The U.S. Congress passed approximately $1.5 trillion worth of tax cuts spread over the next 10 years, just as the economy is in a mature phase operating near full employment and gaining momentum at the start of 2018 (see table 1 for a summary of changes to the tax code). President Donald Trump signed them into law on Dec. 22.
Factoring in this change, S&P Global economists now expect U.S. real GDP to grow 2.8% this year (was 2.6% in our November forecast) and 2.2% in 2019 (was 1.9%). This is largely driven by tax cuts to individuals and corporations.
Several reasons help explain the modest boost to economic growth from the large fiscal stimulus (equivalent to 0.8% of nominal GDP per year). Less generous deductions partially offset the lower tax rates. More importantly, tax cuts are considered to be skewed toward businesses and high-income earners, a combination that historically has shown to have a lower multiplier effect due to a lower marginal propensity to consume out of an additional dollar of income. The fiscal multiplier from the tax package will likely be no more than 0.4 (for every $1 of fiscal stimulus, return on growth of about 40 cents), meaning that the boost to real annual GDP growth this year and the next will be close to 0.3 percentage points (0.8 percentage points of GDP x 0.4 = 0.32 percentage points). But, we expect the growth trajectory to converge back to its long-term trend, which we estimate to be 1.8%.
The economic expansion is likely to transition back toward its longer-run trend below 2% in 2020 as the boost from the fiscal stimulus wanes and the cumulative monetary tightening begins to bite. We expect the Federal Reserve to continue its measured approach toward normalizing monetary policy. We have penciled in three rate hikes (of 25 basis points each) in 2018 and another three in 2019.
However, a big uncertainty in our outlook is how the Federal Reserve will respond to a fiscal boost at a time when the economy has been gaining momentum starting the new year (in fact, the global economy is experiencing a strong synchronized upswing). The large fiscal stimulus comes as the U.S. output gap has more or less closed, increasing chances that the Fed may want to move faster on rate hikes than we currently anticipate. Moreover, the rotation among voting Fed presidents will tilt the Federal Open Market Committee toward a more hawkish stance, though the change of guard at the Board of Governors clouds the view.
We do not anticipate the tax cuts will lead to a meaningful rise in the long-run potential of the economy, which we currently estimate at 1.8% over the next 10 years. The tax cuts are unlikely to boost the economy's potential growth rate by triggering acceleration in labor force or total factor productivity growth above our November baseline projections.
To raise potential real GDP, it is necessary to increase the amount of capital, labor, and/or productivity. Conceptually, tax cuts provide incentives that could increase supply of both labor and capital inputs as the returns they earn (after tax disposable income, dividends, or profits) increase. But to have any appreciable effect on potential GDP, the responsiveness of that input supply, with respect to those returns, needs to be really big.
Empirical evidence suggests that the labor supply elasticity is essentially zero in almost every case, with the exception of married women (see Saez, Emmanuel et.al "The Elasticity of Taxable Income with Respect to Marginal Tax Rates: A Critical Review," March 2012). With an elasticity close to zero, no matter how much you lower the tax rate and raise the return to labor (i.e., the wage), you can't induce a substantial increase in labor supply. Still, the slower recovery in the prime-age employment-to-population ratio suggests that there are still some people sitting on the sidelines, left to be tempted into the labor force. That's assuming these workers have the skills needed to fill these jobs.
The strong monthly average job gains of 171,000 in 2017 from 187,000 in 2016 (and over 200,000 in 2014 and 2015) will slow to a still-solid average of around 150,000 in 2018. Job gains will trend gradually lower thereafter--toward their long-run sustainable pace of near 100,000--as the baby boomers continue their march to the exit from the workforce. This should bring down the unemployment rate to a 3.9% average in 2018 and 2019, from a 4.3% average in 2017. But that's not much lower than the 4.0% we previously expected for both years. We do not see any noticeable impact on wage gains over the next two years compared with our November baseline. We look for the tightening labor market to finally push average hourly wage growth above 3% in 2018.
On the capital side, the lower tax rate reduces the user cost of capital for some industries and will likely lead to higher levels of investment. But history suggests not by much, with lower taxes more likely to boost dividends and stock buybacks than investment, as they have in the past. The tax holiday of 2004 is the best example--it provided U.S. corporations an incentive to bring back foreign earnings to boost the economy, but companies used much of that cash for shareholder-friendly activities. However, the 2017 tax bill signed by the president not only incentivizes the repatriation of accumulated foreign earnings but also includes other tax cuts, including lower corporate tax rates. The changes in expensing rules (firms can now expense 100% of their investments immediately, but the rule is set to phase out after five years) should provide a near-term boost to business investment. That boost is mitigated somewhat by the cap on the interest deduction, which raises the cost of debt-financed investments. In addition, it takes time for firms to adjust their business and investment objectives to a new corporate tax regime.
We continue to expect the immediate economic lift from tax cuts to be modest. We now expect equipment investment to grow by 8.2% in 2018, relative to 5.9% in our November forecast. To the extent this adds to capital deepening and productivity enhancements, it should help lift the potential of the economy at the margin. This is something we'll keep a close eye on as the tax package rolls out.
All said, the economy--if it evolves as we expect--will be $114 billion larger by 2020 (our three-year forecast horizon) compared with our previous base case (from our November forecasts). But this comes at a cost to the fiscal accounts. We now forecast the budget deficit as a percent of GDP to widen to 4.4% by 2020 (previously 3.8%), from 3.5% in 2017. However, Congress has yet to even conclude this year's budget negotiations to avoid sequestration cuts from kicking in and effectively lowering the deficit. The current deadline for a bipartisan deal to loosen the caps on spending and avoid a government shutdown is Jan. 19.
Over the longer term, if tax cuts aren't counterbalanced by reform in spending and based on our assumptions of no increase in longer-term growth dynamics, the resulting increased federal budget deficit will likely lead to reduced national savings and higher interest rates over the long term.
Many provisions of the tax cuts to individuals expire in 2025--outside of our forecast horizon; together with the higher interest rates weighing on growth, the new tax plan looks to switch from stimulus to economic drag over the medium term. The sunset clause sets up a future administration for another fiscal cliff, faced with the tough decision to either let taxes reset back to higher ranges or extend the cuts. Barring spending cuts to pay for the tax cuts, the U.S. debt-to-GDP ratio is expected to rise above its already rising outlook, with an increasing debt level and interest costs eating up a greater share of the Federal budget.
In general, U.S. fiscal trends are for wider budget deficits and higher debt over the next decade, principally because of a rebound in interest costs and the impact of the aging population on mandatory spending--absent offsetting policy changes to tax or mandatory spending.
Overall, S&P Global economists now expect U.S. real GDP to be a bit stronger over the short run, with the tax package. But, given the fiscal multiplier from the tax package is likely to be no more than 0.4, the boost to real annual GDP growth this year and the next will be close to 0.3 percentage points. We expect the U.S. economy to grow 2.8% this year (was 2.6% in our November forecast report) and 2.2% in 2019 (was 1.9%). The near-term boost is largely driven by a pickup in consumer and business spending. We expect the growth trajectory to then converge back to its long-term trend, which we estimate to be 1.8%. But this comes at a cost to the fiscal accounts at a time when the budget deficit is already expected to rise over time, principally because of a rebound in interest costs and the impact of the aging population on mandatory spending. We see little impact on the unemployment rate or wage gains through 2020 from the tax package. Business investment will get a near-term boost. And, to the extent this adds to capital deepening and productivity enhancements, it should help lift the potential of the economy at the margin.