The New Tax Law Should Spur Long-Term Growth, Too
Many forecasting models lowball the effect by ignoring the structural changes to the economy.
By David Malpass
Wall Street Journal
January 28, 2018
The U.S. economy accelerated in 2017 as tax reform became a realistic possibility. Growth topped 3% in the second and third quarters. While the first estimate of the fourth quarter, released Friday at 2.6%, was a bit slower, it was paced by an 11.4% increase in equipment investment. That type of investment raises productivity, adds to the skills of the labor force, and pays dividends for years.
The strong 2017 increase in jobs and equity prices confirms a substantial improvement in economic prospects that went well beyond the slow year-ago forecasts of those who argued that the incoming president’s economic program wouldn’t work.
A key issue for markets and policy makers is whether the economic improvement is temporary, giving way to slower growth later, or longer-lasting, opening a structural reform path to higher sustained growth. The International Monetary Fund’s just-released outlook takes the former stance, increasing its near-term U.S. growth forecast substantially—to 2.7% in 2018 and 2.5% in 2019 from its pre-tax-reform forecasts of 2.3% and 1.9%. But the IMF argues that “the tax policy package is projected to lower growth for a few years from 2022 onwards.”
Many forecasting models lowball the longer-term growth effect of the new tax law by focusing on its fiscal mechanisms rather than the structural change. The law has a provision allowing expensing of new investments for five years, and many of the tax benefits for individuals will expire after 2025 unless Congress extends them. As per the IMF model—which expects U.S. growth to fade to only 1.5% a year in the longer term, even lower than during the Obama years—the dominant features of the tax bill are captured in the “fiscal stimulus” in the early years and fiscal tightening in the middle of the next decade.
This forecasting approach misses the purpose of tax reform, which is to allow the economy to change so that it grows faster. The real-world effect of tax cuts comes from businesses, large and small, responding to improvements in growth policies, including lasting regulatory, tax and energy reforms. Many of the provisions in the law will increase U.S. business investment, allow a better allocation of capital, and encourage small-business dynamism. This combination of structural improvements will draw more workers into the labor force, improving their skills. This will allow the economy to rebuild from the low average growth rate that preceded the Trump administration, rather than reducing long-term growth as many of the inbred government-centric models of growth envision.
By lowering the corporate tax rate to 21% from 35%, the new law aligns incentives so that managers focus more on creating profitable businesses and building their labor pool rather than offshoring jobs and devising expensive financial structures to minimize taxes.
Importantly, the new law will benefit many unincorporated businesses. They are often the nimblest and best able to hire and train workers new to their industry—precisely the workers the president wants to draw into the labor force. The new law provides small pass-through businesses with a 20% tax deduction, helping them compete with big companies and government-dominated industries. As their workers gain skills, their productivity increases rapidly, allowing more growth than assumed in the models.
Many aspects of the growth outlook can’t be reduced to models. A key growth provision in the bill limits the federal deduction for state and local taxes to $10,000 a year. Without that limit, previous law provided a massive federal subsidy to high-tax states, especially wealthy households in those states.
Standard macroeconomic models treat a reduction in a tax deduction as a drag on growth because it reduces the fiscal “stimulus.” But the bigger impact of the so-called SALT limitation will be structural and favorable for growth. Reducing the giant transfer of resources from small-government states to big-government states will allow capital and investment to flow more freely to profitable, job-creating investments around the country. The poorer counties in high-tax states have huge growth potential if their state and local governments were to restrain their spending and taxes in response to the tax-law change. Similarly, low-tax states can grow even faster as the tax headwind from subsidized high-tax states diminishes.
The most important variables in the outlook are whether business and workers respond favorably—all signs are that they will—and whether the economic acceleration and the success with the new tax law will lead to a series of growth-oriented reforms in the U.S. and abroad. A highly favorable outcome would be for other countries to compete with the U.S. on growth-oriented structural reforms. If so, average long-term growth can be substantially faster than the consensus models expect.
Mr. Malpass is Treasury undersecretary for international affairs.
