Wednesday, March 15, 2017

Trump could start a massive fiscal stimulus program

Most forecasters believe the Trump administration’s forecasts of 3 percent to 3.5 percent annual real gross domestic product growth in the next decade are far too rosy. The nonpartisan Congressional Budget Office foresees 1.9 percent per year between 2021 and 2027, and the Federal Reserve expects 1.8 percent annually in the long run.

These differences aren’t trivial. Growth at 3.5 percent per year rather than 1.8 percent would make the economy 18 percent bigger over a decade. It also would involve reducing federal budget deficits by cutting spending on programs such as food stamps and unemployment insurance while boosting taxable personal and corporate incomes.

Pessimists point to the ironclad law of economic growth: Annual increases in employment plus productivity growth equal yearly gains in economic output. Aging and retiring postwar babies, as well as President Donald Trump’s anti-immigration policies, will severely limit labor force growth, they maintain. And output per hour worked, which gained about 2.5 percent a year in earlier decades, has risen just 0.5 percent annually in the 2010-2016 years.

Some blame weak capital spending while others foresee no big productivity-soaked new technologies coming along to propel productivity because everything worth inventing is extant. Malthus is alive and well. At the opposite end of the spectrum are those who believe robots will replace people to the point that there will be too few earners to buy the nation’s output.

I disagree. First of all, consider the bias of most forecasters toward slow growth forever. Since this business expansion started in mid-2009, real GDP growth has averaged a mere 2.1 percent despite the Federal Reserve’s cuts in short-term interest rates to zero and huge quantitative easing. So the tendency of most is to assume that this pattern will last indefinitely and they select evidence to substantiate that view. It’s the easiest forecast to sell as forecasters’ audiences readily agree because it matches their ongoing experience.

Still, the ironclad law of economic growth is actually quite pliable. Real GDP annual growth of 3.5 percent would occur with 2.5 percent yearly growth in productivity and 1 percent rises in employment, the historic numbers. True, with low fertility rates, the Census Bureau sees the U.S. population rising just 0.2 percent a year by 2026, even with net immigration of 1.3 million annually over the next decade.

Nevertheless, the labor participation rate -- the percentage of the population over 16 that is employed or actively looking for work -- had plummeted to 62.9 percent in January from the 67.3 percent peak 17 years earlier. So 4.4 percent of the potential workforce, or 11.3 million people, have departed. About 60 percent were retiring postwar babies, but many are returning or staying in jobs past normal retirement ages because their health is better than their predecessors’ and because they need the income. Postwar babies have been notoriously poor savers throughout their lives. The participation rates of those over 65 are actually rising, not falling, as is normally true for seniors.

Also increasingly looking for work are youths who stayed in school during the dark Great Recession years and are now better educated and attracted by expanding job openings. In addition, skills to meet available jobs are being provided by apprenticeship programs that combine two-year college degrees with on-the-job training. German manufacturers brought this system with them to their factories in the U.S. Southwest, and it is increasingly being emulated by U.S. firms.

Trump’s threats of mass deportation of undocumented immigrants have been scaled back. They now target those with criminal records and other suspects. And with cooler heads in Congress, U.S. immigration policy may end up mirroring Canada’s with a point system aimed at admitting those with the skills this country needs.

Trump’s planned deregulation and lower corporate tax rates may spur capital spending, but the correlation between the growth in capital expenditures and productivity gains is low, sometimes negative. More machines alone don’t spur efficiency. More important, productivity-enhancing new technologies grow explosively, but since they start from essentially zero, it takes decades before they move the productivity needle significantly. Aside from those yet to be developed, today’s well-known technologies such as robotics, additive manufacturing, biotech and self-driving vehicles are no doubt still in their infancy.

The argument that protectionism inhibits economic growth is also suspect. Sure, eras of rapid global economic growth are also periods of strong foreign trade advances, but do trade gains stimulate economic activity or the reverse? You can’t prove causality with statistics. If you beat a drum every time there is a total eclipse of the sun, it will go away. No causality, but 100 percent correlation.

Also questionable is the robots-will-eliminate-workers theory. A recent McKinsey study found only 5 percent of 800 occupations and 2,000 job tasks are likely to be entirely automated. Instead, half of current jobs will be changed significantly, forcing employees to adjust. At the same time, automation may hike global productivity by 0.8 percent to 1.4 percent per year during the next half century.

The catalyst for the return to rapid economic growth will, no doubt, be a huge fiscal stimulus program. Voters who are mad as hell after a decade or more of no growth in real incomes elected Trump and the Republican Congress, and politicians will respond. It will take two or three years to come to fruition, but look for huge infrastructure outlays and large increases in military spending. 

Stocks don’t normally discount that far ahead, but maybe that’s what leaping equities are anticipating, despite all the uncertainty in Washington, the nation and, indeed, the world.

Sunday, March 12, 2017

Tax reform on the way

Tax reform is all the rage in Washington, with the focus on the “Better Way” proposed by House Speaker Paul Ryan and Ways and Means Chairman Kevin Brady. Their aim is to make “the tax code simpler, fairer and flatter, so simple that most Americans can do their taxes on a form as simple as a postcard.” So lookout, H&R Block and the armies of other tax preparers and lawyers!

