The GOP Tax Cut: A Wrong-way turn?

Donald Trump and the GOP’s greatest victory has been their tax cut, aimed mainly at corporations and the rich, but promising to boost the entire economy.

Yet this is increasingly looking like an own goal — and not just because of the optics of how the law favors the wealthy.  Rather, errors in the conception and implementation of this tax cut may be bringing the economy to a halt, rather than creating the desired boost.

70% of US economy activity is provided by consumer spending.  The rest is government spending and investment.  Government spending will go up slightly, but mostly for military procurement.  The tax cut to the rich and corporations was supposed to go into investment spending, but in fact — as was predicted — the greatest part of the corporate tax gains are going into stock buy-backs and increased dividends.  The rich stockholders, executives and investors who benefit the most from all this are not big consumer spenders.  There are too few of them, and while they will spend some of their gains, much goes into overseas travel and property and imported luxury goods, while the rest goes into savings.  The vast majority of Americans, whose spending needs to grow by 3-4% to give the economy a real boost, are getting too little in direct tax cut benefits to raise their spending that much.  And with unions having been destroyed by decades of anti-union policies, workers have no way to pressure companies to direct a larger share of corporate tax benefits to workers’ salaries.

Now, let us put the minimal spending boost created by the tax cut against the headwinds that the economy faces, some created by the GOP tax bill.  First, the demographics are negative for growth.  More and more baby-boomers are retiring, reducing their spending.  Millennials, though a large cohort, are not enthusiastic spenders.  They acquire fewer cars and acquire them later; are buying homes later and instead favoring urban apartments.  Those among them with the best earning potential, namely college graduates, are typically burdened with large college loans.  And they are not (yet) having children — American fertility has fallen to an all-time low, while thanks to Trump policies, immigration has fallen as well. So the basic growth in demand that comes from family formation and population growth is absent.

Second, the tax cut bill imposes the most pain on the most vigorous consumers.  These are households with incomes from $100,000 to $400,000 per year.  Those with smaller incomes are just getting by and, even if optimistic, cannot easily boost their discretionary spending.  It is the higher income group that is most likely to increase its target level of spending in response to rising optimism about their economic prospects.  Yet it is precisely this group that was most hurt by certain provisions of the GOP tax bill, namely the limits on deductions of home mortgage interest and of state and local property and income taxes.  Consumers in this income bracket are likely to either cut back spending or hold fast until they learn how these changes affect them.  For most it will be obvious that their taxes will be higher, not lower, given the loss of these deductions.

Third, the rush to deliver the tax bill before Christmas means that the over 600 page bill was stuffed with errors and provisions with unforeseen consequences.  Many of these errors actually hurt certain industries by changing depreciation schedules and other accounting rules, while others open huge loopholes that will reduce anticipated government tax revenues.  Republicans will need Democratic help to fix the glitches and errors in the law, but Democrats are unlikely to cooperate.  Given that Republicans refused to help Democrats make improvements and fixes to Obamacare after it was passed, Democrats will probably just let these errors fester, and leave Republicans to deal with the consequences of what they have wrought.

Fourth, the fact that the tax bill will boost the government deficit by $1.5 trillion is already driving interest rates up.  This will damp down interest-sensitive sectors such as homes, cars, and construction, and even the discretionary spending that used to be financed by once-deductible (but no longer) home equity loans.  Indeed, given the change in deduction rules and rising interest rates, a home equity line of credit loan that would have had an after-tax interest rate of about 2% per year for a high-income homeowner in 2015 now has an after tax interest rate of 5% per year.

Fifth, and perhaps most important, we are late in the business cycle.  Unemployment has been at record low levels for almost a year.  The recovery from the Great Recession is a decade old, meaning that most people who wanted new cars or new homes have already acquired them.  There is neither pent-up demand from past recession-crimped spending nor from new population growth.  In many areas, the past momentum of housing construction has shot past new demand (in my local area of Reston, apartments are offering discounts of several months free rent on new leases).

The late point in the business cycle also means that we are sitting on years of steady stock-market gains that now may have come to an end.  When the market was shooting upwards, consumers could anticipate future gains and plan to increase their future spending accordingly.  But it is now possible that because of rising interest rates and high valuations, the rapid rise in equity prices is over.  Indeed, since February, the stock market has peaked and stagnated.  If it does not resume its upward climb, much discretionary income will go back into saving rather than consumption.

Some of these headwinds — demographic conditions and the timing of the business cycle — have nothing to do with the GOP tax law.   But other negatives — the limited deductions on state/local taxes and mortgages, the errors in the new law, and the rise in interest rates — are directly due to how the GOP wrote and passed their tax bill.  The combination of these factors, with business cycle and demographic dampers exacerbated by the effects of the new tax law, could drive consumer spending to a halt.  Ironically, far from achieving its goal of boosting growth to new highs, the GOP tax law could drop US economic growth well below 2% per year.  If one adds the impact of uncertainty and penalties over tariffs and a possible trade war, the economy could even spin into reverse.

GOP enthusiasts are fond of saying that the data on the economy have never been better.  Jobs are plentiful, people are entering the labor force, consumer confidence is at all-time highs, as is the stock market.  What could go wrong?

The problem is obvious — all these “feel good” factors are NOT translating into increases in wages or in spending.  For every baby-boomer who retires from a high salary position and is replaced by a millennial at half their salary, spending goes down.  Confidence may be rising among consumers, but until they receive substantially higher wages, they can’t act on it.  Most consumers are not getting significant wage increases, while the consumers most crucial for discretionary spending are being hurt by the tax law, not helped.

The data are already showing these effects.  For the first time since 2012, retail spending has fallen for three consecutive months.  Spending on cars and furniture and electronics all went down.

Far from bursting with energy, the consumer economy — and hence the economy as a whole — is teetering on the edge.  Any major new blow: a trade war, a political crisis, a stock-market correction, could send consumers into a deep freeze and trigger a recession.   The GOP tax law may have achieved its primary goal, which was to shower benefits on wealthy GOP supporters.  But far from providing a broad boost to economic growth, it has stacked the odds higher against US consumers.   The GOP may yet regret this legislative success.

About jackgoldstone

Hazel Professor of Public Policy at George Mason University
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