Republican Tax Plan: Will It Work?

Michael Kurth Thursday, February 15, 2018 Comments Off on Republican Tax Plan: Will It Work?
Republican Tax Plan: Will It Work?

I am writing this on the eve of President Trump’s second State of the Union address to Congress. I don’t know what he will say in his speech, but everyone expects him to praise the tax cut recently enacted by congressional Republicans and make bold predictions about how he is restoring the United States to economic greatness.

Investors appear to believe him, as week after week the stock market sets record highs.

But are the expectations of investors a good predictor of economic performance or simply an assessment of what other investors are doing? In other words, if investors believe other investors are buying, they are going to buy; and if other investors are selling, they are also going to sell.

During the 1920s, investors were similarly euphoric as the Dow-Jones index tripled in value, reaching a record high of $330 in 1929. And why shouldn’t they have been optimistic? We were on the verge of scientific revolution, with combustion engines, aviation, radio, telephones. There were so many investment opportunities …

But then the wheels fell off our economic wagon.

Did the stock market crash cause the Great Depression?

Most economists point to two factors. The first was the Smoot-Hawley Tariff Act passed by Congress on June 17, 1930, raising the tariff on more than 20,000 imported goods in an effort to protect U.S. industries and jobs from foreign competition, but instead setting off a trade war that collapsed world trade and left many of our factories shuttered, their workers standing in breadlines.

The second factor was that the Federal Reserve Bank raised the reserve requirement for banks, forcing them to call in loans and triggering a decade of deflation.

Then there was the bubble that saw the NASDAQ index rise from 900 in 1995 to over 5,000 in 2000, only to burst and lose 80 percent of its value over the next year.

And more recently, there was the housing bubble, when the Dow hit a record high of 14,164 on October 9, 2007, and closed at 6,594 just 18 months later.

I’m not suggesting the current record-high stock prices are entirely a bubble. President Trump removed many regulations that were shackling our producers and sending them to seek less stringent government regulation overseas.  Deregulation is a supply-side stimulus that affects how companies operate as well as their bottom line.  Tax cuts, on the other hand, have traditionally been used by governments as a fiscal stimulus; a means of putting more money into people’s hands to stimulate demand.

When Ronald Reagan was elected in 1980, he inherited a terrible economic situation from President Jimmy Carter: inflation was approaching 20 percent, mortgage interest rates were 18.5 percent, and the unemployment rate was 11 percent. Carter had been pumping more and more money into the economy to stimulate spending in the belief this would lead companies to hire more workers. He was wrong. The practice led to higher prices and higher unemployment.

Reagan’s approach — what became known as “Reaganomics” — was to stop pumping money into the economy and end inflation, deregulate industry to stimulate production, then pass tax cuts to stimulate both supply and demand. It worked, and after two years the economy took off.

The economy Donald Trump inherited from President Obama is very different from the one Reagan inherited from Carter. When Trump entered office in January, 2017, the inflation rate was 2.1 percent; a 30-year mortgage was 4.2 percent; the unemployment rate was 4.8 percent; and the Dow Jones average broke the 20,000 mark for the first time in history. (It was 18,160 one week before Trump’s surprising election as president, so the increase after that might be part of “the Trump Bump” even though he was not yet in office.)

That doesn’t mean that everything in the economy was hunky-dory. Obama had achieved low unemployment by keeping the real interest rate (the difference between the nominal interest rate and inflation) close to zero and borrowing heavily from foreign lenders to finance transfer programs and the mushrooming federal bureaucracy. Our growing federal budget deficits were competing with our export of goods and services for foreign dollars, expanding our trade deficit. Our heavily subsidized schools were teaching students subjects that had little market value, so business and industry had to go overseas to find people educated in the STEM fields (science, technology, engineering and mathematics). And the growing federal bureaucracy stifled business and industry. But the economy Donald Trump stepped into did not appear to need a large infusion of money to stimulate demand.

When more money chases a limited amount of goods, the predictable outcome is higher prices, which in turn usually mean higher interest rates and a weaker dollar in international trade. You may think an increase in interest rates from 4 to 6 percent is no big deal. But for someone buying a home, it is roughly a 25 percent increase in their monthly mortgage payment.

A weaker dollar in foreign trade (the dollar has fallen 10 percent over the past year) may be good for our exporting industries, but it also means consumers will pay 10 percent more for imported goods at the store.

Getting rid of low-skilled, low-wage immigrant workers may increase the wages of low-skilled native workers, but it will also increase the price of the goods and services those workers provide.

I wish I could come to a different conclusion, but I can’t talk myself into it.

The problem this presents for the Republicans is that they, quite naturally, want to tout their economic achievements before the midterm elections in November. But in doing so, they risk setting the bar too high by building up unrealistic expectations of future growth and prosperity.

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