Among other liberalizations, the proposal calls for reducing individual tax brackets from seven to three and dropping the top marginal rate from 39.6 percent to 33 percent. Small business would enjoy a 25 percent maximum tax rate while the corporate tax rate would fall from 35 percent to 20 percent, among the lowest among major countries. Also, a low 10 percent tax on repatriated earnings would encourage the like of Apple to bring money home.

Some argue that repatriation will boost the dollar as assets abroad are converted to greenbacks, but much of those foreign-held earnings are already in dollar-denominated investments. Others expect the money to be plowed into U.S. capital spending, but if major companies want to invest domestically and don’t have the cash at home, they can easily borrow against the collateral of their foreign-held earnings. Similarly, the boosts to stock repurchases and dividends with repatriated cash may be limited. It’s already common, as low interest rates have already encouraged corporations to borrow in order to reward stockholders.

The most novel proposal is the border-adjustment tax, which is needed to make the whole package revenue-neutral, which is attractive at a time when there are lingering concerns over earlier huge federal budget deficits. Border adjustment is a hybrid of the value-added tax used by most countries, and is essentially a tax on domestic consumption. At each stage of production, the costs of purchased goods are subtracted from the sale prices and the tax applied to the remainder. So it is a tax on the value added by labor, management expertise and profits, and so on. It’s useful in areas such as Europe, where components are produced in one country, shipped to another for sub-assembly and a third for final assembly in multi-step supply chains. This is more conducive to international trade and simpler than taxing sales of each company.

It’s also attractive because under World Trade Organization rules, VATs can be added to the cost of imports, thereby discouraging them, and rebated on exports to make them cheaper for foreign buyers. The U.S. has a heavier reliance on income and payroll taxes than other countries and they can’t be rebated on exports. Based on how much the U.S. imports and exports, there would be a net tax revenue gain of 0.6 percent of GDP. That’s $120 billion annually and more than $1 trillion in the next decade.

Here’s where the border adjustment proponents get into their fancy footwork: they assume that more-expensive U.S. imports will curb buyers’ demand and reduce the dollars needed to be paid to foreigners to buy them, while cheaper exports will enhance their appeal to foreigners and, consequently, their demand for greenbacks. So the dollar value will rise 25 percent to re-establish equilibrium by offsetting the taxes on imports and subsidies on exports. Then the exchange rate-adjusted prices of imports and exports return to where they were, except the Treasury collects a $120 billion annual windfall from foreign exporters, enough to offset tax cuts and keep the whole plan revenue neutral.

Sounds like free lunch, but there’s no such thing. If this mechanism worked, the dollar and the current-account balance, which is the broadest measure of trade, would be perfectly correlated. But they aren’t, often moving in opposite directions, as shown in the graph below. This is because the dollar is the international currency for trade and capital flows. Although 87 percent of global currency transactions involve the greenback (out of 200 percent counting both sides of every transaction), most uses of the dollar involve non-U.S. countries trading among themselves and capital transactions that have nothing to do with trade. U.S. trade makes up just 1.4 percent of the daily transactions in the dollar.

Border-adjustment fans also don’t account for the likely violent swings in U.S. imports and exports until their equilibrium is re-established. And, they aren’t considering the effects of the dollar’s leap in the cost of servicing dollar-denominated debts of emerging economies. The ongoing rush of Chinese out of the yuan and into the dollar, which has already slashed China’s foreign-currency reserves from $4 trillion in July 2014 to less than $3 trillion, would turn to an economy-wrenching flood. Credit Suisse estimated that the border adjustment would cut merchandise exports from Asia by 3 percent to 4 percent and the region’s growth by 0.5 percentage point.

Foreign governments might retaliate with shifts in income and payroll taxes to higher value added levies. No other country disallows the deductibility of import costs. The WTO would no doubt object since it regards tax exemptions on exports as illegal unless they are consumption taxes. U.S. importers, ranging from retailers who bring in cheap Chinese goods to importers of fish, are obviously upset. All want exceptions for their products, but House Republican leaders vow to permit no exceptions in imports, lest the dam breaks and the whole scheme is gutted.

The Senate and the Trump administration have yet to formally weigh in on the tax plan, and border adjustment in particular. Trump said it was very complicated, and Treasury Secretary Steven Mnuchin said it has “interesting aspects,” but “there are some concerns about what the impact may be on the dollar.” Trump has railed against the competitive devaluations of other countries’ currencies and said the buck is too robust. Nevertheless, in his Feb. 28 speech to Congress, he appeared to be sympathetic to border adjustment. Trump has noted that other countries impose tariffs and taxes on American products while the U.S. reciprocate.

Don’t expect swift action on tax reform. Many factions on both sides of the aisle will be involved and after inevitable compromises, the final bill may be quite different than the House proposal. Even Mnuchin is aware of likely delays. He said the administration is working with House and Senate Republicans to reconcile differences, with the aim of passing major legislation before Congress’s August recess. But he added, “that’s an ambitious timetable. It could slip to later in the year.” Which year?