“Our country needs a good ‘shutdown’ in September to fix mess!”
Donald J. Trump
The current US debt ceiling is set at $19.8trn. Debt levels are already close to that level, and special accounting measures have already been implemented by the US Treasury. This year alone total federal expenditures will be $3.7trn – leaving a tax shortfall of $559bn. Meanwhile, last week, Treasury Secretary, Mnuchin announced the long-awaited tax cut plan. It included a proposal to reduce the US corporate tax rate to 15% from the current level of 35%. This, it is estimated by the Committee for a Responsible Federal Budget, will increase the government deficit by $5.5trn over the next decade.
The Trump administration’s other spending plans remain on the agenda, including $1trn for infrastructure, $54bn for the military and – assuming the Mexican’s can’t pay and won’t pay – $10bn for the Southern Border Wall.
How can this possibly add up? Through spending cuts, is the simple answer. Cuts have already been made to the budget for the Environmental Protection Agency, Inland Revenue Service and Department of Education but around 65% of government expenditure, in areas such as welfare and healthcare, have been ring-fenced – they will remain off-limits. Balancing the books is going to be an awesome conjuring trick.
Even by the more conservative estimates of the Tax Foundation, the proposed tax cut will cost $2.2trn over the next 10 years. They estimate economic growth would increase by 0.4% as a result of the tax reduction but point out that +0.9% annual GDP growth is required to offset the estimated decline in tax revenues. The sums do not appear to balance.
The chart below looks at US investment as a percentage of GDP going back to 1950, the era of Reaganomics (1981-1989) when the last substantial tax cuts occurred, suggests that the positive impact of tax reduction on economic growth, if Art Laffer is correct, may be, to borrow a phrase from Milton Friedman, long and variable:
The Cato Institute – Lessons from the Reagan Tax Cuts which was published at this week, makes a number of observations (see below) but this chart, showing the GDP growth in the Reagan and Obama recessions, is instructive:
One may argue that the Reagan period was an era of much higher inflation and therefore dispute the real-GDP growth differential, but the Cato Institute produce further evidence to support their argument, that tax cuts boost economic growth. Here are some of the highlights:
Lesson #1: Lower Tax Rates Can Boost Growth
One can draw some conclusions by looking at how low-tax economies such as Singapore and Hong Kong outperform the United States. Or one can compare growth in the United States with the economic stagnation in high-tax Europe.
One can also compare growth during the Reagan years with the economic malaise of the 1970s.
Moreover, there’s lots of academic evidence showing that lower tax rates lead to better economic performance. The bottom line is that people respond to incentives. When tax rates climb, there’s more “deadweight loss” in the economy. So when tax rates fall, output increases.
Lesson #2: Some Tax Cuts “Pay for Themselves”
The key insight of the Laffer Curve is not that tax cuts are self-financing. Instead, the lesson is simply that certain tax cuts (i.e., lower marginal rates on productive behaviour) lead to more economic activity. Which is another way of saying that certain tax cuts lead to more taxable income.
It’s then an empirical issue to assess the level of revenue feedback.
In the vast majority of the cases, the revenue feedback caused by more taxable income isn’t enough to offset the revenue loss associated with lower tax rates. However, there is very strong evidence that upper-income taxpayers actually paid more to the IRS because of the Reagan tax cuts.
This is presumably because wealthier taxpayers have much greater ability to control the timing, level, and composition of their income.
Lesson #3: Reagan Put the United States on a Path to Fiscal Balance
As explained above, it is wrong to blame the Reagan tax cuts for the recession-driven deficits of the early 1980s. Indeed, most leftists will probably privately agree with that assessment.
But there’s still a widespread belief that Reagan’s tax policy put the United States on an unsustainable fiscal path.
Yet, the Congressional Budget Office, as Reagan left office in early 1989, projected that budget deficits, which had been consistently shrinking as a share of GDP, would continue to shrink if Reagan’s policies were left in place.
Moreover, the deficit was falling because government spending was projected to grow slower than the private sector, which is the key to good fiscal policy.
