Sugar high is right diagnosis, tax cuts are the wrong prescription

December 10th, 2017

The approaching end of President Trump’s first year in office, another strong employment report and a still-strong stock market make it appropriate to revisit my year-old judgment that the economy is enjoying a “sugar high.” Unfortunately, the best available evidence suggests that signs of current market and economic strength are largely unrelated to government policy, that the drivers of this year’s economic strength are likely transient and that the structural foundation of the U.S. economy is weakening. Sugar high remains the right diagnosis, and tax cuts are very much the wrong prescription.

Growth in the four quarters of 2017 now looks likely to come in at 2.3 percent, marginally faster than the consensus just before the president’s election. Consensus expectations for 2018 are only marginally greater today than they were before the election. So there has been no substantial updraft in the economy. In fact the United States has trailed the global economy in the sense that other countries, notably in Europe, have seen greater upward forecast revisions.

The U.S. stock market has been very strong, rising by close to 25 percent since the election, which is far more than most observers expected a year ago. This appears to be heavily driven by increases in corporate profits. But performance is running behind Japan and Germany, belying the idea that the market is being driven by U.S.-specific policy factors.

The idea that U.S. fundamentals have importantly improved since the election is further called into question by the observation that the dollar has declined by 8 percent against the yen and 7 percent against the euro. If something fundamental had happened to improve the U.S. business environment, we would have seen capital inflows and an appreciating currency.

Is the growth the United States has seen in 2017 sustainable over the medium term? This seems unlikely, from both supply- and demand-side perspectives. From the supply side, it is hard to imagine that, with 4.1 percent unemployment, the economy can continue creating anything like 200,000 jobs a month, given that normal growth in the labor force is about 60,000 people. From the demand side, this year’s growth was driven in significant part by a more than $6 trillion increase in household wealth from the stock market rally. Even if the market holds its level, similar wealth increments cannot be expected on a regular basis in the future.

Such poor prospects for sustained rapid growth are not surprising given the economy’s weak foundation. Despite record-low capital costs and abundant corporate cash as inducements to investment, productivity growth has been slow. Even very innovative companies such as Apple and Google cannot find enough high-return investments and so choose to engage in large-scale share repurchases. Given record profits and low capital costs, it seems more plausible to blame poor productivity performance on insufficient public investment rather than inadequate incentives for private investment.

This is a major issue because, given slow labor-force growth, a substantial acceleration in productivity growth will be needed to even just maintain the economy’s rate of expansion in the years ahead.

Even if growth can somehow be maintained or accelerated, it is foundational for a healthy economy that its benefits be widely shared. Unfortunately, the tendency has been very different in the United States. Inequality has steadily increased, and much of the growth that has taken place has been captured by a small share of the population. This is a reflection of both increased dispersions in pre-tax income and the inadequate progressivity of the tax and transfer system.

There will be no meaningful and sustained growth in workers’ take-home pay without successful measures both to raise productivity growth and to achieve greater equality. Only in this way can we achieve healthy growth.

The tax-cut legislation now in conference committee on Capitol Hill exacerbates every important problem it claims to address, most importantly by leaving the federal government with an entirely inadequate revenue base. The bipartisan Simpson-Bowles budget commission was surely not biased toward big government. Yet it concluded that the federal government needed a revenue base equal to 21 percent of gross domestic product. The tax-cut legislation now under consideration would leave the federal government with a revenue basis of 17 percent of GDP – a difference that works out to $1 trillion a year within the budget window.

This will further starve already inadequate levels of public investment in infrastructure, human capital and science. It will likely mean further cuts in safety-net programs and cause more people to fall behind. And because it will also mean higher deficits and capital costs, it will likely crowd out as much private investment as it stimulates.

Tax cuts may prolong the sugar high a bit. But they are no substitute for the new economic foundation we desperately need.