The Federal Reserve, the Free Lunch and the Tax Cuts and Jobs Act of 2017

While every administration that changes the U.S. tax code likes to brag about the financial advantages to Main Street America and how the changes will positively impact the economy, a recent speech by William Dudley, the President and Chief Executive Officer of the Federal Reserve Bank of New York provides us with an insider’s viewpoint on the impact of the Trump Administration’s recent 1,097 page-long Tax Cuts and Jobs Act of 2017.

In Mr. Dudley’s January 11, 2018 speech given to the Securities Industry and Financial Markets Association, he opens by noting that, broadly speaking, the prospects for above-average economic growth in 2018 remain “reasonably bright” which will lead to a tighter job market and quicker wage growth which will help the Federal Reserve achieve its 2 percent inflation target.  That said, he goes on to note that he is far more cautious about the longer term prospects for the economy given the recent passing of the aforementioned Tax Cuts and Jobs Act of 2017.  While the act will provide support for continued economic growth over the near-term, the growth will come at a cost for two reasons:

1.) the Act will lead to increases in the federal debt which is already facing pressures related to higher debt servicing costs.

2.) increases in entitlement spending as the baby-boom generation retires and ages.

He notes that “there is no such thing as a free lunch“, that “the current fiscal path is unsustainable” and that “ignoring the budget math risks driving up longer-term interest rates” are diminishing America’s creditworthiness.

Let’s start by looking at Mr. Dudley’s comments on short-term economic growth prospects and the impact of the recent changes to the tax code :

While this legislation will reduce federal revenues by about 1 percent of GDP in both 2018 and 2019, I anticipate the boost to economic growth will be less than that. Most importantly, most of the tax cuts accrue to the corporate sector and to higher-income households that have a relatively low marginal propensity to consume.  This suggests that a significant portion of the tax cuts will be saved, not spent.

On the business side, the boost to investment from the lower corporate tax rate and full expensing is likely to be relatively modest.  In the past, aggregate investment spending has not been very sensitive to the cost of capital, which is only one of many factors that influence investment spending.  Moreover, the reduction in the effective tax rate for corporations—or what they typically pay in practice—is only about 3 to 4 percentage points, far smaller than the reduction in the statutory rate.  On the household side, the impact is likely to be attenuated by the temporary nature of many important provisions.  Households may not spend much of the additional after-tax income if they perceive the gains as likely to be transitory.” (my bold)

Given that Corporate America has generally paid far less taxes than the headline corporate tax rate of 35 percent would suggest, his observations that the reduction in the effective corporate tax rate to 21 percent is rather moot, meaning that corporate spending is unlikely to increase based on the Trump Administration’s tax cuts.

It is also interesting to note his comments on how the tax reductions will impact economic growth through consumption.  Given that nearly 70 percent of the U.S. economy is related to consumer spending as shown here:

…Mr. Dudley’s observation that most of the tax cuts accrue to higher-income households who have a “relatively low marginal propensity to consume“.  After all, how many toasters, refrigerators, big screen televisions can one wealthy family consume when compared to hundreds of thousands or millions of middle class households?

Now, let’s look at Mr. Dudley’s views of the long-term.  As I noted above, Mr. Dudley has greater concerns for the long-term economic growth prospects for the economy as follows, both of which are related to the Tax Cuts and Jobs Act of 2017:

1.) Economic Overheating – with a labor market that is already tight and an economy that is growing at a rate that is above-trend, even a modest economic boost related to the reductions in tax revenues in 2018 and 2019 could push the Federal Reserve into having to tighten even further than expected or, as Mr. Dudley states “the Federal Reserve may have to press harder on the brakes“.

2.) Federal Fiscal Position – the current federal fiscal position of the United States is precarious as quoted from his speech here:

The second risk is the long-term fiscal position of the United States.  Recognizing that fiscal policy is the domain of the executive and legislative branches rather than the Federal Reserve, I would emphasize several points.  For one, the current U.S. fiscal position is far worse than it was at the end of the last business cycle.  For example, in fiscal year 2007, the budget deficit was 1.1 percent of GDP; in fiscal 2017, it was 3.5 percent of GDP.  Similarly, federal debt held by the public was 35 percent of GDP in fiscal 2007, and 77 percent in fiscal 2017.  Additionally, three factors will undoubtedly cause these budgetary pressures to intensify over time: the tax legislation will push up the federal deficit and federal debt burden; debt service costs will rise as interest rates normalize; and entitlement outlays will increase as the baby boom generation retires.” (my bold)

The Joint Committee on Taxation estimates that the changes to the tax code will total $1.08 trillion over the next ten years as shown here:

Mr. Dudley projects that debt service costs will continue to rise, reaching more than $800 billion or 3 percent of GDP annually (Congressional Budget Office estimates).  He does note the following:

Debt service costs will undoubtedly be boosted by higher levels of federal debt and higher interest rates.  In fiscal year 2007, federal debt service costs totalled $237 billion on $5 trillion of federal debt held by the public.  By fiscal year 2017, although federal debt held by the public had nearly tripled to almost $15 trillion, debt service costs were $263 billion, only modestly above where they were 10 years earlier.  Over the past decade, the sharp decline in short- and long-term interest rates has kept a lid on debt service costs—that lid is now being lifted.” (my bold)

We can see this quite clearly on this graphic from FRED which shows the yield on ten-year Treasuries going back to 2000:

Thanks in large part to the Federal Reserve’s easy money policy since it rescued the global economy from certain collapse in 2008, Washington (not to mention other governments around the globe) have gone through a season of unfettered debt accrual since there appears to be no day of debt reckoning in the current low interest rate environment.  While it is a bit off topic, when you see a debt-cursed nation like Greece with yields like this:

…you know that the global fiscal situation is unsustainable.

Let’s close with Mr. Dudley’s closing remarks:

As the economist Herbert Stein once remarked, trends that are unsustainable must end.  How, precisely, the United States chooses to address its fiscal challenges will have important consequences for the economy, monetary policy, and financial markets in the years ahead.

To sum up, I am optimistic about the near-term economic outlook and the likelihood that the FOMC will be able to make progress this year in pushing inflation up toward its 2 percent objective.  The economy has considerable forward momentum, monetary policy is still accommodative, financial conditions are easy, and fiscal policy is set to provide a boost.  But, there are some significant storm clouds over the longer term.  If the labor market tightens much further, it will be harder to slow the economy to a sustainable pace, avoiding overheating and an eventual economic downturn.  Another important issue is the need to get the country’s fiscal house in order for the long run.  The longer that task is deferred, the greater the risk for financial markets and the economy, and the harder it will be for the Federal Reserve to keep the economy on an even keel.(my bold)

Indeed, we are living in an unsustainable economic reality.  The “free lunch” granted by the Tax Cuts and Jobs Act of 2017 could prove to be extremely costly over the longer-term.  Eventually, as painful as it will be, Washington will have to face reality do one of two very unpopular things; raise taxes or cut spending or some combination of the two.  While that is a clear cut path to losing an election, there will come a point when Congress and the Executive Branch have no choice but to rescind the tax savings of the Tax Cuts and Jobs Act of 2017.

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