As we enter the era of Trumponomics, it is important to understand the difference between a well-articulated, -constructed and -executed fiscal stimulus and a poorly designed one.
Currently, unemployment is low, and the economy has not seen a recession in nearly seven years. Meanwhile, monetary policy is tightening, dampening some of the potential benefits. Simply, the U.S. economy now stands in a different place than is usually the case during the introduction of the typical fiscal package. Understanding where the economy sits is critical to getting the most bang for the added deficit buck.
It is tempting to draw parallels, but substantial differences exist between the current economic environment and the era of Reagonomics. In 1981, the United States fell into a recession. After seven years of expansion, it is debatable whether the United States is due for a recession soon. In an attempt to increase the size of their toolkit, the Fed is tightening monetary policy to combat the next recession, whenever it might be. President Reagan entered office after Volcker broke inflation, and fed funds were (for the most part) declining. The U.S. dollar hit a half-century peak in 1985, and proceeded to devalue rapidly in response to the 1985 Plaza Accord. This was an added tailwind to policies implemented. Today, the dollar is surging.
There is little question the Fed will be tightening over the next year or so (barring a recession). At least to some degree, this will undoubtedly dilute the overall impact of any stimulus package. The incoming administration will need to confront this reality.
The U.S. economy is not in crisis mode, but the U.S. economy is not growing as quickly as it was in the 1990s, and participation in the labor force is declining. This is also not the time of Reagan, when similar policy ideas were implemented. The Boomers are on their way out, and no longer the economic catalysts they once were. To a degree, this limits the effectiveness of infrastructure spending on employment; Boomers may not come back to participate in such a program.
President-elect Trump’s $1 trillion infrastructure proposal is substantial, but there are hurdles. For instance, the United States already passed an infrastructure bill in early 2016 at a much smaller $300 billion. This was a smaller package than the plan’s original $478 billion. The possibility of a package more than three times that size seems tenuous. Furthermore, with U.S. economic expansion well underway, it makes little sense to wait on an infrastructure plan. Infrastructure investment would have a direct employment benefit, and the U.S. economy will require it more earnestly during the next recession than it does presently.
The possible inability to push through an infrastructure package may be a good thing. Research findings consistently suggest that infrastructure spending is less stimulative than tax cuts. In a study by Alberto Alesina and Silva Ardagna spanning nearly forty years of fiscal adjustments across developed economies, they find fiscal stimulus done through tax cuts and paid for by spending cuts to be the most effective method of having a two-pronged, longer-term stimulus package that could effectively reinvigorate some demand and inflation for a time.
This may seem intuitive, but perhaps even more important is the timing and promotion of a fiscal package.
This is because the type of tax cuts and delivery matters. Not all tax cuts will stimulate in the same manner. Infrastructure spending, direct payments and tax cuts elicit different reactions depending on how they are packaged and delivered. The size of payments, their frequency, the permanence and length of policy shifts also plays into the effectiveness of a stimulus. Cutting taxes and having the outcome be effective at stimulating economic growth is not as straightforward as it might seem.
The importance of intentional design and delivery comes from the work of Richard Thaler, and his theory of mental accounting. The basic thrust of the theory, as applied to stimulus packages, is that people react differently to different sized stimuli. A large sum is more likely to be considered an asset, and smaller amounts treated as income. A study by Graziani, van der Klaauw, and Zafar found that when people considered the “lump sum” of the 2011 payroll tax cut, they intended to spend 10–18 percent of it. But after it was doled out in pieces, they spent far more: 28–43 percent. Mental accounting matters.
For individuals, incremental, small pieces are more likely to be considered income, and less likely to be saved or used to pay down debt. Lump sums or a dramatic drop in marginal rates may not be the most effective route. In other words, a shock amount would be less effective than a steady increase. As politicians consider designing a new tax policy, they must keep this in mind.
If the current tax proposal were unaltered, it would result in a significant drop in rates. If the new administration wants maximum effectiveness, it should slowly and steadily phase in the new, lower tax rates. Done all at once, the tax cuts may not be as successful as they could be otherwise.
One reason the phase-in may be worth considering is the amount of reduction on the higher income tax brackets. While the percentage decrease declines at the top, the dollar amounts will be much larger. The likelihood is consumers will treat these windfalls as assets instead of as income. And, if spent, those larger upper bracket tax cuts could be a primary driver of a successfully implemented plan.
By implementing the tax cuts through a stepdown—say 25 percent of the total per year, the digestion may feel more like income than an asset. With about one trillion of expected budgetary impact, the implementation of personal income tax policy will be critical to the overall success or failure of Trumponomics. Yes, corporate tax policy is important as well, but the loopholes make an assessment onerous and inaccurate, rendering increases to potential growth inestimable.
The United States cannot afford to have tax cuts and infrastructure spending that do not generate substantial benefits. The deficits and resulting debt will simply become too burdensome over time, and will further reduce growth in the future. Slow and steady cuts are the best path to making America spend again.
Samuel Rines is the Senior Economist and Portfolio Strategist with Avalon Advisors in Houston, TX.
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