth and lower inflation

By implementing a pro-cyclical policy in a context of already tight labor market conditions, one could assume that the implicit goal of the US government consists of reaching a higher level of inflation and a higher level of growth. Historically, generating higher inflation has represented an indirect albeit disorderly way to reduce the level of debt expressed as a % of GDP as it boosts fiscal revenues via higher tax income revenues if a wage – inflation loop is at work. In the present environment however, even with fiscal expansion, it is unlikely that a regime of higher inflation will emerge. In modern economies, characterized by independent central banks, the materialization of higher inflation in a late phase of the cycle usually triggers a tightening of the monetary policy. In the current context, where inflation remains under control, and where the new FOMC aims at consolidating its credibility, the normalization in rates policy is likely to be gradual, probably contributing to prolong the current upswing. Indeed, we estimate that US wage acceleration should be limited with a range of 3% y/y – 3.5% y/y in 2018 and expect a muted reaction of prices to salaries

(CPI inflation at 2.3% y/y in 2018 and 2.4% y/y in 2019). The same is true for the regime of growth. Tax cuts will have positive effects on supply. However, the impact of the tax cuts on the US potential of growth is expected to be positive albeit being limited. Indeed, we evolve now in a regime of low productivity growth and the demographic dynamism has been significantly impaired (productivity and growth of active population are the main determinants of the potential of growth of an economy).

These significant differences, compared with past administrations having similar fiscal initiatives, are visible in the Table 6. In this radically different environment, marked by a lower potential of growth and a regime of lower inflation, there is a higher probability to observe a rapid increase of public debt (Figure 2).


(1) The growth and inflation impact of fiscal expansion will be quite moderate, hopes for extended self-financing of fiscal expansion will be disappointed, debt will rise (as was observed in former fiscal expansions). The corporate tax cuts besides the holiday on repatriated profits will have positive supply side effects, albeit moderate and temporary ones.

(2) Despite strong fiscal expansion, the US economy will not enter an inflationary boom in 2018 and 2019 and the Fed can remain gradual in its tightening approach. Growth will be dampened beginning in 2019 and thereafter as post mid-term election measures are likely to reign in high public borrowing. 

(3) Financial markets will not have to correct the basic view that inflation and interest rates will remain relatively low. The analysis of fiscal policy is compatible with our baseline scenario. Although volatility will rise for various reasons in the late stage of the cycle, we do not expect interest rate shocks as a result of massive overheating.