Many forecasting models lowball the effect by ignoring the structural changes to the economy.
By David Malpass
Wall Street Journal
January 28, 2018
The U.S. economy accelerated in 2017 as tax reform became a realistic possibility. Growth topped 3% in the second and third quarters. While the first estimate of the fourth quarter, released Friday at 2.6%, was a bit slower, it was paced by an 11.4% increase in equipment investment. That type of investment raises productivity, adds to the skills of the labor force, and pays dividends for years.
The strong 2017 increase in jobs and equity prices confirms a substantial improvement in economic prospects that went well beyond the slow year-ago forecasts of those who argued that the incoming president’s economic program wouldn’t work.
A key issue for markets and policy makers is whether the economic improvement is temporary, giving way to slower growth later, or longer-lasting, opening a structural reform path to higher sustained growth. The International Monetary Fund’s just-released outlook takes the former stance, increasing its near-term U.S. growth forecast substantially—to 2.7% in 2018 and 2.5% in 2019 from its pre-tax-reform forecasts of 2.3% and 1.9%. But the IMF argues that “the tax policy package is projected to lower growth for a few years from 2022 onwards.”
Many forecasting models lowball the longer-term growth effect of the new tax law by focusing on its fiscal mechanisms rather than the structural change. The law has a provision allowing expensing of new investments for five years, and many of the tax benefits for individuals will expire after 2025 unless Congress extends them. As per the IMF model—which expects U.S. growth to fade to only 1.5% a year in the longer term, even lower than during the Obama years—the dominant features of the tax bill are captured in the “fiscal stimulus” in the early years and fiscal tightening in the middle of the next decade.
This forecasting approach misses the purpose of tax reform, which is to allow the economy to change so that it grows faster. The real-world effect of tax cuts comes from businesses, large and small, responding to improvements in growth policies, including lasting regulatory, tax and energy reforms. Many of the provisions in the law will increase U.S. business investment, allow a better allocation of capital, and encourage small-business dynamism. This combination of structural improvements will draw more workers into the labor force, improving their skills. This will allow the economy to rebuild from the low average growth rate that preceded the Trump administration, rather than reducing long-term growth as many of the inbred government-centric models of growth envision.
By lowering the corporate tax rate to 21% from 35%, the new law aligns incentives so that managers focus more on creating profitable businesses and building their labor pool rather than offshoring jobs and devising expensive financial structures to minimize taxes.
Importantly, the new law will benefit many unincorporated businesses. They are often the nimblest and best able to hire and train workers new to their industry—precisely the workers the president wants to draw into the labor force. The new law provides small pass-through businesses with a 20% tax deduction, helping them compete with big companies and government-dominated industries. As their workers gain skills, their productivity increases rapidly, allowing more growth than assumed in the models.
Many aspects of the growth outlook can’t be reduced to models. A key growth provision in the bill limits the federal deduction for state and local taxes to $10,000 a year. Without that limit, previous law provided a massive federal subsidy to high-tax states, especially wealthy households in those states.
Standard macroeconomic models treat a reduction in a tax deduction as a drag on growth because it reduces the fiscal “stimulus.” But the bigger impact of the so-called SALT limitation will be structural and favorable for growth. Reducing the giant transfer of resources from small-government states to big-government states will allow capital and investment to flow more freely to profitable, job-creating investments around the country. The poorer counties in high-tax states have huge growth potential if their state and local governments were to restrain their spending and taxes in response to the tax-law change. Similarly, low-tax states can grow even faster as the tax headwind from subsidized high-tax states diminishes.
The most important variables in the outlook are whether business and workers respond favorably—all signs are that they will—and whether the economic acceleration and the success with the new tax law will lead to a series of growth-oriented reforms in the U.S. and abroad. A highly favorable outcome would be for other countries to compete with the U.S. on growth-oriented structural reforms. If so, average long-term growth can be substantially faster than the consensus models expect.
Mr. Malpass is Treasury undersecretary for international affairs.
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