Economics, by definition, is not an exact science. You should, therefore, hate oversimplifications. But this, however, should make no one detract from trying to get a better grasp on these issues.
I, like many others, find that the myths going around are creating much confusion in an already complex subject. Much of it based on gut feelings, incomplete or incorrect information, etc., not to speak of all that partisan empty talk or even the recent blame-the-fed discourse by those who know little or not enough.
The consequences of economic malfunction are quite dangerous. Our business environment, our society, and livelihood are at stake.
We are not talking about a Harvard case study or a “test tube” in the economist’s head lab. The risks are real. Hence, the buck doesn’t stop at the Oval Office desk as Harry Truman’s slogan went; it “stops” deep into everyone’s pockets.
FISCAL DEFICIT
According to the Trump administration, the U.S. federal budget in 2018 rises to the highest in 6 years, after a spike last year. That’s a 17% increase from the previous fiscal period. I don’t know if all readers understand the magnitude of a 17% increase. It’s a huge increase in one year. That’s almost a 5th more of expenses from one year to the other. Right? What did the knowledgeable lawmakers have to say – particularly those that stand for fiscal discipline – about what they expected for 2018 after last year’s tax reform?
Quoting from GOP senior senator, Mitch McConnell, as late as December 2017, quote: “I not only think it will increase the deficit. I think it will be beyond revenue neutral. In other words, I think it will produce more than enough to fill that gap”. Mick Mulvaney, Director of the Office of Management and Budget, also stated: “America’s booming economy will create increased government revenues“. Their expectations proved wrong, very wrong. This type of speculation is extremely dangerous. So, what to do now? Obviously, find excuses. But what’s the problem with excuses?
First, it proves that they know they were very wrong in their expectations and it also proves that the deficit matters, otherwise excuses wouldn’t be necessary. As they know too well, the excuses will not address the insufficient increased revenues “projection”. The culprit will be the outlays. Typically: Medicaid, Social Security, and disaster relief. And, of course, they cannot deny increasing military expenditures as figures speak for themselves. But then please also keep in mind that the total increase in expenditures is up by 3.2%, not 17%, which is the deficit’s increase.
Is all that expense necessary? You can figure it out yourselves by considering that the U.S. military expenditure is larger than the ten other largest U.S. Federal expenditures combined.
But what if we break down the outlays. What was the increase in total military expenditure (enacted for 2018 versus real for 2017): 6.85 % But what did the Department of Defence (DoD) had in mind but was not allowed to do? For example, that among different proposals they should close down some bases, etc., and by that they were referring to what they meant was, or is, an excess capacity of 21%. Well, this – and other proposals – didn’t go through. One reason: the loss of civilian jobs in those military bases. Where? In some of the states from which those House of Representative elected members come from. The military would, therefore, have to reduce expenses by cutting on the number of soldiers. How significant is that? Let’s not forget that personnel expenditures are about one-third of the military budget. Military expenditure cutbacks were blocked when lawmakers added $180 billion to the limits imposed by sequestration for both the FY 2018 and FY 2019. Is all that expense necessary? You can figure it out yourselves by considering that the U.S. military expenditure is larger than the ten other largest U.S. Federal expenditures combined. And if you focus it more closely on other countries’ military expenditures, the U.S. military expenditure is four times that of China and ten times those of Russia.
Another very interesting fact in this equation is that military expenditure in the U.S. is larger than the following ten largest government expenditures combined. The only larger expenditure is Social Security. But how much? A figure of US$ 1046 trillion, an amount to which we can add Medicare and Medicaid, all of which are considered and referred to as mandatory expenditures. This said, keep also in mind – very important – that Social Security costs are covered 100% buy payroll taxes and interests and, very important, that the outlays on Social Security come from the Social Security Trust Fund that up until this year has been running on a surplus due to interests earned by the fund. This said the prospects for the fund are that the surplus will be depleted and it’s estimated that by 2035 only about 75% of the expenditures on Social Security will be covered by the Trust Fund.
Keep also in mind that the Social Security Fund Surplus is invested in U.S. Securities and that it’s in 2018 that the Fund (or, more exactly, funds) must cover its obligations by redeeming these Securities. The implication is that the amount of debt that is redeemed has to be replaced by foreign investors as long as the rest of the Federal Budget is running a deficit (and, as is the case, growing rapidly).
Not to leave anything out, Medicare is already underfunded, while Medicaid is 100% funded by the Fund.
So, we have talked about two groups of expenditures, mandatory and discretionary, the former being double the amount of the second group. Which is the third group? Interest on US Debt is the third group, which for this year is US$ 363 billion. But let’s keep in mind these additional two important facts, one being that Interest on US Debt is the fasting growing federal expense item, and second – in order to better understand its comparative dimension – that Medicaid runs at US$ 412 billion, though the latter is 100% covered by the general fund.