The Border Tax
One of the ways the Trump administration intends to balance the books is through the imposition of border taxes. They may become embroiled in the quagmire of legal challenges, that they are in contravention of World Trade Organisation rules, but that topic is better left for another time.
This February 2017 article from the Peterson Institute – PIIE Debates Border Adjustment Tax is an excellent primer on the pros and cons of this controversial policy proposal. The Peterson conference delegates did manage to concur that the corporate tax rate should be lower – the Trump proposal would merely bring the rate in line with the current level of corporate tax in Germany. The delegates also agreed that some form of ad valorem tax should be introduced to make up the tax shortfall, although they accepted that this would directly encroach on individual State taxation systems. Peterson’s Adam Posen raised the valid concern that VAT tends to fall most heavily upon the poorest in society, thus increasing income inequality still further. Adjusting the tax system is always fraught with dangers.
At the heart of the Peterson debate was the impact a Border Adjustment Tax (BAT) would have on US businesses:
The chart below shows net exports to total trade in a sector, relative to how labour intensive the sector is. The size of the bubbles reflects the size of total trade in the sector. Two things are important: (1) Most industries are net importers. Thus, they believe they will be forced to raise prices under the proposal. (2) The industries that will gain the most—those with a relatively high labour cost share and positive net exports—are largely absent in the United States. The aerospace industry is the lone exception. This breakdown implies that many more big lobbies will be against the BAT than in favour.
BAT revenues are estimated to be around $100bn per annum, about half the cost of the corporate tax cut, using the more conservative Tax Foundation estimate. However, this assumes that the trade deficit remains unchanged in response to the imposition of BAT. Whilst some countries will see their currencies decline versus the dollar, the recent plight of the Mexican Peso begs caution. It depreciated from USDMXN 18.2 to 21 versus the dollar in the aftermath of the US election but has since recovered to around USDMXN 19.
Financial Market Response and Investment Opportunities
The table below shows the level of the Dollar Index, S&P 500 Stock Index and the US 10yr Government Bond Yield on elections week and yesterday:
It is worth noting that the Dollar Index initially strengthened into the end of 2016, testing 104. It has subsequently moderated. 10yr bond yields also rose sharply, reaching 2.64%, but have since consolidated. It is the US stock market, which continues to achieve new all-time highs, which maintains faith in the pro-business credentials of the new administration.
The US bond market is dogged by the twin concerns of the fiscal profligacy of the government on the one hand and the hawkish intentions of the Federal Reserve, determined to normalise interest rates whilst they still can, on the other.
US GDP growth moderated in Q1. Commodity prices for staples, such as iron ore, copper and oil have diminished, as Chinese demand has waned of late. Meanwhile, rising purchasing managers indices seem to be correlating with a rise in inventories. Personal income continues to growth slowly, and personal savings has remained subdued, household debt to GDP is rising slightly, but it remains well below the levels seen early in the decade. Consumers are unlikely to increase spending dramatically until they are more confident about long-term employment prospects.
The author wrote, last month about the impact of technology on jobs, in Will technology change the prospects for emerging market growth? The impact on developed market employment will also be profound, but it is also influencing the consumers’ response to higher prices. As prices rise, demand will fall. Central banks should not target an inflation rate because it distorts the efficient working of the economy, but wage inflation, about which they are inclined to obsess, is likely to be subdued for a protracted period – years rather than months – by the effects of new technology.
Where does this leave stocks and bonds? Bond yields may rise if the US government deficit explodes: and a significant increase in bond yields will inevitably detract from the allure of the stock market. For the present, however, stocks are continuing to see new highs – the Nasdaq finally breached its, dot-com induced, 2000 highs at the end of April, after sixteen years – S&P 500 valuations are high (a PE of 23 times and a CAPE of 27 times earnings) and yet “Buy American, Hire American” is a compelling slogan.