If the U.S. should default on its interest payments, or if the US debt is perceived as more risky, interest rates have to go up to compensate. That has been, and is, considered unthinkable.
So, back to our starting point: the deficit is growing and, since issuing debt finances the deficit, the interest on this debt will also climb, but not just because the deficit is growing, but because the interest on the debt is expected to rise too. Let’s face it, the only reason why anyone buys US Debt is because of the returns (the interest rate) and because US Debt is considered secure. If the U.S. should default on its interest payments, or if the US debt is perceived as more risky, interest rates have to go up to compensate. That has been, and is, considered unthinkable. But this said, throw in the whole equation a trade war, or create more international frictions, the question is: which effects will this have on the willingness of foreign investors and/or how can this affect interest rate in the Fed’s borrowing transactions? Keep in mind that US Debt (in terms of its GDP among OECD nations in 2017) is only behind Japan’s, Greece’s, Italy’s and Portugal, which is quite high debt ratio, all other comparisons aside.
And just how big is the US Debt? It’s above the GDP, that is, the total value of all goods and services produced in the US in any given year. This is considered a high debt ratio. We are reaching figures that are only comparable to the other high debt ratio peak: WWII. What are the main components of the GDP? The biggest is consumer spending, about two-thirds of the economy. The second is business investment. And then, a current account surplus also boosts the GDP. Hence, government spending is also a contributor, but always depending on how the money is spent. This said, when spending and the economy get heated up, inflation can require monetary discipline by way of higher interest rates, all of which could lead to an economic slowdown or turn down. This will take us to a whole new discussion.
Taking much of the above, there seem to be two very pertinent considerations. One is, last years tax reform, and the other is “trade wars”. Both of these have a huge impact on the economy, on the size of the deficit and the magnitude and the direction of US Debt (and its cost).
In this article, we will only attempt to consider last year’s Tax Reform in a given context.
TAX REFORM
Lower tax electoral promises sell well everywhere, not just in the U.S. The “one marshmallow now” beats the expectation of “two later”, which is what Walter Mischel’s gratification studies dealt with. What does this mean in term of tax reform and other economic indicators for the U.S.?
We start:
SAVING AND INVESTMENTS IN THE U.S, HAVE DECLINED SUBSTANTIALLY DURING THE LAST 40 YEARS. (In % of GDP). We shall briefly take a look at the implications.
So, we should ask: what are tax-reforms be geared for? For evident reasons most people are aware of:
- Stagnation in disposable income growth, if not a real decrease for many.
- Most people are highly in debt.
So, the easy immediate solution is lower taxes: the ONE MARSHMALLOW NOW kind of nation. But it’s not as easy as that if one understands the implications and how in the economy all things are related.
WHAT LOWER TAXES WILL NOT DO ON ITS OWN
Ever since Classicists’ monetarism felt into disgrace “Supply-side economics” – which is what has been in vogue for decades – focus more on inflation than on money supply, with the FED keeping tight control of the discount rate. With the prevailing low inflation and still falling it’s to be tempted that an overall tax overhaul (read: major tax decrease on both demand and supply side) will produce the economic stimulus everybody wants: more production, higher disposable income, increased consumption, more jobs and, voilà, economic growth.
SUPPLY SIDE TAX REFORM (Corporate taxes, allowances, etc.)
It’s not that simple to understand and much less to explain, but we should try keeping the following in mind: The basic idea is that by tax reform businesses are encouraged to invest. But in what do they invest? Which businesses are likely to follow such a course? What about if tax savings serve to increase dividends (increasing stock prices) or to repurchase stocks or invest overseas? The last scenario is what happened with Bush tax cuts and the TARP bailouts to create jobs. We will get back to that scenario on the demand side too by looking at the trickle-down theory further below.
Modern production related equipment is increasingly less labour intensive, with the labour intensive industries moving much of their production abroad.
So, what other factors should be kept in mind in order to understand the possible effects of supply-side tax reform? And when would business be inclined to invest and what would be the impact of such investment? And where does the investment come from, domestic or international investors. Traditional industries have moved from the “stage centre”, making room for the service industry and new technologies. That explains why the type of capital that has increased is “intellectual property”, not the labour-intensive type of capital. True, industrial equipment and other fixed assets need repair or replacement. But what new equipment would be talking about? Modern production related equipment is increasingly less labour intensive, with the labour intensive industries moving much of their production abroad. The trend toward automation will accelerate further. This is not a faith issue, it’s just the direction and speed by which business and technology are moving now.