As an international firm, hoping to continue selling your products to the United States, it makes sense to invest there. Pro-business US economic policy will continue to drive US stocks: the words of Pink Floyd spring to mind… one calls it riding the gravy train.
Bulletproof Clothing: How US Fashion Is Going Ballistic
As the US continues to allow civilians to carry weapons and gun violence becomes more of a concern, an increasing number of bulletproof apparel retailers are emerging across the country. Their target clients? The average Joe. Or at least those who can afford the hefty price tags associated with the “exotic” new fashion segment.
Miguel Caballero, a Colombian designer, sells his bulletproof blazers for 4,343.50 euros, and his tank tops for 2,023 euros. At a lower price, but still too high for most people, Joe Curran, who owns BulletBlocker, sells his bulletproof leather jacket for $875 and bulletproof classic two-piece suit for $1,200.
Caballero said that his clients include world leaders from South America and the Middle East, and international businessmen. Damien Ross, another manufacturer of bulletproof clothing, said that his clients are mostly college-educated, professional men, between the ages of 34 and 75.
“They [clients] see what’s happening on the news, and, any time they’re in a crowd or an area that can be prone to attack, they are concerned.”
Body armour manufacturing is a $465 million-a-year industry in the US, according to a report in August from Market Research. The retailers, who mostly entered the industry because of the surge in gun violence taking place around them, are presenting upscale bulletproof clothing, from blazers to tank tops.
Owning body armour is completely legal, and does not require a special permit or background check. However, guidelines vary from state-to-state, and felons are not able to purchase it.
Trump Promises Tax Cut “for Christmas”
US President Donald Trump has said the country is “just days away” from the biggest tax reform since the Reagan administration. Speaking at the White House, Trump said he was close to fulfilling his campaign promise “to cut taxes for the everyday working American” and that he wanted “to give [the American people] a giant tax cut for Christmas”.
As a candidate, I promised we would pass a massive tax cut for the everyday, working Americans. If you make your voices heard, this moment will be forever remembered as a great new beginning – the dawn of a brilliant American future shining with PATRIOTISM, PROSPERITY AND PRIDE! pic.twitter.com/exsBzrlCdw
— Donald J. Trump (@realDonaldTrump) December 14, 2017
This week, Republicans and Democrats have reached an agreement on the two different tax bills that were rapidly pushed through Congress last month. If passed, it will be the first significant piece of legislation passed by the Trump administration. The compromise reached by both parties will see a corporate tax cut from 35% to 21% and cap the top tax rate for individuals at 37%.
Following a Democrat victory in Alabama’s senatorial election on Tuesday, the GOP was left with a majority of just 51 out of 100 in the upper house. As such, the Republicans are pushing for a vote on the tax bill for early next week, before the newly-elected Doug Jones can take his seat in Congress.
Tax reform was a keystone in Trump’s electoral campaign and success here would allow other tax deductions at a state and local level to work. It would also give Trump a chance to reverse his low approval ratings which have averaged at 39%, which makes him one of the most unpopular Presidents in the history of political polling.
Venezuelan Digital Currency Backed by Oil
Venezuela has announced plans to launch a digital currency, “the petro”, backed by the country’s oil and mineral reserves. The petro aims to help ease the country’s monetary crisis but sceptics claim the proposal has no credibility and will not help those in extreme need.
Why It’s Important
Hyperinflation has eroded the Venezuelan bolivia’s value by 97% this year, making imports incredibly expensive and causing many to abandon trust in the currency. The country’s oil reserves made up 95% of its exports in 2016, while oil and gas extraction accounted for 25% of GDP. Rich supplies of resources provide some initial credibility to the proposal, but President Maduro’s questionable track record when it comes to monetary policy is making many sceptical about the proposal. His currency controls and money printing have only added to the monetary crisis. Maduro has not announced when the digital currency would come into use or any details regarding how the country would create such a system.
Opposition leaders argue the country’s shortages of food and medication are far more pressing and that the digital currency will not address this. The digital currency may provide a more trusted medium of exchange, but it is unlikely to help those in excessive poverty.
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